What’s the Deal? (A)

(thirteenth of a series)

By Frank Demmler

Last week we looked at a process by which a first-time entrepreneur can increase the likelihood of successfully attracting money. In it I referenced getting commitments from investors.

“Commitments to what?” you might well ask. A dollar amount, sure. But what is their money buying? What’s the deal?

Unlike institutional investors who almost always purchase preferred stock, in the private investor arena, deal structures are only limited by the imaginations of the involved parties, and the legal environment in which they are struck.

WEEKLY WARNING: I am not an attorney. Some of what I’m about to write could violate securities laws if not done correctly. Make sure your attorney is aware of what you are doing.

Range of Private Investors

As pointed out in prior columns, private investors are not all the same, and in fact, differ along many dimensions: how well they know you; how well they know the business; how much experience they have investing in early stage companies; how those prior investments have worked out; their net worth; and their risk tolerance, among other characteristics.

As it relates to deal structure, we can define the two extreme poles of return expectations and then look at how deal structures might accommodate these different desires.

At one pole is the risk averse individual who primarily wants to lock in a cash-on-cash return that is better than what he can get from conventional sources, i.e., CDs or money market funds. Losing their principal amount is not something that they want to consider.

At the other pole is the gambler. He is willing to lose 100% of his principal, as long as the potential upside is a “home run.” Mixing metaphors, he’s willing to roll the dice and hopes he doesn’t crap out, but will be philosophical if he does.

Most people fall somewhere in between.

Range of deal structures

Let’s take a look at how all of this can play out.

Notes with interest: There have been occasions in which a private investor is willing to lend the company money at some interest rate higher than what the investor is getting elsewhere.

This is rare. Think about it. A bank will lend a company money if it has sustained a record of profitability; if it has the ability to pay the debt service; and if it has sufficient assets the liquidation value of which will collateralize the loan (and, in many circumstances, if you provide a personal guarantee).

The people who will consider this form of investment are likely to be unsophisticated and not fully appreciate the risk involved in investing in early stage businesses, or people who are not investing primarily for financial purposes (friends, family, etc.). A note from a company is a security, and does need to meet securities laws, filings, and reporting requirements.

Notes with interest and warrants: One way to address the riskiness of this type of loan is to offer warrants. A warrant is the right to buy stock in a company at a price that is determined today but can be exercised until some time in the future. For example, if the price were set at $1.00 per share and the company was sold at a later date, the investor could exercise the warrant at the time of the acquisition at $1.00 per share and get an immediate $9.00 per share gain.

Unlike a conventional note, this investment structure does involve selling equity, albeit at some future date.

Convertible notes: One of the benefits of notes is that if the company were to face an unpleasant ending, notes are higher in the pecking order for repayment in the case of liquidation or some similar event. A convertible note addresses these concerns. It is a note, with stated interest, but it may be converted into stock by the investor based upon some predefined circumstances, such as a following round of equity investment, and on terms that have been negotiated (usually a discount to the price per share of the equity round, or warrant coverage).

Convertible notes are often used if you think there’s a compelling reason to avoid placing a valuation on the company at the time of the transaction. For example, if the company has received investment interest from a venture capital firm, but is only willing to proceed when certain accomplishments have been achieved (such as customer acceptance of a product or a patent issued). You will argue to the private investor that putting a value on the company today will establish a lower baseline from which the venture capital firm will establish its value for the next round. By doing a convertible note, you will add, the investor gets into a deal with an almost guaranteed return (the discount or warrants) with very little risk.

Moving along the continuum, this structure is a commitment to sell equity, with many of the terms of the equity predetermined.

Convertible preferred stock: We have discussed this in prior weeks in the context of venture capital. This is the sale of equity. The preferred nature of the security has many significant features associated with it; including a preference in receiving proceeds from any exit other than a qualifying initial public offering, and various protective provisions that require investor approval for certain actions by the company.

Common stock: This is plain old vanilla stock in the company. Everybody’s equal. If the company does well, everybody does well. If it doesn’t, everyone suffers equally. That’s the way it’s presented, at least.

The reality can be much different. If you don’t manage the company so that an investor exit is likely, then what? Dividends? Law suits? Disintegration of friendships? [I’m probably being overly dramatic, but as they say, “The road to Hell is paved with good intentions.]

As the preceding should illustrate, the types of deal structures that can be used with private investors are many. Attitudes about sharing equity, the distribution of risk and reward, and sophistication of the parties involved will impact what deals are acceptable to you, and what types of investors will be willing to participate in such deals.

Advice to Entrepreneurs

Private investors are a varied group of individuals.
Deals can be structured to accommodate these differences.
You need to understand the implications of different structures and select the ones that are acceptable to you.
Take the results of this exercise and map it into the fund raising process presented last week to launch a successful fund raising campaign.
Surround yourself with professionals, mentors, and advisors who can help you level the playing field.

Next week we’ll look at other deal structures that might be employed with private investors.

Frank Demmler (fd0n@andrew.cmu.edu) is Associate Teaching Professor of Entrepreneurship at the Donald H. Jones Center for Entrepreneurship at Carnegie Mellon University. (http://web.gsia.cmu.edu/display_faculty.aspx?id=168)