HOW TO STRUCTURE A DEAL
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What Is a Deal?
Deals are economic agreements between at least two people. In the context of entrepreneurial finance, most deals involve the allocation of cash flow streams (with respect to both amount and timing), the allocation of risk, and hence the allocation of value between different groups. For instance, deals can be made between suppliers and users of capital, or between management and employees of a venture.
To assess and to design long-lived deals, the following series of questions are a guide for deal makers in structuring and in understanding how deals evolve:
Who are the players?
What are their goals and objectives?
What risks do they perceive and how have these risks been managed?
What problems do they perceive?
How much do they have invested, both in absolute terms, at cost and at market value?
What is the context surrounding the current decision?
What is the form of their current investment or claim on the company?
What power do they have to act? To precipitate change?
What real options do they have? How long does it take them to act?
What credible threats do they have?
How and from whom do they get information?
What will be the value of their claim under different scenarios?
How can they get value for their claims?
To what degree can the appropriate value from another party?
How much uncertainty characterizes the situation?
What are the rules of the game (tax, legislative)?
What is the context (e.g., state of economy, capital markets, industry specifics) at the current time? How us the context exposed to change?
The Characteristics of Successful Deals
While deal making is ultimately a combination of art and science, it is possible to describe some of the characteristics of deals that have proven successful over time:
They are simple.
They are robust (they do not fall apart when there are minor deviations from projections).
They are organic (They are not immutable).
They take into account the incentives of each party to the deal under a variety of circumstances.
They provide mechanisms for communications and interpretation.
They are based primarily on trust rather than on legalese.
They are not patently unfair.
They do not make it too difficult to raise additional capital.
They match the needs of the user of capital with the needs of the supplier.
They reveal information about each party (e.g., their faith in their ability to deliver on the promises).
They allow for the arrival of new information before financing is required.
They do not preserve discontinuities (e.g, boundary conditions that will evoke dysfunctional behaviour on the parts of the agents or principals).
They consider the fact that it takes time to raise money.
They improve the chances of success for the venture.
Elements of Deals
A number of terms govern value distribution, as well as basic definitions, assumptions, performance incentives, rights, and obligations. The deal should also cover the basic mechanisms for transmitting timely, credible information. representations and warranties, plus negative and positive covenants, will also be part of the deal structure. Additionally, default clauses and remedial action clauses are appropriate in most deals.
Tools for Managing Risk/Reward
In a deal, the claims on cash and equity are prioritized by the players. Some of the tools available to the players are common stock, partnerships, preferred stock (dividend and liquidation preference), debt (secured, unsecured, personally guaranteed, or convertible performance conditional pricing (ratchets or positive incentives), puts and calls, warrants, and cash. Some of the critical aspects of a deal go beyond just the money:
Number, type, and mix of stocks (and perhaps of stock and debt) and various features that may go with them (such as puts) that affect the investor’s rate of return.
The amount and timing of take-downs, conversions, and the like.
Interest rates on debt or preferred shares.
The number of seats, and who actually will represent investors, on the board of directors.
Possible changes in the management team and in the composition of the board.
Registration rights for investor’s stock( in the case of a registered public offering).
Rights of first refusal granted to the investor on subsequent private placements or an IPO.
Employment, non-compete, and proprietary rights agreements.
The payment of legal, accounting, consulting , or other fees connected with putting the deal together.
Specific performance targets for revenues, expenses, market penetration , and the like, by certain target dates.
Negotiations
Negotiations are a back-and-forth communication designed to reach an agreement when you and the other side have some interests that are shared and others that are opposed. Far more are negotiated than entrepreneurs think. During the negotiation, the investors will be evaluating the skills, intelligence, and maturity of the entrepreneur. The entrepreneur has precisely has the same opportunity to size up the investor. If the investor sees anything that shakes their confidence of trust, they probably will withdraw from the deal.
Similarly, if an investor turns out to be arrogant, hot-tempered, unwilling to see the other side’s needs and to compromise, and seems bent on getting every last ounce of the deal, by locking an entrepreneur into as many of the “burdensome clauses” as is possible, the entrepreneur might want to withdraw. Throughout the negotiations, entrepreneurs need to bear in mind that a successful negotiation is one in which both sides believe they have made a fair deal. The best deals are those in which neither party wins and neither loses, and such deals are possible to negotiate.
The purpose of negotiations is to “to decide issues on their merits rather than through a haggling process focused on what each side says it will or won’t do. It suggests that you look for mutual gains wherever possible, and that where your interest conflict, you should insist that the result be based on some fair standards independent of the will of either side.”
Principled negotiations could be described in the following four points:
People: Separate the people from the problem.
Interests: Focus on interests, not problems.
Options: Generate a variety of possibilities before deciding what to do.
Criteria: Insist that the result be based on some objective standard.
Specific Issues Entrepreneurs Typically Face
Whatever method you use in your negotiation, the primary focus is likely on how much the entrepreneur’s equity is worth and how much is to be purchased by the investor’s investment. Even so, numerous other issues involving legal and financial control of the company and the rights and obligations of the various investors and the entrepreneur in various situations may be as important as valuation and ownership share. Not the least of which is the value behind the money – such as contacts and helpful expertise, additional financing when and if required, and patience and interest in the long term development of the company – that a particular investor can bring to the venture.
The following are some of the most critical aspects of a deal that goes beyond “just the money”:
Number, type, and mix of stocks (and perhaps of stock and debt) and various features that may go with them (such as puts) that affect the investor’s rate of return.
The amount and timing of take-downs, conversions, and the like.
Interest rate in the debt or preferred shares.
The number of seats, and who actually will represent investors, on the board of directors.
Possible changes in the management team and the composition of the board of directors.
Registration rights for investor’s stock (in case of a registered public offering).
Right of first refusal granted to the investor on subsequent private or initial public stock offerings.
Stock vesting schedule and agreements.
The payment of legal, accounting, consulting, or other fees connected with putting the deal together.
Entrepreneurs may find some subtle but highly significant issues negotiated. If they, or their attorneys, are not familiar with these, they may be missed as just boilerplate when, in fact, they have crucial future implications for the ownership, control, and financing of the business.
Some issues that can be burdensome for entrepreneurs are:
Co-sale provision: This is a provision by which investors can tender their shares of their stock before an initial public offering . It protects the first round investors but can cause conflicts with investors in later rounds and can inhibit an entrepreneur’s ability to cash out.
Ratchet anti-dilution protection: This enables the lead investors to get for free additional stock if subsequent shares are ever sold at a price lower than originally paid. This protection allows first-round investors to prevent the company from raising additional necessary funds during a period of adversity for the company. While nice from the investor’s perspective, it ignores the reality that, in distress situations, the last money calls the shots on price and deal structure.
Washout financing: This is a strategy of last resort, which wipes out all previously issued stock when existing preferred shareholders will not commit additional funds, thus diluting everyone.
Forced layout: under this provision, if management does not find a buyer or cannot take the company public by a certain date, then the investors can proceed to find a buyer at terms they agree upon.
Demand registration rights:Here investors can demand for at least one IPO in three to five years. In reality, such clauses are hard to invoke because the market for new public stock issues, rather than the terms of an agreement, ultimately governs the timing of such events.
Piggyback registration rights: These grant to the investors (and to the entrepreneur, if he or she insists) rights to sell stock at the IPO. Since the underwriters usually make this decision, the clause normally is not enforceable.
Key-person insurance: This requires the company to obtain life insurance on key people. The named beneficiary of the insurance can be either the company or the preferred shareholders.
Regardless of whether you secure capital from angels or venture capitalists, you will want to be informed and knowledgeable about the terms and conditions that govern the deal you sign. Any experienced entrepreneurs will argue that the terms and who your investor is are more important than the valuation.
Today, the technical sophistication in deal structures creates an imperative for entrepreneurs and their legal counsel: If you don’t know the details you will get what you deserve – not what you want.
