WhatÕs the Deal? (B)

(fourteenth of a series)

By Frank Demmler

Last week we looked at a range of investment structures that might be employed with private investors.  They fell upon a continuum based upon risk tolerance and desired rates of return for investors, ranging from notes with interest to common stock.

This week weÕll look at some alternative deal structures that donÕt really fit in that range, and do reflect last weekÕs observation that deal structures are only limited by the imaginations of the involved parties.

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

avoid giving up equity

Many entrepreneurs donÕt want to give up any equity in their company. Such entrepreneurs often fall into one of two groups.

First-time entrepreneurs rarely look at equity as a bargaining chip that theyÕre willing to bet.  They view their equity as sacrosanct and wonÕt give it up for anything as crass as money.

Secondly, sophisticated entrepreneurs who want to build their companies, but donÕt want to take them to an exit that rewards equity investment (acquisition or IPO) will need to create a reward incentive that can be met through other means.

WeÕll look at some examples that satisfy these conditions.

Revenue participation certificate

This is a simple and relatively elegant investment vehicle. ItÕs really a royalty with a fancy name. Its essence says:

I will pay you X% of revenues until you get Y times your money back.

This has several appeals. 

Revenues are relatively straightforward to measure.

Both sides know how much money is owed; the only variable is timing.

X and Y will be negotiated in the context of your business plan.  X will be large enough to provide a reasonable cash flow to the investor and Y will be set based upon perceived risk.  Using your business plan as the basis, you will be able to tell the investor this deal will provide him with a particular annual rate of return.

For the investor, this is structured so that the focus of the negotiation is on when he will get his return on investment, not if he will.

If the company takes longer to grow sales than the plan anticipates, the rate of return will be reduced, but it is still likely to be attractive.  For example, if it takes five years to provide the return rather than the three years that was anticipated when the deal was struck, that may mean the annual rate of return might be reduced from 30% to 17%.

The persistence of the payment will be an incentive for you to pay the security off as quickly as possible. You will begin to look at those payments representing money that you could use to grow your business, or put in your own pocket.

This base deal can be modified to accommodate specific circumstances.  For example, the parties can agree to delay the commencement of payments until 6 or 12 months after closing so that the company has some runway to put the investment to work before impacting the companyÕs cash flow.

Beyond the standard legal warning above, while the deal appears to be very simple, it will be a challenge from an accounting and tax basis, so get good professional advice if you go down this road.

Put and call

Another fairly simple structure is for you to sell a security to an investor that has a straightforward put and call.  A put is an investorÕs right to force the company to buy his security upon specified terms; to put the security to the company.  A call is the companyÕs right to buy back the investorÕs security on specified terms; to call the security. A deal using this structure might be phrased:

The company has a call on the investorÕs security at X times the investorÕs investment amount until the third anniversary of the investment. After the third anniversary of the investment the investor may put his security to the company at X+1 times the invested amount.

Those multiples might be 2 and 3, for example, or 3 and 4, for that matter. The important point here is that you have a finite period of time to pay off your investor before the cost of that money increases significantly. Therefore you will manage your business with that in mind so that you can avoid that. By setting up these rules at the beginning, everyone knows the consequences of their actions.

Special situation: unwinding a partnership

While this is a little off topic, I offer it as another example of imaginative deal making.

It is not unusual for two people to start a business and after a period of time realize that their goals are not the same.  The worst thing that can happen is for the business to be paralyzed because no decisions can be made.  Under these circumstances, a ÒdivorceÓ is usually the best thing to do, and have one partner buy out the other.  What if they canÕt agree on how to do this?  HereÕs an approach that I have seen used:

Right or wrong, the conundrum gets resolved and each partner can get on with his life, and the business can prosper in the way that the buying partner envisioned.

Advice to Entrepreneurs

Next week weÕll recap what weÕve covered thus far.

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)