Editor's Note: Learn from a panel of experts and entrepreneurs who have successfully financed their own ventures and are helping others do it at the Thought Leaders Live 2013 event May 29, in Long Beach, Calif. Event and ticket information can be found here.
When you finally hear the magic words "We want to invest," temper your enthusiasm just a bit. That means nothing coming from an investor's mouth until you successfully negotiate the letter of intent.
The letter of intent, or LOI, is the first official document you receive from an investor after the handshakes are over and the real work on the deal begins. Though 99 percent of LOIs are not binding, don't underestimate the document's importance, says Jay McEntee, an attorney and venture capitalist with Harron Capital, a private venture capital firm located in Frazer, Pennsylvania. "The letter of intent will serve as the blueprint of the deal and moves negotiations from an indication of interest to the closing table," says McEntee.
Most deals die at the LOI stage because that is where you finally spell out the precise terms and conditions of the investment. In the lighter moments of making a presentation and accommodating investors' due diligence, entrepreneurs often fail to discuss the finer points of the deal with their potential investors. When those details are spelled out in the letter of intent, disagreements may surface. Many entrepreneurs are disappointed when their deals go off track at the LOI stage, but the truth is, the letter of intent is doing its job by preventing deals that are doomed in the long term. On the other hand, if you can get a signed letter of intent with an investor, the deal will probably happen, and you're on your way to getting capital.
The letter of intent is really a tool for your own protection and benefit, so don't take it lightly. Here are some common errors entrepreneurs make when creating letters of intent and how to avoid them.
1. Absence of time frame: McEntee says entrepreneurs should avoid signing letters of intent that do not have a specific time frame for consummation-typically about 90 days-or a so-called "drop dead" date by which the deal must be finished and the company should have its capital. "When you combine this with prohibitions against the entrepreneur seeking other sources of capital-often in the letter of intent as well-the result can be disastrous," says McEntee. Specifically, entrepreneurs sometimes find themselves bound by LOIs not to seek other financing deals, but, at the same time, have little or no power to force a consummation or termination of the deal in any sort of time frame. Thus, they not only have no financing, but they also have no way of getting it anywhere else.
For companies that already have other sources of capital, letting investors drag their feet may be uncomfortable but palatable. For an emerging company that is not yet bankable and has no other sources of financing, however, a letter of intent that permits dithering on the part of the investor can be a death knell. "Remember," says McEntee, "you do not want to put investors in a position where they have an open-ended right to invest but not any obligation."
2. Letting the investor take over the hunt: Say you need $8 million, and a venture capitalist agrees to put in $3 million but makes the deal contingent upon syndicating the rest among other investors he or she does business with. "Strategically," says McEntee, "it would be a mistake for an entrepreneur to sign a letter of intent with these terms."
The mistake is that you're staking your destiny on the venture capitalist's ability to raise additional funds. "I would not want to give up control to a third party," McEntee says. "Founders and majority shareholders are most qualified, and most motivated, to make sure a financing gets done." You should only make an exception, he says, if the venture firm you're dealing with happens to be a marquee name. Otherwise, if you receive a letter of intent that says the investor will kick in $3 million contingent upon raising another, say, $5 million, McEntee's advice is: "Do a deal for $3 million, and agree to keep raising funds to get the other five. Just don't make getting the other five a condition of the first $3 million."
3. Not taking ratchet provisions into account: In neoclassical venture investing, the investor and the entrepreneur both try to ensure that each round of financing puts a higher value on the company than the one before. However, LOIs often contain provisions that put the onus on the entrepreneur if a later round is done at a lower valuation. Specifically, says McEntee, "ratchet provisions" mean that if the value of a company goes down, the ownership stake of the VC goes up to compensate for the loss they've experienced. Of course, if their stake goes up, guess whose comes down?
"Ratchet provisions will hurt you exponentially if you are unsophisticated about them while negotiating the letter of intent," says McEntee. "While eclining values may be a fact of life, especially in [today's] market, taking 100 percent of the hit is not. The best tactic is to make sure all shareholders, VCs and founders take a weighted averages portion of the decline in value, if there is one.
As you've probably already guessed, you'll need legal counsel to get you through an LOI. You and your lawyer may have several comments to make on any letter you get from an investor. McEntee says you can save time by having the attorneys hash out the easy agreements. "At the end of the day, there may be one or two major sticking points the entrepreneur and the investor need to address as principals," he says.
"But by all means," adds McEntee, "make sure your attorney has experience. If not, they will dig in their heels on issues they shouldn't. With all the deals I have on my desk, I'll gravitate to the ones that can get done and stay away from those where the other side is presenting problems."
David R. Evanson is a principal at Gregory FCA , an investor relations firm.
- Harron Capital