Some entrepreneurs have concerns about giving away too much of
the company for too little relative investment. Others worry that
call options or convertible features could dilute the original
owners' stakes in the enterprise. Let's take a look at some
of the more common terms and conditions as they relate to settling
on a workable deal for funding your venture. As you approach the
discussions with your funding source, keep these four items at the
top of your list:
1. The discussion must be anchored to
an acceptable valuation of the business, one that the
funding partner and the entrepreneur can agree is both inclusive of
the full potential for success and reasonable with respect to
relative equity stakes. There are a variety of methods by which to
arrive at a value. Some accountants use adjusted net worth, asset
replacement value or net asset value with the excess earnings due
to goodwill added in. Perhaps the most widely used method is the
discounted cash flow model where the firm's value is calculated
as the present value of the future stream of after-tax free cash
flow coming back to the owners over time. Other valuators use
multiples of earnings or assets, or even comparable values from
publicly traded companies. Consult a professional about having your
venture valued with a formal analysis. With this information in
hand, a starting point for funding has been established. For a free
business valuation, check out
USBX in Entrepreneur.com's Tools section.
2. Consider the type of funding (debt
vs. equity) and the stake in the venture that you're willing to
offer. For example, once your valuation figure is firm,
the dollar amount of the incoming funds can be easily figured as a
percentage of the post-deal value of the company. If funds are
coming in the form of a loan, the debt ratio can establish a fair
interest rate for creditors to earn given the relative value of the
debt to the owners' equity.
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3. Take a look at the
"attachments" to the core terms and
conditions. These include call features on debt
(which allows owners to retire loans prior to maturity), or
cumulative provisions on preferred stock (where previously
skipped dividend payments accrue for eventual payment at a future
date). There are also convertible features (these allow
holders of prefer red or loans to swap these positions for a
predefined amount of common stock), and options given to
funding partners (which allows them to purchase additional shares
at a set price based on the firm hitting certain performance
benchmarks).
4. The final area involves the
potential exit strategy by which capital providers can
look forward to realizing a gain on their initial investment in
your business. You should present some kind of reasonable scenario
by which outside investors can expect an opportunity for cashing
out at a profit. And it can't be that you simply expect to
"go public" in five years. Owners can do one of the
following:
calculate an earn-out over time,
provide a short-list of firms that might acquire the
enterprise,
present a second-stage funding source that has an
option to buy out the initial block of investors at a premium if
the venture hits certain sales or profit milestones,
secure a letter-of-intent from a large
commercial lender committing to a long-term financing package with
a cash-out premium once the business achieves a specified sales
level and is ready to acquire significant property and/or
equipment.
There are major details that must be addressed in each of these
four categories of terms and conditions. Using professionals
(attorneys, accountants, finance consultants) for advice is highly
recommended. In the coming months, I'll address each section of
terms and conditions in greater depth and pass along examples of
how my clients have effectively negotiated these over the years.
But remember this: Everything is negotiable, and no term or
condition is ever set in stone. Invest time and gain expertise on
the front end to ensure that your funding deal is reasonable and
workable for your venture's unique needs.
David Newton is professor of entrepreneurial finance at Westmont
College in Santa Barbara, California. He is the contributing editor
on growth capital for Industry Week Growing Companies and a
moderator on small-cap stocks for eRaider.com. His books
include Entrepreneurial Ethics(Kendall-Hunt)
and How To Be a Small-Cap Investor(McGraw-Hill), named November 1999 book-of-the-month by
Money magazine and a 1999 Top 10 book by Forbes. His latest book
is How To Be an Internet-Stock Investor
(McGraw-Hill). He has written or contributed to more than 80
articles for publications including Entrepreneur, Your
Money, Business Week and Solutions, and has been a
consultant to emerging, fast-growth entrepreneurial ventures since
1984.
The opinions expressed in this column are those
of the author, not of Entrepreneur.com. All answers are intended to
be general in nature, without regard to specific geographical areas
or circumstances, and should only be relied upon after consulting
an appropriate expert, such as an attorney or
accountant.