To The Letter
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In the world of initial public offerings for emerging entrepreneurial companies, the six most beautiful words in the universe are "We want to do your deal." Wow, what a rush. But the thrill of bagging the quarry quickly fades as the enormity of the next task comes into view: negotiating the letter of intent.
By definition, the letter of intent is the first legal document sent to a company from its underwriter setting forth the parameters of the deal, according to Nicholas Moceri, vice president of investment banking in the Providence, Rhode Island, office of Schneider Securities Inc. Moceri's firm specializes in raising capital for fast-growing technology companies primarily in the New England area. With most venture capitalists pouring money into established businesses in their existing portfolios, Moceri says, there's a shortage of early-stage capital that presents huge opportunities for investment banking companies like Schneider Securities.
Still, no matter how big the opportunities, after the hand-shaking, the back-patting, the dinners, the breakfasts, the presentations and the facility tours, the letter of intent is where the rubber hits the road. "The letter spells out what each party will do," says Moceri, "and also acts as a blueprint or 'constitution' for the deal."
But just as the U.S. Constitution was hammered out at the Constitutional Convention over a period of weeks in 1787, so, too, is a letter of intent. And in this sense, the letter of intent is more than a document, says Moceri: "It's the process by which the deal is negotiated."
David R. Evanson, a writer and consultant, is a principal of Financial Communication Associates in Ardmore, Pennsylvania.
The Dead And The Dying
Truth be told, most deals, public or private, crash and burn before they even get off the runway. But if you did some financial forensics, you would find the cause of death in most cases could be traced to negotiations regarding the letter of intent.
It's not that entrepreneurs aren't good at negotiating letters of intent, says Moceri. "Every deal is so different, there are no hard and fast rules about how to do it." No, the letter of intent document (and the attendant process) kills deals because that is exactly what it's supposed to do.
"It's no good for the company, for the investors or for us if we bring out deals that aren't structured in a way that makes sense," explains Moceri. "When we negotiate the letter of intent, we're also weeding out the deals that won't work."
And parenthetically, this truth leads to a good rule to live by: Never tell people you are going public just because an underwriter says they are doing your deal. Much better to say you are "negotiating a public offering"-there will be far less egg on your face later on.
And while there's more than one way to tackle the letter of intent, there are some important things to know that will keep you from annoying your prospective underwriter into outright rejection of your company.
First, says Moceri, it takes some time for your investment banker to make the transition from a verbal commitment to a written one. The time frame to get the initial draft from the underwriter can be anywhere from three to eight weeks, according to Moceri. And unless you're Microsoft, there's little chance of speeding the process up.
"Entrepreneurs need to realize that a public offering represents a huge commitment for us in terms of resources and potential liability," Moceri says. As a result, your investment banker will spend considerable time conducting a due diligence review of your company and its operations. This kind of analysis, Moceri explains, is the only way the underwriter can find out enough to properly structure the deal.
Second, you'll likely get a bill with your unsigned (in most cases, anyway) letter of intent. Regional firms typically charge around $25,000 to underwrite promising upstarts. The fee is an advance against the underwriter's expense allowance, which is generally 3 percent of the total offering proceeds. For a $5 million deal, this expense allowance will be something like $150,000-so the initial bill may be just the beginning.
Best advice: Don't balk. This is the way the game is played. "The minute we start doing due diligence and drafting the letter of intent, we start committing resources to the project," Moceri says. "We want to know the entrepreneur is as serious as we are."
Don't have that kind of cash? You might not-after all, the objective here is to raise capital. If you don't, offer less, but document that what you are offering is putting you on the line in a big way.
The moment you have the underwriter's letter of intent in hand is, in effect, the start of negotiations, Moceri says. But before you load up for bear, make sure your attorney reads the letter of intent. (And if, for some unimaginable reason, you've gotten this far in the process without any legal counsel, it's time to get some.)
As for the issues at hand, there may be several of them, but, says Moceri, the ones sure to raise the most dust are the underwriter's compensation, the valuation of the business and the future share ownership or capitalization of the company. Valuation and future capital structure are the subjects of several hefty tomes, the life's work of many financial professionals and, therefore, beyond the scope of this article. But what is not-and what just as frequently scuttles the deal-is compensation.
"There are few, if any, underwriters who will negotiate their fees," says Moceri. The compensation investment bankers can receive on an initial public offering is regulated by the National Association of Securities Dealers Committee on Corporate Finance. According to Moceri, the maximum allowable compensation is often structured as a 10 percent commission, a 3 percent nonaccountable expense allowance, a consulting agreement with a monthly retainer, and warrants, which are options to buy additional shares of common stock. All this is spelled out in the letter of intent.
"It may seem like the underwriter gets paid an awful lot," says Moceri, "but in reality, it's hard for us to make money on fees." Aside from large costs of their own, a sleeping giant lurks in the underwriter's cost structure. If investors start selling your stock two months down the road, guess who's got to step up to the plate with millions of dollars and start buying? Of course, if the stock takes off, the underwriter's warrants will be worth millions. But by then everyone is rich, so who cares?
The moral of the story: Don't kvetch about fees because you will never win, you will always lose face, and you will very likely blow the deal.
The Ties That Bind
The big question most entrepreneurs have about a letter of intent is whether or not it binds the underwriter into doing the deal. Until the underwriting agreement is signed, the answer is no. Then, says Moceri, "the underwriter can't back out of the deal-unless there is cause."
Unfortunately, in the world of investment banking, "cause" comes in many forms. The ubiquitous catch-all that will cover almost any situation is market conditions. "If the market's not right for initial public offerings," says Moceri, "that's a perfectly valid reason not to do it."
Another reason that underwriters frequently cite is a deterioration of a company's basic business. "If a company shows meteoric sales and earnings," says Moceri, "and then starts going flat while we are negotiating, to the point where it shows a downward trend in its prospectus, that can cause very serious problems." The perception becomes that the underwriter and the company are trying to leave the public holding the bag when the bottom falls out.
And finally, there may be "material disclosures" that are made to or uncovered by the underwriter after the letter of intent is signed. "These are findings that, had we known them before we issued the letter, we might not have issued it," says Moceri. A typical example of a material disclosure might be the discovery that patents the company told the underwriter it had on products or processes were in fact never filed for or perhaps expired.
Many entrepreneurs, says Moceri, try to hide their warts. "That never works because we eventually find out everything," he says. "When we know something upfront, we can do something about it and save the deal. But when it creeps up from behind, that's a real deal-killer."
Schneider Securities Inc., 2 Charles St., Providence, RI 02904, (401) 861-0320.