Read The Fine Print
Take another look at that financial contract before you sign on the dotted line.
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.
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.
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.
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.
David Newton is a professor of entrepreneurial finance and head of the entrepreneurship program, which he founded in 1990, at Westmont College in Santa Barbara, California. The author of four books on both entrepreneurship and finance investments, David was formerly a contributing editor on growth capital for Industry Week Growing Companies magazine and has contributed to such publications as Entrepreneur, Your Money, Success, Red Herring, Business Week, Inc. and Solutions. He's also consulted to nearly 100 emerging, fast-growth entrepreneurial ventures since 1984.