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No question--it's scary out there. The ever-tightening capital market has many cash-hungry souls grabbing the first deal dangled before them, and that's a dangerous plan at a time when investors and finance companies are demanding onerous terms.
Sure, you will have to make concessions and consider terms unheard of in those glory days when VCs, banks and other financing sources bid against one another for a chance to supply funding with favorable terms and few strings attached. But even in a tight market, terms are negotiable, and fending off unreasonable demands now can help stave off disastrous consequences later. So when judging the benefit of potential funding, be on the lookout for the following red flags.
- A lender undervalues your company--and won't budge. Always a thorny issue, valuation debates are more heated than ever in today's post-downturn market, says Joe Heller, managing director of Plainview, New York-based NextLevel Venture Partners. Heller notes that while venture capitalists and entrepreneurs rarely see eye to eye on the subject, there are some gaps too wide to bridge. "If all the VC is interested in is rock-bottom pricing," Heller says, "that should raise a flag that they're trying to take advantage of the times."
of employee wages are matched by the average 401(k) plan (down from 3.3% in 1999).
SOURCE: Profit Sharing/401(k) Council
"What we see today harkens back to the VC market in the early '90s and the term 'vulture capitalists,'" says 43-year-old John Ticer, president and CEO of Vienna, Virginia-based biometric authentication company BioNetrix Systems Corp., which has secured three rounds of financing. "We hear about venture-financed companies liquidated where the valuation wasn't significantly high, and management and the employees get nothing." For example, a venture capitalist that stipulates "three times liquidation preference" would be entitled to receive three times his or her investment before remaining funds are disbursed-which could leave company management empty-handed.
Disagreements can sometimes be resolved by making valuation contingent on hitting performance targets-but that's another desperation move that could get you in trouble. "The VC can say, 'This is the valuation I place on the company today, but if you hit certain milestones, the company would be worth more money and I would be willing to pay more for it,'" explains Heller, who is quick to add that the difficulties of delivering on set targets must be weighed carefully, as dire consequences can ensue if targets are missed. "Depending on how the contract is worded, either no new money will go into the venture or new money will go in at a significantly lower valuation. So entrepreneurs have to consider whether hitting the targets is reasonable and how much of the company will they give away if they don't."
- Lenders demand stifling partnership commitments. You might be able to negotiate more favorable financing terms or even investment capital from your supplier as a way to manage cash flow in difficult times. But be warned: Such agreements can backfire if terms are too stringent. "Developing financing relationships with suppliers can be meaningful in times like these," notes Joel Magerman, president and CEO of New York City-based Bryant Park Capital, an investment bank that works with small to midsized companies, "but you don't want to be in a position where you've made an exclusivity commitment to a supplier and you have no other options if they're unable to deliver." Instead, Magerman advises making purchase contracts contingent on delivery within a given time period, such as 30 days.
- Hidden fees push cost of capital above what it would cost elsewhere. "Particularly when dealing with factoring companies, which will give you a loan against your accounts receivable, people often don't calculate the fees," notes Magerman, who points out that fees can vary widely by institution. "Origination fees, auditing fees, fees on any unused portion of the loan and other expenses you pay can be profit centers for the bank--and have you paying over 20 percent. So factor in the fees when evaluating a loan rate."
- Lenders want ultimate approval power. Investors and lenders are no longer shy about asking business owners for decision-making power, a prospect that puts experienced entrepreneurs on edge. "VCs sometimes ask for supermajority rights, which can effectively prevent you from doing things that make sense for the business," warns Magerman. Before joining Bryant Park, Magerman found himself hobbled by just such a provision while running a golf putter company he and his brother started. "We couldn't do anything strategic without the fund's approval, and the only thing it would approve was selling the business. So we were forced to sell prematurely."
To gain guidance without sacrificing ultimate authority, Magerman advises negotiating for a provision that additional funding or approval of business decisions will not be "unreasonably" withheld. "There are legal standards of what is considered reasonable," he explains, "so having 'reasonable' terms enables you to make sure they act and behave responsibly."
Of course, sometimes you have to accept unwelcome terms--or forsake the cash. "If there are no other options and not having money will result in dire consequences, you have to strongly consider any option to have the business funded," shrugs Magerman. "At the end of the day, you can't be successful if you're not around."
Jennifer Pellet is a freelance writer in New York City specializing in business and finance.