Debt, Equity and Control

This is an extension of my Friday post based on some timely reminders...

Many investors, eager to get started and get their company moving, will agree to terms that are not good business in the long run. It is understandable, and I have a partner that is fond of saying "we hope that is a problem" because if it is then the deal has probably been successful. Unfortunately, because of the inequity some deals will get sideways almost immediately and never reach their potential (or even launch).

The results tend to get even worse if a company tries to raise a second round after a poorly negotiated first round. In that situation, either the parties have to recast the deal or the deal will usual blows apart because the shorted party has the incentive eliminated.

Normally, if an early investor is worries about control, it is much better to bring them in as convertible debt and add a control provision giving them voting control until the debt is paid back at which point they convert to common ownership based on the negotiated pre-money valuation of the company and the capital amount they invested. That structure is a lot less likely to blow up and become inequitable over time and a lot less likely to mess up a follow on round of funding.

It is certainly real poker to negotiate an early round hard, with real risks on the other side as well, but the risks entrepreneurs take when they sign on to a bad deal is that they have really signed the death certificate for their company and just don't know it yet.

Company Valuations When Raising Capital...

There is a ton of information available on the internet about how to value a business enterprise. There is even a lot of information regarding the valuation of a pre-revenue startup during rounds of funding. Unfortunately, most of that information is not particularly helpful for startups unless they are in a major center of startup finance (i.e. Silicon Valley, Boston or NY), have a good track record, and plan to be working with the established players.

If you are a startup company with high aspirations in Hometown, USA (like most of the South), then that deal making process, including valuation, will probably be very different.

First off, there are not a ton of institutional players interested in pre-revenue deals, so angels play a larger role. Angels, however, are just people and people don't tend to write a binding prospectus with projections and investment philosophies, etc. when investing their own money. Instead they invest based on a much fuzzier standard that depends on a lot of qualitative factors, including things such as mood.

In many of the deals I know well, the focus tended to be on shorter term goals and getting the investment paid back while still providing an opportunity for the company to reach its goals. That often results in terms that are based a lot more on the stage of the business (pre-prototype, pre-revenue, pre-profitability, etc.) and will incorporate debt or debt-like features.

For example, BAN seems to be looking at deals with a post-money valuation of $1mm or so that includes an investment of a few hundred thousand dollars with a 1x participating liquidation preference. But those terms are really driven by the type of typical deal:

1. pre-revenue (or little revenue) and post-prototype,
2. reasonable cap-ex for launch,
3. large potential market,
4. clear near term profitability milestones,
5. 1-2 years to initial milestones,

and the desire to provide necessary funding, create a significant potential upside for the investors while maintaining functional control for the founder(s).

However, individual (as opposed to group) angel deals can have some really interesting (and convoluted) terms if the investor is being creative. Sometimes that can help a deal and sometimes they are just clunky, but if it gets the deal done...

Either way, if you are working on raising capital in "Hometown USA" be prepared to openly discuss the deal and be creative because the process probably won't be as cut and dried as the internet may lead you to believe.

Alabama Launchpad opens registration for Governor's Business Plan Competition starting Aug. 30th

Alabama Launchpad will open registration for the 2010-11 Governor's Business Plan Competition on Aug. 30th.

"The purpose of the Alabama Launchpad Governor's Business Plan Competition is to promote and reward marketable, high-growth, innovative ventures that have the potential to grow rapidly, transform an industy, attract future funding, and add to the diversity of Alabama's economy. The competition is for new, independent ventures in the seed, start-up or early growth stages, or for the expansion of an existing business into a new high-growth market.

On an annual basis, Alabama Launchpad will seed three winning companies with cash and in-kind services:

1st Place = $100,000 cash plus in-kind services
2nd Place = $50,000 cash plus in-kind services
3rd Place = $25,000 cash plus in-kind services"

Interested parties may see eligibility and rules here, and may register here.

ESOPs...with rising taxes it may be time to look.

Our main clients are closely held businesses (and their owners), so business and individual planning are often tied at the hip in our office.

With what appears to be inevitable rising taxes, both business and individual, in a still tough business environment we are having to look hard for tax advantaged strategies that (at a minimum) won't hurt the underlying business operations.

One of the strategies that keeps popping up are ESOPs (employee stock ownership plans).

Basically, ESOPs have some commonly stated benefits that include:

1. Capital gains tax deferral (IRC Section 1042); **this is the one that gets all the press

2. Tax free income to the ESOP from an S-corp.;

3. Employee motivation and retention; and

4. Succession planning.

ESOPs have been bounced around in our offices for a long time, but we seem to be finding more situations that fit than in the past. I think that is because in the past, most of our clients were looking at a leveraged ESOP as a tax free exit (#1 above) and often the underlying economics didn't work, but recently we have had some clients looking at ESOPs for other reasons and the results seem to be more favorable.

There are, of course, a lot of factors to to look at before anyone pulls the trigger on an ESOP, but it looks like we may be seeing more of them in our future and they are definitely something to consider in the right situation.

Who can be a successful entrepreneur?

During a discussion today with a colleague, the topic came up of "what makes a successful entrepreneur?"

We discussed lots of attributes and reminisced about books and studies we have read on the topic, but when we finished it seemed that we only had two characteristics left...Vision and Practicality.

1. Vision because the entrepreneur needs to be able to see the big picture and create.

2. Practicality because they need to see where the big picture vision intersects with reality, so they can plan and follow through with the steps required to create the vision.

Of course there are a million other things that are either related too or can support those characteristics, but those two are cornerstones.

Salary in a pre-revenue deal....to be or not to be?

Dad and I were working on a deal not too long ago and he made the comment that:

"a deal where one party can succeed where the other party fails pretty much guarantees that is what will happen, but if a deal is set up where everyone has to succeed for anyone to succeed, then it has a chance."

At the time we were talking about a deal that just didn't feel right, even though there was a lot to like. Ultimately, we passed on the deal and the founders moved on to another investor I know (who drove a different deal altogether), but I was frustrated that we couldn't put it together. I never want to see a deal fail to launch simply because of deal structure, or worse yet, a deal fail because of poor structure, but it happens all the time and I think Dad hit on a pretty common reason.

Often in start-ups, I see deals where the founder(s) has spent a lot of time developing from idea into a legitimate business opportunity and is ready to monetize that effort or they are ready to jump into the business full time and need to replace the income from their job.

The scenario usually is played out with a founder inserting a "living wage" salary into the pro-formas and hoping to raise enough money to cover it and the launch plan. Unfortunately, that salary creates a form of exactly what Dad was talking about...all the future risk of failure is on the investor because the founders are now covered (so long as they get a new job lined up before the company goes belly up). With that arrangement, until the company is cash flow positive the founder and investor will be out of sync, which inevitably leads to tension. Even most novice investors will sense that likely outcome and shy away...maybe to the point of not doing the deal, even on a good core opportunity.

A few other (and more investor friendly) options are:

1. The founder receives only a percentage of revenue (up to his salary level); or
2. the founder receives salary, but only out of net cash flow of the business; or
*(That still could leave open the possibility of encouraging a lifestyle company that doesn't ever net much to the investor, but that is a lot better than encouraging a full flop.)
3. founders and investors split any net cash flow (splits can vary).

This is not to say that no deal should have pre-revenue salary for the founders, because some deals just cannot get done any other way, but it is always something that needs to be carefully considered and probably avoided unless it is truly necessary.

Content Based Website - Profitability Analysis

I love spreadsheets for evaluating the relative financial feasibility of a deal. It just helps me to take the personalities out of the equation for a little while and run some scenarios.

I have a fairly basic and flexible version (See Link) that I thought might be a helpful place to start if you are thinking about monetizing a content based (i.e. "eyeball" or advertising based) business.

**Hint - don't start unless it looks REALLY good because no one ever seems to meet the pro formas (at least not in the short run).

For more in depth help (or if you are a Spreadsheet Jockey in training) there are any number of books, etc. available.

Monetizing a Website or Blog...just the Basics

Ok, I have had several conversations in the last few days about monetizing websites or web businesses (Blogs certainly included here). Basically, it comes down to adding up the value of each visitor, plus any services or products a site sells.

But for a simple lawyer like me, I needed to have a basic course in what revenue streams were available for a content based site.

After a bit of reading...the core seems to be: (Article)

1. AdSense
2. Affiliate Marketing (Article)
3. Banners
4. Sponsors

AdSense pays a percentage of the (reportedly 1/3) of the Google Adwords fee paid by the advertiser. Affiliate marketing (like Amazon's program) is similar, except the payment is a sales commission. Banners are similar to AdSense, especially if you use a banner management program.

In all of these situations, click through rate ("CTR") is very important. Typical CTRs are in the range of 1-5%, but there are occasional reports of higher rates. (Article)

Sponsors (and sometimes banners) are simply companies paying a fee for a branding presence or maybe even individual donations. The drawback with site sponsorship are that they usually need to be individually sold (which requires time), but they have the benefit of bringing a potentially larger revenue stream into the site owner if the correct fit is available.

If all that revenue grows substantial the time may eventually come to sell..., but that is another topic for another day.

Sales Strategy...Solutions v. Products

I see a lot of startups and more seasoned companies that are trying to cold sell their product. Cold selling a product is hard.

What I mean by cold selling is that they have a product (could be a service too) they like/love and they think just about everyone else will too, if they knew about it. This attitude is often characterized by statements like:

- "Everyone is a potential customer"
- "Sales are not a problem if I just had some more money"
- "I'm not worried about sales"

****Newsflash - Everyone should be worried about sales...it is the lifeblood of the company****

And there is help available.

Sales are indeed a process. In fact there are any number of websites that will be happy to show them to you. One simple flowchart is from www.better-sales-and-selling.com :



This type of chart is a good start toward a real sales strategy because it is simple enough to be flexible for a variety of companies, but segmented enough to build a legitimate strategy outline.

Each step in the process should have a defined solution and in really great sales organizations there are numerous solutions to each step.

Nonetheless, the heart of the process will almost always be the solution. The solution has to have a compelling value proposition to the customer, or inertia and the noise of life/business will makes sales much more difficult. If a company has a solution with a compelling value proposition then most of the remaining process is simply communication.

To validate or formulate a value proposition is critical and there are also any number of websites that will talk about that process as well. Blue Ocean Strategy is probably my favorite, but the simplest one is something I have heard many times around the house:

1. The easiest thing to sell is something that "makes" money,
2. the next easiest thing to sell is something that "saves" money, and
3. the hardest thing to sell is something that "cost" money.

Whatever they choose to use, if a company wants to have better sales, they probably need to look at their overall sales strategy because it can (and usually will) drive the success of a company.

Is a Company ready to think about outside investment....?

"Sequence of Blue Ocean Strategy" is pretty much a summary of the initial evaluation of an angel deal... www.blueoceanstrategy.com/abo/sequence.html

1. Product/Service has Significant Value/Utility to the User
2. Compelling Price
3. Appropriate Cost of Production (i.e. good margins at the compelling price)
4. Reasonable Adoption Plan

At least self certifying (if not certification by a relevant 3rd party) that a deal passes well through this evaluation should probably be a requirement for beginning any fundraising effort.