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Chapter Fifteen

The Deal: Valuation, Structure, and Negotiation

Results Expected

Upon completion of this chapter you will have:

1. Determined methodologies used by venture capitalists and professional investors to esti-mate the value of a company.

2. Examined how equity proportions are allocated to investors.

3. Studied how deals are structured, including critical terms, conditions, and covenants.

4. Examined key aspects of negotiating and closing deals.

5. Characterized good versus bad deals and identified some of the sand traps entrepreneurs face in venture financing.

6. Analyzed an actual deal presented to an entrepreneur in the “Bridge Capital Investors” case study.

Teaching Pedagogies

There are four pedagogical options the chapter that you can consider when conducting class sessions. These notes are organized to enable you to create whatever format and blend of these teaching plans that you'd like. The four pedagogies are:

1. a lecture or mini-lecture

2. the traditional case study

3. the use of exercises or role plays

4. a combination of the above.

The syllabi earlier in this Instructor's Manual (pages 28-53) also illustrate how some in-structors have blended the pedagogies.

Lecture Outline

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I. The Art and Craft of Valuation.A. The entrepreneur’s world of finance is very different from cor-

porate finance of public companies.

B. The private capital world of entrepreneurial finance is more volatile, more imperfect, and less accessible than capital mar-kets.

1. The sources of capital are different.

2. The companies are much younger and the environment more rapidly changing.

3. Cash is king, and liquidity and timing are everything.

4. The determination of a company’s value is elusive.

II. What Is a Company Worth?A. It all depends—the market for private companies is very im-

perfect.

B. Determinants of Value.

1. The criteria and methods used to value companies traded publicly have severe limitations.

2. The ingredients to the entrepreneurial valuation are cash, time, and risk.

C. Long-Term Value Creation versus Quarterly Earnings.

1. An entrepreneur’s core mission is to build the best com-pany possible.

2. Building long-term value is more important than maxi-mizing quarterly earnings.

D. Psychological Factors Determining Value.

1. At market peaks, price/earnings have exceeded 20 times earnings.

2. During the dot.com bubble from 1999 to early 2000, valuations were more extreme.

3. Behind this is a psychological wave, a combination of euphoric enthusiasm exacerbated by greed and fear of missing the run up.

E. A Theoretical Perspective.

1. There are at least a dozen different ways of determining the value of a private company.

2. It can be a mistake to approach valuation in hopes of ar-riving at a single number.

3. It is more realistic to set a range of values within which the buyer and the seller need to negotiate.

F. Investor’s Required Rate of Return (IIRR).

1. Various investors will require a different rate of return (ROR) for investments in different stages of develop-

Text Exhibit 15.1“Rate of Return Sought by Venture Capital Investors” summarizes the annual rates of return that venture capital in-vestors seek on investments by stage of development and how long they expect to hold these investments.

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ment.

2. Factors underlying the required ROR include premium for systemic risk, illiquidity, and value added.

G. Investor’s Required Share of Ownership.

1. The rate of return required by the investor determines the investor’s required share of the ownership.

2. Text Exhibit 15.2 illustrates this calculation.

3. By changing any of the key variables, the results will change accordingly.

Also:Transparency Master 15-1“Rate of Return Sought by Venture Capital Investors” (Text Exhibit 15.1)

Results Expected #2Examined how equity propor-tions are allocated to investors.

Text Exhibit 15.2“Investor’s Required Share of Ownership under Various ROR Objectives” shows how rate of return required deter-mines the investor’s required share of ownership.Also:Transparency Master 15-2“Investor’s Reqauiried Share of Ownership under Various ROR Objectives” (Text Ex-hibit 15.2)

III. The Theory of Company Pricing.A. The capital market food chain depicts the evolution of a com-

pany from its idea stage through an initial public offering (IPO.)

1. The appetite of the various sources of capital varyied by company size, stage, and amount of money invested.

2. Entrepreneurs who understand the food chain are better prepared to target fund-raising strategies.

B. The Theory of Company Pricing is simplistically depicted in Text Exhibit 15.4.

1. A venture capital investor envisions two to three rounds of financing.

2. The per share equivalent increases with each round: four to five4 to 5 times markup to Series B, followed by a double markup to Series B, then again by double markup to Series C.

Text Exhibit 15.3“The Capital Markets Food Chain for Entrepreneurial Ventures” depicts the “food chain” of sources and amounts of capital needed at each stage of development.

Text Exhibit 15.4“Theory of Company Pric-ing” shows a simplistic depic-tion of the per-share pricing ex-pected at each progressive se-ries of financing.Also:Transparency Master 15-3“Theory of Company Pric-ing” (Text Exhibit 15.4)

IV. The Reality.A. The venture capital industry has exploded in the past 25 years.

1. Current market conditions, deal flow, and relative bar-gaining power influence the actual deal.

2. The dot.com implosion led to much lower values for pri-vate companies.

B. The Down Round or Cram Down circa 2003.

1. In this environment, entrepreneurs face rude shocks in

Text Exhibit 15.5“The Reality” shows how cur-rent market conditions, deal flow, and relative bargaining power influence the actual deal struck.Also:Transparency Master 15-4“The Reality” (Text Exhibit 15.5)

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the second or third round of financing.

2. Instead of a four or even five times increase in the valu-ation from Series A to B, or B to C, entrepreneurs en-counter a “cram down” round.

3. The price is typically one-fourth to two-thirds of the last round, severely diluting the founders’ ownership.

4. In many financings in 2001 and 2002, heavy onerous additional conditions were imposed.

5. The valuation of a company is vulnerable and volatile.

6. Even strongly performing companies were crammed down in this market environment.

7. Underperforming companies had difficulty finding any financing.

Text Exhibit 15.6“The Reality: The Down Round” shows the loss of valu-ation that can occur during the second round of financing, the “cram down” Also:Transparency Master 15-5“The Reality: The Down Round” (Text Exhibit 125.6)

V. Valuation Methods.A. The Venture Capital Method.

1. is appropriate for investments in a company with nega-tive cash flows at the time of the investment, but which anticipates significant earnings in a number of years.

21. Venture capitalists are the most likely investors to par-ticipate in this type of investment.

32. The steps involved are:

a. Estimate the company’s net income in a number of years.

b. Determine the appropriate price-to-earnings ratio, or P/E ratio.

c. Calculate the projected terminal value by multi-plying net income and the P/E ratio.

d. The terminal value can then be discounted to find the present value of the investment.

e. To determine the investor’s required percentage of ownership, the initial investment is divided by the estimated present value.

f. Finally, the number of shares and the share price must be calculated.

B. The Fundamental Method is simply the present value of the future earnings stream.

C. The First Chicago Method.

1. The method, developed at First Chicago Corporation’s venture capital group, employs a lower discount rate, but applies it to an expected cash flow.

2. That expected cash flow is the average of three possible scenarios.

3. The formula is presented in Transparency Master 15-

Results Expected #1Determined methodologies used by venture capitalists and professional investors to esti-mate the value of a company.

Transparency Master 15-6A“The Venture Capital Method, Part A:: Final Own-ership” summarizes the calcu-lations involved in determining the final ownership required us-ing the venture capital method.

Transparency Master 15-6B“The Venture Capital Method, Part B:: New Shares” shows the calculations involved in determining the number of new shares.

Text Exhibit 15.7“Example of the Fundamen-tal Method” shows the calcula-tions used to determine the present value of the future earn-ings stream.Also:Transparency Master 15-7“Example of the Fundamen-tal Method” (Text Exhibit 15.7)

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8.

4. This formula differs in two ways:

a. The basic formula assumes there are no cash flows between the investment and the harvest.

b. The basic formula does not distinguish between the forecast terminal value and the expected ter-minal value.

5. Text Exhibit 15.8 is an example of using this method.

D. Ownership Dilution.

1. The previous example is unrealistic because several rounds of investments are necessary to finance a high-potential venture.

2. As illustrated in Text Exhibit 15.9, three rounds of fi-nancing are expected.

3. The final ownership that each investor must be left with, given a terminal price/earnings ratio of 15, can be calcu-lated using the formula presented in Transparency Master 15.10.

E. Discounted Cash Flow.

1. In a simple discounted cash flow method, three periods are defined:

a. Years 1-5.

b. Years 6-10.

c. Year 11 to infinity.

2. The necessary operating assumptions are initial sales, growth rates, EBIAT/sales, and (net fixed assets + oper-ating working capital)/sales.

3. The discount rate can be applied to the weighted average cost of capital (WACC.)

4. Then the value for free cash flow (Years 1-10) is added to the terminal value.

F. Other Rule-of-Thumb Valuation Methods.

1. Other valuation methods are based on similar, most re-cent transactions of similar firms.

2. Venture capitalists know the activity in the current mar-ketplace for private capital.

3. These methods are used most often to value an existing company rather than a startup.

Transparency Master 15-8“The Formula for the First Chicago Method” gives the formula used to calculate re-quired final ownership using the First Chicago Method.

Text Exhibit 15.8“Example of the First Chicago Method” presents the First Chicago Method calcula-tion of valuation based on the average of three possible sce-narios.Also:Transparency Master 15-9“Example of the First Chicago Method” (Text Ex-hibit 15.8)

Text Exhibit 15.9“Example of a Three-Stage Financing” presents a pricing worksheet in which three fi-nancing rounds are expected.

Transparency Master 15-10“Dilution of Final Owner-ship” shows how to determine the final ownership that each investor must be left with, given a terminal price/earnings ratio of 15.

Text Exhibit 15.9“Example of a Three-Stage Financing” shows

VI. Tar Pits Facing Entrepreneurs.A. There are several inherent conflicts between entrepreneurs, or

the users of capital, and the investors, or the suppliers of capi-tal.

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1. The entrepreneur wants to have as much time as possi-ble for the financing, while the investors want to supply capital just in time.

2. Users of capital want to raise as much money as possi-ble, while the investors want to supply just enough capi-tal in staged commitments.

3. In the negotiations of a deal, each side balances and deal terms.

B. The styles of providers and users of capital differ.

1. The users value their independence and flexibility.

2. The investors are hoping to preserve their options.

C. There are also clashesd in the composition of the board of di-rectors.

1. The entrepreneur seeks control and independence.

2. The investors want the right to control the board if the company does not perform as well as expected.

D. The long-term goals of the users and suppliers of capital may also be contradictory.

1. The entrepreneurs may be content with the progress of their venture.

2. The investors will want their capital to produce extraor-dinary gains.

E. Management styles also differ.

1. The entrepreneur is willing to take a calculated risk or to minimize unnecessary risks.

2. The investor is willing to accept higher risks for higher return.

3. Entrepreneurs see opportunities and seize those opportu-nities.them.

4. Investors are looking for clear steady progress.

F. The ultimate goals may differ.

1. The entrepreneur views success as a process of long-term company building.

2. The investors will want to cdash out in two to five years.

VII. Staged Capital Commitments.A. Venture capitalists rarely invest all their external capital that a

company will require.

1. Instead, they invest in companies at distinct stages in their development.

2. By staging capital, the venture capitalists preserve the right to abandon a project whose prospects look dim.

B. Staging the capital also provides incentives to the entrepre-

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neurial team.

1. To encourage managers to conserve capital, venture capital firms apply strong sanctions if capital is misused.

a. Increased capital requirements invariably dilute management’s equity share.

b. The staged investment process enables venture capital firms to shut down operations.

2. The threat by investors to abandon a venture is a key in-centive for entrepreneurs.

C. Venture capitalists can also discipline wayward managers by firing or demoting them.

1. The stock purchase agreement then becomes important.

2. Noncompete clauses can impose strong penalties on those who leave.

D. Entrepreneurs understand that if they meet those goals, they will end up owning a significantly larger share of the company than if they insisted on receiving all the capital up front.

VIII. Structuring the Deal.A. What Is a Deal?

1. Deals are economic agreements between at least two parties.

2. A way of thinking about deals over time: William A. Sahlman from Harvard Business School suggest a series of questions—presented on page 510—as a guide for deal makers.

3. The characteristics of successful deals are presented in Transparency Master 15-11.

4. The Generic Elements of Deals.

a. The deal includes value distribution, basic defini-tions, assumptions, performance incentives, rights, and obligations.

b. It also involves mechanisms for transmitting timely, credible information, plus negative and positive covenants, default clauses, and remedial action clauses.

5. Tools for Managing Risk/Reward.

a. The claims on cash and equity are prioritized by the players.

b. Tools available are common stock, partnerships, preferred stock, debt, performance conditional pricing, puts and calls, warrants, and cash.

c. Nonmonetary tools include:

Results Expected #3Studied how deals are struc-tured, including critical terms, conditions, and covenants.

Transparency Master 15-11“Characteristics of Successful Deals” shows some of the char-acteristics of deals that have proven successful over time.

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• Number, type, and mix of stocks.

• The number of seats on the board of directors.

• Possible changes in the management team and in the composition of the board.

• Specific performance targets for revenues, ex-penses, market penetration, and the like.

B. Understanding the Bets.

1. Deals are based on cash, risk, and time, and are subject to interpretation.

2. Various valuation methods contribute to the complexity of deals.

3. The text presents three examples of term sheets.

4. The entrepreneur needs to identify the underlying as-sumptions, motivations, and beliefs of the individuals proposing the deals.

C. Some of the Lessons Learned: The Dog in the Suitcase.

1. Raising capital can have all the surprises of a “dog in the suitcase.”

2. Tips that can help minimize many of these surprises:

a. Raise money when you do not need it.

b. Learn as much about the process and how to man-age it as you can.

c. Know your relative bargaining position.

d. If all you get is money, you are not getting much.

e. Assume the deal will never close.

f. Always have a backup source of capital.

g. The legal and other experts can blow it.

h. Users of capital are invariably at a disadvantage in dealing with the suppliers of capital.

i. If you are out of cash when you seek to raise capi-tal, suppliers of capital will eat you for lunch.

j. Startup entrepreneurs are raising capital for the first time; suppliers of capital have done it many times.

IX. Negotiations.A. Negotiations have been defined by many experts in many ways.

B. What Is Negotiable?

1. It is possible for an entrepreneur to negotiate and craft an agreement that represents his or her needs.

2. During the negotiation, both the investors and the entre-preneur have the opportunity to size each other up.

Results Expected #4Examined key aspects of nego-tiating and closing deals.

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3. Successful negotiation is one in which both sides be-lieve they have made a fair deal.

4. The best deals are those in which neither party wins and neither loses.

5. Instead of soft or hard negotiation tactics, an approach based on principle negotiation has been developed.

6. Principled negotiation is based on four points:

a. People: Separate the people from the problem.

b. Interests: Focus on interests, not positions.

c. Options: Generate a variety of possibilities before deciding what to do.

d. Criteria: Insist that they result be based on some objective standard.

7. By being reasonable, you’ll have a better chance of get-ting what you want.

C. The Specific Issues Entrepreneurs Typically Face.

1. The primary focus is likely to be on how much the en-trepreneur’s equity is worth and how much is to be pur-chased by the investor’s investment.

a. Other issues involving legal and financial control of the company and the rights and obligations of investors and entrepreneurs.

b. Another issue is the value behind the money that a particular investor can bring to the venture.

2. Many of the tools for managing risk/reward discussed in the previous section also apply.

3. Subtle but highly significant issues may be negotiated;

a. Co-sale provision, by which investors can tender their shares of their stock before an initial public offering.

b. Ratchet antidilution protection, which enables the lead investors to get free additional common stock if subsequent shares are ever sold at a price lower than originally paid.

c. Washout financing, which wipes out all previ-ously issued stock when existing preferred share-holders will not commit additional funds.

d. Forced buyout, allowing the investor to find a buyer if management cannot.

e. Demand registration rights for at least one IPO in three to five years.

f. Piggyback registration rights grant rights to sell stock at the IPO.

g. Key-person insurance, requiring the company to

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obtain life insurance on key people.

D. The Term Sheet.

1. Regardless of the source of capital, the entrepreneur will want to be informed about the terms and conditions that govern the deal signed.

2. For example, there are four common instruments:

a. Fully participating preferred stock.

b. Partially participating preferred stock.

c. Common preference.

d. Nonparticipating preferred stock.

3. As presented in Text Exhibit 15.10, there can be up to a $24 million difference in the payout received in each of these four instruments.

E Black Box Technology, Inc., Term Sheet.

1. One excellent presentation of the deal structure, term sheet contents, and their implications is presented in Black Box Technology, Inc.—Term Sheet.

2. This term sheet is a blue print for successful negotia-tions.

Text Exhibit 15.10“Considering the Economics: $200 Million IPO or Acquisi-tion?” shows the different eco-nomic consequences of using four common instruments.Also:Transparency Master 15-12“Considering the Economics: $200 Million IPO or Acquisi-tion?” (Text Exhibit 15.10)

X. Sand Traps.A. Strategic Circumference.

1. Each fund-raising strategy causes actions and commit-ments that will eventually scribe a strategic circumfer-ence around the company.

2. The entrepreneur needs to think through the conse-quences of each fund-raising strategy.

3. Scribing a strategic circumference may be intentional, or may be unintended and unexpected.

B. Legal Circumference.

1. Legal documentation spells out the terms, conditions, responsibilities, and rights of the parties to a transaction.

2. Because these details come at the end of the fund-rais-ing process, an entrepreneur may arrive at a point of no return.

3. To avoid this trap, entrepreneurs need to sweat the de-tails.

Results Expected #5Characterized good versus bad deals and identified some of the sand traps entrepreneurs face in venture financing.

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a. It is very risky for an entrepreneur not to carefully read final documents.

b. It is also risky to use a lawyer who is not experi-enced and competent.

C. Attraction to Status and Size.

1. Simply targeting the largest or the best-known firms is a trap entrepreneurs often fall into.

2. Such firms may or may not be a good fit.

3. It is best to focus your efforts toward financial backers, whether debt or equity, who have intimate knowledge and experience in the competitive area.

D. Unknown Territory.

1. Entrepreneurs need to know the terrain, particularly the requirements and alternatives of various equity sources.

2. A venture that is not a “mainstream venture capital deal” may be overvalued and directed to investors who are not a realistic match.

3. The text uses the example of “Opti-Com”’s” ill-directed search for suitable venture capital.

E. Opportunity Cost.

1. An entrepreneur’s optimism can lead to grossly underes-timating the real costs of getting the cash in the bank.

a. They also underestimate the real time, effort, and creative energy required.

b. There are opportunity costs in expending these re-sources in a particular direction when both the clock and the calendar are moving.

2. In the months it takes to develop a capital source, cash and human capital might have been better spent else-where.

3. It is common for top management to devote as much as half of its time trying to raise a major amount of outside capital.

a. The effect on near-term performance is invariably negative.

b. If high expectations are followed by a failure, morale can deteriorate and key people can be lost.

4. Significant opportunity cost are also incurred in forgone business and market opportunities.

F. Underestimation of Other Costs.

1. Entrepreneurs tend to underestimate the out-of-pocket costs associated with both raising money and living with it.

a. The Securities and Exchange Commission re-

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quires regular audited financial statements.

b. There are also outside directors’ fees and liability insurance premiums, legal fees, and so on.

2. Another “cost” is of the disclosure that may be neces-sary to secure a backer.

a. Personal and company details may need to be re-vealed to people whom the entrepreneur does not really know and trust.

b. The ability to control access to the information is also lost.

G. Greed: The entrepreneur may find the money irresistible

H. Being Too Anxious.

1. Another trap is believing that the deal is done and termi-nating discussions with others too soon.

2. Entrepreneurs want to believe the deal is done with a handshake.

3. The entrepreneur may need to create an illusion of mul-tiple financing options.

I. Impatience.

1. Another trap is being impatient when an investor does not understand quickly.

2. If the entrepreneur becomes too impatient, they expose themselves to additional risk.

J. Take-the-Money-and-Run Myopia.

1. This trap prevents an entrepreneur from evaluating to what extent the investor can add value to the company beyond money.

2. In this trap the entrepreneur does not adequately con-sider the prospective financial partner’s relevant experi-ence and know-how in the market and the contacts the entrepreneur needs.

3. Many founders overlook the high value-added contribu-tions and erroneously opt for a “better deal.”

XI. Chapter Summary.

Answers to Study Questions

1. Why can there be such wide variations in the valuations investors and founders place on the companies?

The determination of a company’s value is more art than science. Unlike the market for public companies, the market for private companies is very imperfect. The criteria and methods

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used to value companies traded publicly have severe limitations when applied to entrepreneurial companies.

2. What are the determinants of value?

The ingredients to the entrepreneurial valuation are cash, time, and risk. The amount of cash available and the cash generated play an important role in valuation. Timing of the deal plays an influential role. Finally, risk or perception of risk contributes to the determination of value. “The greater the risk, the greater the reward” plays a role in how investors value the ven-ture.

3. Define and explain why the following are important: long-term value creation, investor’s required IRR, investor’s required share of ownership, DCF, deal structure, and sand traps in fund-raising.

Long-term value creation means building the best company possible. This is theo core mission of the entrepreneur. Creating value for the long-run is very different from simply maxi-mizing quarterly earnings to attain the highest share price possible.

Investor’s required rate of return (IRR) is the annual rate of return that venture capital in-vestors seek on investments. The required ROR is a function of premium for systemic risk, illiq-uidity, value added, stage of development, and amount of capital invested.

Investor’s required share of ownership is the percentage of the venture which the in-vestor seeks to obtain. This involves computing the future value of the company. The rate of re-turn required determines the investor’s required share.

DCF is the discounted cash flow, based on three time frames. This is calculated by using initial sales, growth rates, EBIAT, and working capital in each time period. The discount rate can be applied to the weighted average cost of capital. Then the value for free cash flow is added to the terminal value.

Deal structure is the set of negotiated agreements between investor and entrepreneur. Most deals involve the allocation of cash flow streams, the allocation of risk, and allocation of value between the different groups. The deal includes value distribution, basic definitions, as-sumptions, performance incentives, rights, and obligations.

Sand traps in fund-raising are the pitfalls a venture can fall into when trying to obtain fi-nancing. These include strategic circumference, legal circumference, attraction to status and size, unknown territory, opportunity cost, underestimation of other costs, greed, being too anxious, im-patience, and take-the-money-and-run myopia.

4. Explain five prevalent methods used in valuing a company and their strengths and weak-nesses, given their underlying assumptions.

The venture capital method is appropriate for investments in a company with negative cash flows at the time of the investment, but which anticipates significant earnings in a number of years. Venture capitalists are the most likely investors to participate in this type of investment. The steps involved are:

(1) Estimate the company’s net income in a number of years.

(2). Determine the appropriate price-to-earnings ratio, or P/E ratio.

(3) Calculate the projected terminal value by multiplying net income and the P/E ratio.

(4) The terminal value can then be discounted to find the present value of the invest-ment.

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(5) To determine the investor’s required percentage of ownership, the initial invest-ment is divided by the estimated present value.

(6) Finally, the number of shares and the share price must be calculated.

This method is commonly used by venture capitalists because they make equity invest-ments in industries often requiring a large initial investment with significant projected revenues. The percentage of ownership is a key issue in the negotiations.

The fundamental method is simply the present value of the future earnings stream.

The First Chicago Method, developed at First Chicago Corporation’s venture capital group, employs a lower discount rate, but applies it to an expected cash flow. That expected cash flow is the average of three possible scenarios, with each scenario weighted according to its per-ceived probability. The formula is presented in Transparency Master 15-8. This formula differs in two ways:

(1) The basic formula assumes there are no cash flows between the investment and the harvest.

(2) The basic formula does not distinguish between the forecast terminal value and the expected terminal value.

The traditional method uses the forecast terminal value, which is adjusted through the use of a high discount rate.

The ownership dilution method considers the discount rates that are most likely to be ap-plied in succeeding rounds. The previous valuation example is unrealistic because several rounds of investments are necessary to finance a high-potential venture. As illustrated in Text Exhibit 15.9, three rounds of financing are expected. In addition to estimating the appropriate discount rate for the current round, the first round venture capitalist must now estimate the discount rates that are most likely to be applied in the following rounds. The final ownership that each investor must be left with, given a terminal price/earnings ratio of 15, can be calculated using the formula presented in Transparency Master 15.10.

In a simple discounted cash flow method, three periods are defined: Years 1-5. Years 6-10, and Year 11 to infinity. The necessary operating assumptions are initial sales, growth rates, EBIAT/sales, and (net fixed as-sets + operating working capital)/sales. Using this method, one should also note relationships and trade-offs. The discount rate can be applied to the weighted av-erage cost of capital (WACC.) Then the value for free cash flow (Years 1-10) is added to the ter-minal value.

There are other valuation methods based on similar, most recent transactions of similar firms. Venture capitalists know the activity in the current marketplace for private capital. These methods are used most often to value an ex-isting company rather than a startup.

5. What is a staged capital commitment, and why is it important?

Venture capitalists will rarely, if ever, invest all the external capital that a company will require to accomplish its business plan; instead, they invest in companies at distinct stages in their development. By staging capital, the venture capitalists preserve the right to abandon a project whose prospects look dim. Staging the capital also provides incentives for the management team.

6. What is a company worth: explain the theory and the reality of valuation.

A company evolves from its idea stage through an initial public offering (IPO.) The ap-petite of various sources of capital varies by company size, stage, and amount of money invested. In the theory of company pricing, a venture capital investor envisions two to three rounds. The

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per share equivalent increases with each round: four to five times markup to Series B, followed by a double markup to Series B, then again by double markup to Series C.

In reality, current market conditions, deal flow, and relative bargaining power influence the actual deal struck. Changes in the overall market can radically impact the valuation of a com-pany. During the dot.com bubble from 1998 to early 2000, the valuations became extreme—some companies were valued at 10 times revenue. When the collapse came, even strongly performing companies saw their valuations plummet. In this environment, the price per share of ventures may actually decline in the second round of financing, diluting the founder’s ownership.````````

7. What is a “cram down” round?

Ventures typically go through three to four rounds of financing from idea stage to initial public offering. In theory, the per share equivalent increases with each round: four to five times markup to Series B, followed by a double markup to Series B, then again by double markup to Series C. In reality entrepreneurs face rude shocks in the second or third round of financing. In-stead of a substantial four or even five times increase in the valuation from Series A to B, or B to C, they are jolted with a “cram down” round, in which the price is typically one-fourth to two-thirds of the last round.x

8. What are some of the inherent conflicts between investors and entrepreneurs, and how and why can these affect the venture’s odds for success?

There are several inherent conflicts between entrepreneurs, or the users of capital, and the investors, or the suppliers of capital. The entrepreneur wants to have as much time as possible for the financing, while the investors want to supply capital just in time.

Users of capital want to raise as much money as possible, while the investors want to supply just enough capital in staged commitments. In the negotiations of a deal, each side bal-ances capital and deal terms.

The styles of providers and users of capital differ. The users value their independence and treasure the flexibility their own venture has brought them. However, the investors are hoping to preserve their options, including reinvesting and abandoning the venture.

There are also clashes in the composition of the board of directors. The entrepreneur seeks control and independence. The investors want the right to control the board if the company does not perform as well as expected.

The long-term goals of the users and suppliers of capital may also be contradictory. The entrepreneurs may be content with the progress of their venture and happy with a single or dou-ble. The investors will not be quite as content with moderate success, but instead want their capi-tal to produce extraordinary gains.

Management styles also differ. The entrepreneur is willing to take a calculated risk or is working to minimize or avoid unnecessary risks. The investor is willing to accept higher risks for higher return.

Entrepreneurs see opportunities and seize those opportunities. Investors are looking for clear steady progress.

The ultimate goals may differ, also. The entrepreneur views success as a process of long-term company building. The investors will want to cash out in two to five years.x

9. What are the most important questions and issues to consider in structuring a deal? Why?

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Most deals involve the allocation of cash flow steams, the allocation of risk, and the allo-cation of value between different groups. To design long-lived deals, Professor William A. Sahlman from Harvard Business School suggests using a series of questions as a guideline for structuring deals. These questions include: Who are the players? What are their goals and objec-tives? What risks do they perceive and how have these risks been managed? What problems do they perceive? How much do they have invested? What is the context surrounding the current de-cision? What is the form of their current investment or claim on the company? What power do they have to act? To precipitate change? What real options do they have? What credible threats do they have? How and from whom do they get information? What will be the value of their claim under different scenarios? How can they get value from their claims? To what degree can they appropriate value from another party? How much uncertainty characterizes the situation? What are the rules of the game? What is the context at the current time? x

10. What issues can be negotiated in a venture investment, and why are these important?

Far more is negotiable than entrepreneurs think. The “boilerplate” investors use may not be fixed in concrete. It is possible for an entrepreneur to negotiate and craft an agreement that represents his or her needs. A successful negotiation is one in which both sides believe they have made a fair deal.

The primary focus is likely to be on how much the entrepreneur’s equity is worth and how much is to be purchased by the investor’s investment. Other issues involving legal and finan-cial control of the company and the rights and obligations of investors and entrepreneurs. Another issue is the value behind the money that a particular investor can bring to the venture. Many of the tools for managing risk/reward also apply.

Subtle but highly significant issues may be negotiated, including co-sale provision, ratchet antidilution protection, washout financing, forced buyout, demand registration rights, pig-gyback registration, and key-person insurance.x

11. What are the pitfalls and sand traps in fund-raising, and why do entrepreneurs some-times fail to avoid them?

The entrepreneur encounters numerous strategic, legal, and other “sand traps” during the fund-raising cycle and needs awareness and skill in coping with them. Some of these sand traps include:

Strategic circumference. Each fund-raising strategy causes actions and commitments that will eventually scribe a strategic circumference around the company. The entrepreneur needs to think through the consequences of each fund-raising strategy. Scribing a strategic circumference may be intentional, or may be unintended and unexpected.

Legal circumference. Legal documentation spells out the terms, conditions, responsibili-ties, and rights of the parties to a transaction. Because these details come at the end of the fund-raising process, an entrepreneur may arrive at a point of no return. To avoid this trap, en-trepreneurs need to sweat the details. It is very risky for an entrepreneur not to carefully read final documents and to use a lawyer who is not experienced and competent.

Attraction to status and size. Simply targeting the largest or the best-known firms is a trap entrepreneurs often fall into. Such firms may or may not be a good fit. It is best to focus your efforts toward financial backers, whether debt or equity, who have intimate knowledge and expe-rience in the competitive area.

Unknown territory. Entrepreneurs need to know the terrain, particularly the requirements and alternatives of various equity sources. A venture that is not a “mainstream venture capital deal” may be overvalued and directed to investors who are not a realistic match.

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Opportunity cost. An entrepreneur’s optimism can lead to grossly underestimating the real costs of getting the cash in the bank. They also underestimate the real time, effort, and cre-ative energy required. There are opportunity costs in expending these resources in a particular di-rection when both the clock and the calendar are moving. In the months it takes to develop a capi-tal source, cash and human capital might have been better spent elsewhere. It is common for top management to devote as much as half of its time trying to raise a major amount of outside capi-tal. Significant opportunity cost are also incurred in forgone business and market opportunities.

Underestimation of other costs. Entrepreneurs tend to underestimate the out-of-pocket costs associated with both raising money and living with it. The Securities and Exchange Com-mission requires regular audited financial statements. There are also outside directors’ fees and li-ability insurance premiums, legal fees, and so on. Another “cost” is of the disclosure that may be necessary to secure a backer.

Greed: The entrepreneur may find the money irresistible.

Being too anxious. Another trap is believing that the deal is done and terminating discus-sions with others too soon. Entrepreneurs want to believe the deal is done with a handshake. The entrepreneur may need to create an illusion of multiple financing options.

Impatience. Another trap is being impatient when an investor does not understand quickly. If the entrepreneur becomes too impatient, they expose themselves to additional risk.

Take-the-money-and-run myopia. This trap prevents an entrepreneur from evaluating to what extent the investor can add value to the company beyond money. In this trap the entrepre-neur does not adequately consider the prospective financial partner’s relevant experience and know-how in the market and the contacts the entrepreneur needs. Many founders overlook the high value-added contributions and erroneously opt for a “better deal.” X

Notes on Case

“Bridge Capital Investors, Inc.”

Use of the BCI, inc. Case

This is a case that lends itself to a structuring— – valuing— -- negotiating exercise and role-play in which pairs or trios as founders meet with pairs or trios as investors to come to terms. It has worked very well with a variety of groups and students, and enables them to get into the details and guts of the issues.

Positioning and Objectives

The case can be preceded by outside speakers from various financial sources, and/or your own lecture on the meat in the chapter. Vu-graph templatesTransparency masters of the key ex-hibits and tables in the chapter are available in Section 8.0Part IV of this manual of the key ex-hibits and tables in the chapter for this purpose. The chapter also ties in with the Appendixes on the investment agreement, deal structuring, vesting, sample terms sheet, etc.

Preparation Questions

Students are asked to consider the following questions:

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1. Evaluate the situation and financing alternatives Hindman is now facing. What is his strategy?

2. Is the $10 million Bridge investment enough money? How long will it last? What is Hindman’s relative bargaining position? BCIs? Be prepared to represent both the company and BCI in a meeting to negotiate the proposed financing.

3. What are the consequences for JLI of the proposed financing?: Calculate the con-sequences of the “put.”

4. What should Hindman do? What should Bridge do?

In this case study we rejoin Jiffy Lube in November, 1985, two and one half years down the road from the Hindman case. Briefly describe to students what has happened to the company: Since March 1983, through some creative arrangements suggested by their accountants, Jiffy Lube was able to obtain sufficient financing from Hindman's personal assets and current share-holders. The company has survived and is by far the largest oil franchisor in the United States. Jiffy Lube now faces another financial crisies.

The class session will involve meetings between teams of students representing Jiffy Lube and a potential investor, Bridge Capital Investors (an investment partnership), and between Jiffy Lube's accountants and Jiffy Lube. The purpose of the first meeting, between the accoun-tants and Jiffy Lube, will be to develop a financial strategy for Jiffy Lube and to develop an un-derstanding of what the accountants can do to help Jiffy Lube. The second meeting will be to de-cide if a deal can be closed in which this partnership will invest in Jiffy Lube.

The actual negotiations can be held during the regular class session (fine if MBA's, 2 hour + class length) or on the outside on their own. See questions on page 528. Both ways have worked well. A brief discussion of the case (1f 5-20 minutes) can be helpful to introduce the exer-cise. The class will be divided into small groups representing BCI, the company, and the accoun-tants. Their main tasks are: a(1) prepare for the final meeting; (2b) develop a strategy and plan; (3c) determine what they will agree on plus any other terms and conditions. Each meeting will last approximately 20-30 minutes. Each team should select two members to take part in the actual meetings. Recommend that each team spend approximately one hour to prepare for the meeting after individual members have spent time on their own preparing the case.

Class Session

You may want to preface the team meetings with some or all of the following comments. First, it is impossible to replicate the people or exactly how they would have behaved. There are many ways to successfully conduct a meeting. Remember, our goal is to try out our own ideas and learn as much as we can from doing and from observing each other in action. Second, be as realistic as you possibly can in your role. Try to put yourself in the shoes of the person you are representing.

Ask the two representatives from the Jiffy Lube team and the accountant’s team to meet in the center of the class to start the meeting. It is helpful to use name cards to keep track of the different teams. Remind the class of the purpose of the meeting: Jim Hindman and John Sasser of Jiffy Lube are meeting with their accountants because they are facing another crises. By the end of this meeting, they need to make some progress toward developing a financing strategy and get a better understanding of what their options are.

Remind the team that the meetings are limited to 30 minutes, and that despite the time constraints, their objective is to reach some type of closure by the end of the meeting. During the meeting, you should provide any assistance needed to keep the discussion on track.

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When the meeting is over, ask representatives from the other two teams, Jiffy Lube and Bridge Capital Investors, to come to the center of the class. Before starting, review the back-ground of the meeting: Bridge Capital Investors, an investor partnership, has proposed that Jiffy Lube meet its current financing needs by selling Bridge Capital $10 million in unsecured notes. Jiffy Lube must decide whether the deal is acceptable as is, whether it needs to be modified, or whether Jiffy Lube will reject it and pursue another alternative. The objective of this meeting is to determine if the deal can be closed.

After the meeting, begin the discussion session.

BRIDGE CAPTTAL INVESTORSBRIDGE CAPITAL NEGOTIATING TEAM

INSTRUCTIONS AND TEAM ASSIGNMENTS FOR TEAMS REPRESENTING BRIDGE CAPITAL INVESTORS

Your team will prepare for a 30 minute meeting with Jim Hindman end John Sasser (CFO) from Jiffy Lube. Two members of your team should be selected to represent Don Remey and another officer from Bridge Capital Investors, and take part in the meeting.

YOUR OBJECTIVE DURING THE MEETING IS TO DETERMINE WHETHER YOUR INVESTMENT PARTNERSHIP, BRIDGE CAPITAL INVESTORS, WILL COM-PLETE AN AGREEMENT TO PROVIDE $10 MILLION IN FINANCING TO JIFFY LUBE.

Background of Meeting

It is November 1985; Jiffy Lube has rapidly expanded over the last three years and now has over 270 service centers in operation. Revenue and net income are projected to reach $30 mil-lion and $1.9 million respectively in fiscal 1986 (the third straight year of positive net income). Jiffy Lube's growth (and survival) was made possible by creative financing obtained in 1983.

Your firm, Bridge Capital Investors, is a limited partnership specializing in later-stage ex-pansion financing of growing companies. Shearson Lehman Brothers referred Jiffy Lube to you, the investment banking firm. You were one of the parties Shearson contacted in an attempt to market a $10 million private placement for Jiffy Lube.

Don Remey describes the initial meetings with Hindman:

"On the surface, we didn't think that there was any way we were going to want to invest in Jiffy Lube. The company was in a terrible financial position. It still intrigued us, though.

"What made the difference was meeting Jim Hindman. When you meet him, you know he is good. I developed a great personal chemistry with him right away. Their business concept is ex-citing and the timing is right. Talking to Jim makes me believe that he can pull it off.”

Preparation for the Meeting

To help prepare for the meeting you should have read the case material and address the following questions:

1. Review the deal you have proposed for Jiffy Lube. How do the deal structure and terms fit into your objectives as an investor? Be prepared to explain (end justify) the terms to James Hindman and John Sasser.

2. What are Jiffy Lube's capital requirements? How much cash do they need?

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When? Is the $10 million deal sufficient for their needs?

3. How does the deal you proposed fit into Jiffy Lube's goal and long-term business strategy? What are the implications for building a successful relationship between Jiffy Lube and Bridge Capital?

4. Evaluate the other financing alternatives facing Jiffy Lube. What relative bargain-ing position does the company have with regard to your proposal, and with each of the other alternatives?

5. How will you handle the meeting and negotiations with Hindman and Sasser to-morrow? What possible changes to the deal terms might they propose, and how will you respond? (What changes are you willing to accept?)

Description of the Proposed Deal

The financing deal you have proposed to Jjiffy Lube is almost identical in the structure to the other deals your firm has completed, and is composed of debt with an "equity kicker.” You prefer to finance companies using this structure. One of your selling points for Jiffy Lube is the speed at which you can complete the agreement due to its simplicity and your experience with this type of financing.

Bridge Capital will not be providing the entire $10 million in financing if the deal is con-cluded. As lead investor, you have assembled the following syndicate willing to invest under the terms proposed:

Bridge Capital $4,000,000

Three Cities $2,500,000

Conn Mutual $2,000,000

Allied Capital $1,000,000

Investcorp $ 500,000

In addition to $10 million in unsecured notes, the financing deal you proposed includes warrants allowing you to purchase 100m 100M of Jiffy Lube's common stock. The proposal also includes a put provision (described in Exhibit 5, page 14 in the case materialG). Under the provi-sion, Jiffy Lube's stock must trade publicly at certain minimum prices by the end of 1990. If the stock never reaches these minimum prices, you have the right to "put”' the warrants back to Jiffy Lube.

The amount Jiffy Lube would be required to pay upon your put of the warrants is de-scribed in the proposal as follows:

The price will be determined by the calculation of the amount necessary to result in a 300Mm internal rate of return to the Purchasers, taking into account all interest and principal pay-ments on the Notes.

The price will vary based upon certain actions that Jiffy Lube takes. You have calculated the potential price under different scenarios, three of which are listed as follows:

Scenario Amount Payable by Jiffy Lube Scenario If Warrants Are Put

No public offering, Notes are outstanding $ 17.1 millionfor entire term

Public offering after 2 years, $5 million of $ 13.1 millionNotes are prepaid

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Entire $10 million of Notes are prepaid $ 9.1 millionafter 2 years

(Details of these calculations are included on the attached pages.)

Under your proposal, if Jiffy Lube's stock never reaches the minimum levels, and the company is unable to make the payment required under the put provision, Bridge Capital will have the right to take over control of the board. In Don Remey's words, the put provision "makes the entrepreneur bet on the future success of his company."

(Details of these calculations are included at the end of this chapter beginning on page 315.)

The Meeting

THE MEETING IS LIMITED TO 30 MINUTES

.

You are going into the meeting willing to conclude the deal you have proposed, iff Jiffy Lube accepts your terms. If Hindman and Sasser request a different deal structure, you will have to decide whether you are willing to negotiate modifications to the deal you have pro-posed. But, you are also willing to walk away as you do have other deals on your plate.

BY THE END OF MTHE MEETING YOU WANT TO REACH A CONCLUSION CONCERNING THE FINANCING DEAL YOU HAVE PROPOSED TO JIFFY LUBE.

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