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January 1, 1998
By Michael H. Wirpel
Your ability to find a way to obtain an investment in your company is greater if you
know how to design a deal flexibly. You can be more flexible by recognizing the different
stages a company goes through and using each stage’s risk factors to tailor a deal.
"Digging around in the corporate (and it doesn’t have to be a corporation) finance
toolbox" is a phrase I use to describe an attitude I want my clients to have when
negotiating a deal. It means that, as long as the underlying fundamentals work, there is a
tool (i.e., legal structure) to make a deal work despite any perceived problems.
In this case, a flexible approach to structuring a funding is the tool. It recognizes
that funding should not be viewed as having the same risk and return factors over time,
since a company grows and/or changes as time passes. When you view funding as a dynamic,
changing situation rather than as a static one, you can apply different economics over the
life of the investment and give yourself more flexibility as well as make the deal conform
to reality. But, you need to keep it simple.
You can restart stalled funding negotiations by breaking a business plan into definable
stages. This activity can simplify issues, create more flexibility in calculating and
justifying risk and return, and make it easier for all parties to understand the values
presented. It also may increase the likelihood of getting the money you want.
I’m not suggesting you break the deal down into a large number of complicated,
hard-to-understand stages based on esoteric formulae. I recommend four stages, all based
on the activities for which the money is needed.
To make the process more effective, both sides must be reasonable and work toward a
value-for-value deal. It rarely works to insist on overbearing terms. Likewise, it rarely
works to believe either parties will accept unreasonable terms already rejected if one
continually yells at the other. I have never understood this negotiating tactic: You
expect the other guy to say, "I find your terms unacceptable, but if you yell at me
long enough, I’ll suddenly decide they are acceptable." More likely, the other guy
will think you’re a lunatic and move on to another deal. There are better tactics, believe
You want to get funding? Cut the bull. Better to follow my three-phase formula for
1. Know what will work for you.
2. Negotiate for it.
3. Don’t accept a deal that will not meet your goals.
It saves time. I’ve been in situations when all of the parties’ goals were met, but the
holdup was one guy who thought he could get unreasonable terms by holding out. You may
meet with some success by using such tactics. However, most of the time you’ll wreck the
deal. If I’m on the other side, I won’t waste the time. I’ll recommend my client find a
deal that’s more within our goals. If you follow my three-phase formula and deal with what
fits everyone’s needs, you will have more success in less time.
Each stage of financing has its own set of rules both sides must follow. The following
is a definition of each stage, explanations of how each should be utilized, and the
specific return and equity factors of each stage.
Early stage financing involves both seed money and start-up money. Seed money usually
is a relatively small investment provided to the enterprise originator (that’s you). It is
used to prove the commercial viability of a concept, including product or service
development and market research. Start-up funds typically are used to complete product or
service development and to initiate marketing, and they are the funding used to take a
development company into commercial operation.
Gate financing is the next stage. Because venture companies typically consume their
start-up financing in achieving commercial operation, typically, they need additional
capital to expand sales or add markets. In other words, they now are ready to operate, but
they need capital to help them out of the gate.
Expansion financing allows companies to expand faster than internal cash flow will
allow. There are three types of expansion financing:
Type 1 is a continuation of gate financing (i.e., financing to expand
sales and add markets), but achieved by your more mature company through a mix of
commercial borrowing and equity funding.
Type 2 is for companies that have capped their commercial borrowing
ability, but use additional equity funding to add offices or further develop their product
Type 3 is for companies that are poised to become significant players
in their market segments. Such companies typically will have a short-term (six to 18
months) plan to go public and retire earlier borrowing.
You can use the specifics of each stage to create a more flexible financing plan. Take
the return and equity figures of the stages the company will go through and for what
purpose the money will be used, and match them to their appropriate time periods over the
life of the investment. Blend the numbers or use a sequential declining model.
The following table is an example of the return and equity suitable for each stage.
Neither the higher nor the lower ends of the ranges should be considered absolute, and the
equity ranges are purposely broad. The investors’ equity in any particular venture will be
a function of risk, total capitalization, anti-dilution protections and more. Each
specific funding will represent the particular needs of the parties and current status of
For investors looking at venture companies, return and equity are not the only factors
to consider. With or without a staged approach to the economics, there still is no one
formula or "correct" way for investors to evaluate the merits of a venture or a
"proper" capital-equity-return structure.
When seeking funding, it helps to structure your plan so the key issues are addressed
clearly and you don’t create obstacles for yourself. If the business plan answers key
issues brought up by the investor, and you use the flexible funding analysis I recommend
(if needed), your investment funding should go more smoothly.
The following are examples of key issues investors may address:
Does the proposed product or service have unique features?
Is there support for the marketing assumptions?
Are the risk factors fully explained?
Can you determine the venture’s markets and position at start-up, three years and five years?
Are present and potential competitors analyzed?
Is there any proprietary technology or application that improves competitiveness?
Do the financial projections, including cash flows and expected profits, tie back to the capital requirements and other stated sources and uses for funds?
What is the payback period?
Do the investors have control mechanisms (e.g., special voting rights, board seats)?
Is there a management buy-back mechanism?
Are there anti-dilution protections?
Are there liquidation preferences?
Are there redem.ption rights?
Is piggyback registration provided?
If you and an investor are moving right along, great; make the deal. Use this staged
approach, however, when more flexibility is needed. Remember that for you, the one seeking
the investor, the staged approach always should result in a lower cost of capital.
For example, say you plan to pay back an investment in three years. Your company is a
start-up. In a traditional financing arrangement, the investment will be treated as a
start-up for the entire period.
On the other hand, say you will be operating by the sixth month and be cash
flow-positive by the 12th month. Is it fair to treat your investment as a start-up after
that period? Do you really represent the same risk? The answer to both questions is no.
Using the staged approach, you will do better to treat the investment as a start-up only
during the start-up phase, then move on to gate financing and so on. Your cost of the
investment constantly declines in a staged model. Hence, you always will pay less for the
money under this model than you would under a static model.
But, there is a catch. For an investor to buy off on this approach, you will need a
strong, experienced management team. Also, the threshold dates will have to be supported.
The staged approach can be used to increase your value, lower your risk factor or get a
stuck deal off the dime. Don’t give up to soon; dig around in the corporate finance
toolbox. You may come up with just the tool you need to get the money you want.
Michael Wirpel, an attorney with Breazeale, Sachse & Wilson LLP, handles
domestic and international business and regulatory matters in telecommunications. He can
be reached at (504) 387-4000.
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