Dollinger index

308 ENTREPRENEURSHIP

• Management is crucial to investors. They must have faith in the capabilities of the
  founder and the management team. As noted earlier, investors often prefer a B pro-
  posal with an A team to an A proposal with a B team.

If the proposal is rejected and the entrepreneur receives feedback, he or she ought to

respectfully consider that input and attempt to adjust to investor requirements. If the

proposal is accepted, the negotiation phase begins and the actual details of the deal can

be hammered out.

The Negotiations. The objective of the negotiation phase is to come to an agreement

concerning the rights, duties, contingencies, and constraints that will bind the parties to

the deal. The first stage of agreement is a short document called the term sheet. It out-

lines the general areas of the investment and the relationship between the parties. A sam-

ple term sheet appears in Appendix 8A. This information will later be codified in a for-

mal contract known as the investment agreement. An outline of a typical investment

agreement appears in Appendix 8B.

An entrepreneur whose venture possesses many of the four attributes of sustainable

competitive advantage has negotiating power. However, if the business is already using

up cash faster than it generates sales, the power may reside with the investors. The

investors and the entrepreneurs must agree on three crucial issues: the deal structure,

protection of the investment, and the exit.^20

The Deal Structure. The two issues to be resolved here are:

1. How is the venture to be valued?


2. What investment instruments will be employed?
   We discussed valuation issues in Chapter 7. The entrepreneur wants to justify the high-
   est valuation possible, one that will require him or her to sell less equity and relinquish
   less ownership. For example, if the entrepreneur can reasonably negotiate a value of $2
   million for the business and a $1-million investment is required, the post-investment
   value of the firm is $3 million. The $1-million investment represents 33.3 percent of the
   post-investment ownership. If the original valuation had been only $1 million, the post-
   investment equity ownership position of the investor would have been 50 percent.
   The investment instruments are also negotiable. Investors prefer capital structures
   that maximize their return and minimize their risk. They try to negotiate deals in which
   their investment is preferred stock or some form of senior debt (with collateral, interest
   payments, and guaranteed return of principal) unless the business is already a success, in
   which case they want their debt to be convertible into equity! Once the debt is convert-
   ed, investors can share proportionately in any profits. The entrepreneur, on the other
   hand, prefers a capital structure of common equity—simple, clean, and requiring no cash
   payout unless and until the company can afford it.
   Many other provisions and covenants can be included in the deal structure.
   Definitions, descriptions, and examples of these negotiable terms are provided in
   Appendix 8C.