Focus on Returns

By Frank Demmler

This week, I’m going to get caught up with a few odds and ends.

First, I will revisit another deal structure that avoids giving up equity.

Second, I want to provide an interim summary of the recent topics addressed in this series of articles.

Third, I want to give you some confirmation that at least in terms of topics, I haven’t taken you too far off the beaten path.

The Put & Call

I introduced this back in the 14^th entry of this series, but it is worth repeating in this non-equity sequence.

“Another fairly simple structure is for you to sell a security to an investor that has a straightforward put and call. A put is an investor’s right to force the company to buy his security upon specified terms - to put the security to the company. A call is the company’s right to buy back the investor’s security on specified terms, to call the security. A deal using this structure might be phrased:

The company has a call on the investor’s security at X times the investor’s investment amount until the third anniversary of the investment. After the third anniversary of the investment the investor may put his security to the company at X+1 times the invested amount.

Those multiples might be 2 and 3, for example, or 3 and 4, for that matter. The important point here is that you have a finite period of time to pay off your investor before the cost of that money increases significantly. Therefore you will manage your business with that in mind so that you can avoid that. By setting up these rules at the beginning, everyone knows the consequences of their actions.”

Interim Summary: Nature of Returns

As I reviewed the recent set of articles, I realized that I could put the issue of fund raising in another 2-pronged context. It seems that that’s the way my mind works; everything fall into one of two buckets, regardless of the topic under consideration.

I’ve claimed that investment is a function of risk vs. reward. Further, I suggested that risk is composed of business risk and people risk. Taking it to the next level, I’ve posited that each of those risk dimensions could be divided based upon the whether a potential investor knew you, or didn’t know you; and whether he knows the business or not.

Carrying that thought process further, the rewards sought be investors can be divided into two categories:

• Cash-on-cash
• Capital gains

While not particularly profound, it does give you another dimension to consider as you are plotting your fund raising strategy.

Cash-on-cash

These are the types of deals that we’ve been discussing in recent weeks. They’re characterized by a specific method by which the investor will receive his return on investment. In most cases, these deals avoid giving up any equity, UNLESS the original intentions of the deal are not met and the investor has some default equity conversion rights. Such rights serve two purposes (here we go again with the “two’s”). First, it is part of the incentive that you have to meet the terms of the deal. Second, it provides the investor with some protection.

Among the deal structures that fall into this category are:

• Revenue Participation Certificate
• Loan with Purchase Option and Purchase Option Buyback
• Purchase Order Loan
• Put & Call

In most cases, these deals are most likely to be employed by private investors.

Capital gains

Capital gains are achieved by buying a security in a company with the expectation that the company will be sold or go public some time in the future at a value that is significantly greater than that at the time of investment.

In contrast to the cash-on-cash deals that are capped on the upside, i.e., the cash to be received is pre-defined, or the formula to calculate it is defined, capital gains deals are looking for the proverbial home run.

Among the deal structures that fall into this category are:

• Convertible Note
• Convertible Preferred Stock
• Common Stock

These deals are often characterized as “high risk, high reward.”

The Wall Street Journal: Small Business, November 29, 2004

The Journal had a special section entitled, “The Great Money Hunt.” I was pleased to see that the articles focused on topics that we’ve addressed in these articles.

“It’s All Relative” – Loans from family members.

“Long Shot” – Bank loans are desirable, but hard for early stage businesses to get.

“Charge It!” – Credit cards are used for small business financing more often than any other source.

“Fed Funds” – Small Business Administration’s main financing options.

“A Helping Hand” – Economic development programs to assist start-ups.

“A Piece of the Action” – Selling equity to private investors.

“Small Purchases” – Valuation is only one of several important issues that an investment firm will consider before investing in a company.

“First Things First” – The importance of a business plan.

[The links may require a subscription to the Wall Street Journal.]

Frank Demmler is Associate Teaching Professor of Entrepreneurship at the Donald H. Jones Center for Entrepreneurship at the Tepper School of Business at Carnegie Mellon University. Previously he was president & CEO of the Future Fund, general partner of the Pittsburgh Seed Fund, co-founder & investment advisor to the Western Pennsylvania Adventure Capital Fund, as well as vice president, venture development, for The Enterprise Corporation of Pittsburgh. An archive of this series of articles can be found at my website.