only for prof washington

9 - 8 0 6 - 0 8 5 N O V E M B E R 7 , 2 0 0 5

________________________________________________________________________________________________________________ Sr. Lecturer Michael J. Roberts and Professor Howard H. Stevenson prepared the original version of this note, “Deal Structure,” HBS No. 384-186 which is being replaced by this version prepared by the same authors. Copyright © 2005 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School.

M I C H A E L J . R O B E R T S

H O W A R D H . S T E V E N S O N

Deal Structure and Deal Terms

A critical aspect of the entrepreneur’s attempt to obtain resources is the development of an actual “deal” with the owner of the resources. Typically, the entrepreneur needs a variety of resources, including dollars, people, and outside expertise. As in any situation, the individual who desires to own, or use, these resources must give up something. Because the entrepreneur typically has so little to start with, she will usually give up a claim on some future value in exchange for the ability to use these resources now.

Entrepreneurs can obtain funds in the form of trade credit, short- and long-term debt, and equity or risk capital. This note will focus on the structure and terms of the deal which may be used to obtain the required financial resources from investors. The note will center on financial resources because raising capital is a common problem which virtually all entrepreneurs face.

What is a Deal?

In general, a deal represents the terms of a transaction between two (or more) groups or individuals. Entrepreneurs want money to use in a (hopefully) productive venture, and individuals and institutions wish to earn a return on the cash that they have at risk.

The entrepreneur’s key task is to make the whole equal to more than the sum of the parts. That is, to carve up the economic benefits of the venture into pieces which meet the needs of particular financial backers. The entrepreneur can maximize his/her own return by selling these pieces at the highest possible price, that is, to individuals who demand the lowest return. And the individuals who demand the lowest return will typically be those that perceive the lowest risk.

Factors that drive a Deal

In order to craft a deal which maximizes his/her own economic return, the entrepreneur must

• understand the fundamental economic nature of the business; • understand financiers’ needs, and perceptions of risk and reward; and, • understand his/her own needs and requirements.

For the exclusive use of Y. Shao, 2017.

This document is authorized for use only by Yuanrui Shao in Entrepreneurship-440 F 2017 taught by Naumann, Arizona State University from August 2017 to December 2017.

806-085 Deal Structure and Deal Terms

2

Understanding the Business

The first thing the entrepreneur must do is assess the fundamental economic nature of the business itself. Most business plans project a set of economics which determine

• the amount of funds required: � the absolute amount; and, � the timing of these requirements.

• the riskiness of the venture: � the absolute level of risk; and, � the underlying factors which determine risk.

• the timing and potential magnitude of returns.

It is important to remember that the venture itself does not necessarily have an inherent set of economics. The entrepreneur determines the fundamental economics when he makes critical decisions about the business. Still, there may be certain economic characteristics which are a function of the industry and environment, and which the entrepreneur will generally be guided by.

For instance, a venture such as a biotech start-up has a much different set of characteristics than a real estate deal. The biotech start-up may require large investments over the first several years, followed by years with zero cash flow, followed by a huge potential return many years out. The real estate project, on the other hand, may require a one-time investment, generate immediate cash flow, and provide a means of exit only several years down the road.

0ne technique for understanding a venture’s economic nature is to analyze the potential source of return. Let’s take this example: a manufacturing business with the following projected cash flows; including a sale in year 5.

Year 0 1 2 3 4 5 Cash flow ($000) (1,000) 400 400 400 400 5,600

Now, we can break this cash flow down into its components.

• investment: money required to fund the venture; • tax consequences: not precisely a cash flow, but nonetheless a cash benefit which

may accrue if an investment has operating losses in the early years; • free cash flow: cash which the business throws off as a result of its operations

before financing and distributions to providers of capital; and, • terminal value: the after-tax cash which the business returns as a result of its

sale. Here, this is assumed to occur at the end of year 5.

Let’s assume that these flows are as follows (where figures in parentheses are negative cash flows):

Year

Cash Flows ($000) 0 1 2 3 4 5 Original investment (1,000) Tax consequences 300 300 0 (100) (200) Free cash flows 100 100 400 500 800 Terminal value (after tax) 5,000 Total (1,000) 400 400 400 400 5,600

For the exclusive use of Y. Shao, 2017.

This document is authorized for use only by Yuanrui Shao in Entrepreneurship-440 F 2017 taught by Naumann, Arizona State University from August 2017 to December 2017.

Deal Structure and Deal Terms 806-085

3

Now, we can take the internal rate of return (IRR) of these cash flows—i.e., the IRR for the total investment = 64.5%.

Next, we calculate the present value of each of the individual elements of the return at that IRR, and then, the percent which each element contributes to the total return. 0f course, the present value of the total return will be equal to the original investment.

Present Value Element @ 64.5% ($000) % of Total Tax consequences 263 26.3 Free cash flows 322 32.2

+ Terminal value 415 41.5 Total $1,000 100.0%

This analysis illuminates the potential sources of return inherent in the business, as projected.

Now, the task of the entrepreneur is to carve up the cash flows and returns and “sell” them to the individuals/institutions that are willing to accept the lowest return. That is, the parties that are willing to take the smallest share of these cash flows in exchange for a given amount of capital. This will leave the biggest piece of the economic pie for the entrepreneur. To do so requires an understanding of the financiers’ needs and perceptions.

Understanding Financiers Needs and Objectives

Providers of capital clearly desire a “good” return on their money, but their needs and priorities are far more complex. Differences do exist among different financial sources, and they vary along a number of dimensions, including:

• magnitude of return desired; • magnitude and nature of risk which is acceptable; • perception of risk and reward; • magnitude of investment; • timing of return; • form of return; • degree of control; and, • mechanisms for control.

And, the priorities attached to these various elements may differ widely. For instance, certain institutions (e.g., insurance companies, pension funds) have legal standards which determine the type of investment which they can undertake. For others, the time horizon for their return may be influenced by organizational or legal constraints.

Certain investors may want a high rate of return and be willing to wait a long period, and bear a large amount of risk to get it. Still other investors may consider any type of investment, as long as there exists some mechanism for them to exert their own control over the venture. To the extent that the entrepreneur is able to break down the basic value of the business into components which vary along each of these dimensions, and then find investors who want this specific package, the entrepreneur will be able to structure a better transaction: a deal which creates more value for her.

For the exclusive use of Y. Shao, 2017.

This document is authorized for use only by Yuanrui Shao in Entrepreneurship-440 F 2017 taught by Naumann, Arizona State University from August 2017 to December 2017.

806-085 Deal Structure and Deal Terms

4

If we return to our example of the manufacturing business which requires a $1 million investment, we can see how the entrepreneur can take advantage of these differences in investor characteristics.

• The tax benefits, for example, are well-suited for sale to a risk-averse wealthy individual in a high marginal tax bracket. Because the benefits accrue as a result of operating losses, if the business does poorly, the tax benefits may be even greater. But let’s assume that a wealthy individual believes that these forecasts are realistic, and requires a 25% return. If we discount the tax benefits at this 25% required return, we arrive at a present value of $325,500. Therefore, this individual should be willing to invest $325,500 in order to purchase this portion of the cash flows.

• The operating cash flows would, in total, be perceived as fairly risky. However, some portion of them should be viewed as a “safe bet” by a bank. Let’s assume that the entrepreneur could convince a banker that no less than $60,000 would be available in any given year for interest expenses. Further, if the banker were willing to accept 12.0% interest and take all of the principal repayment at the end of year 5 (when the business is sold), then he should be willing to provide 60,000 ÷ .12 = $500,000 in the form of a loan.

• Now, the entrepreneur has raised $825,500 and needs only $174,500 to get into business.

• The terminal value, and the riskier portion of the operating cash flows, remain to be sold. Let’s assume that a venture investor would be willing to provide funds at a 50% rate of return.

First, we need to see precisely what cash flows remain:

Year 1 2 3 4 5 Total 400 400 400 400 5,600 - Wealthy investor 300 300 0 (100) (200) - Bank 60 60 60 60 560 = Remaining 40 40 340 440 5,240

Now, the remaining cash flows in years 1 through 5 have a present value, at the venture firm’s 50% rate, of $922,140. If we need $174,500, we need to give up $174,500 ÷ $922,140 = 18.9% of these flows in order to entice the venture investor to provide risk capital.

This leaves the entrepreneur with a significant portion of the above “remaining” flows. 0ne can see how these differences in needs and perceived risk allow the entrepreneur to create value for her.

In an attempt to highlight the logic and underlying principles, this example is both simplistic and overly precise. In the real world, all of these assumptions would be the subject of negotiation. But, the principles at work remain the same.

Understanding the Entrepreneur’s Own Needs

The example we have just worked through was based on the assumption that the entrepreneur wants to obtain funds at the lowest possible cost. While this is generally true, there are often other mitigating factors.

For the exclusive use of Y. Shao, 2017.

This document is authorized for use only by Yuanrui Shao in Entrepreneurship-440 F 2017 taught by Naumann, Arizona State University from August 2017 to December 2017.

Deal Structure and Deal Terms 806-085

5

The entrepreneur’s needs and priorities do vary across a number of aspects including the time horizon for involvement in the venture, nature of that involvement, degree of business risk, etc. All of these variables will affect the entrepreneur’s choice of a venture to pursue. However, once the entrepreneur has decided to embark on a particular business, his needs and priorities with respect to the financing of the venture will vary with respect to:

• degree of control desired; • mechanisms of control desired; • amount of financing required; • magnitude of financial return desired; and, • degree of risk which is acceptable.

For instance, in the above example, the entrepreneur could have decided to obtain an additional $100,000 or $200,000 as a cushion to make the venture less risky. This would certainly have lowered the economic return, but might have made the entrepreneur more comfortable with the venture.

Similarly, the bank which offered funds at 12%, or the venture investor, might have imposed a series of very restrictive covenants. Rather than accept this loss of control, the entrepreneur might rather have given up more of the economic potential.

In addition, the entrepreneur may need more than just money. There are times when some investor’s money is better than others. This occurs in situations where once an individual is tied into a venture financially, she has an incentive to help the entrepreneur in nonfinancial ways. For instance, an entrepreneur starting a business which depended on securing good retail locations would prefer to obtain financing from an individual with good real estate contacts than from someone without those contacts. Venture capital firms are frequently cited for providing advice and support in addition to financing.

Alternative Structures

0nce the fundamental economics of a deal have been worked out, the entrepreneur must still structure the deal. This requires the use of a certain legal form of organization, and a certain set of securities.

The vehicles through which the entrepreneur can raise capital include the general partnership, the limited partnership, an LLC, and A “regular” (or “C”) corporation. While these forms of organization differ with respect to their tax consequences, they also differ substantially in regards to the precision with which cash flows may be carved up and returned to various investors. In a limited partnership, for instance, virtually any distribution of profits and cash flow is feasible so long as it is spelled out clearly, and in advance in the limited partnership agreement. (Losses, however, are usually distributed in proportion to capital provided.)

Securities can involve debt, warrants, straight or preferred equity, and a host of other legal arrangements. The structuring of securities requires the assistance of good legal counsel, with an eye towards securities and corporate law, as well as an intimate knowledge of the tax code.

For the exclusive use of Y. Shao, 2017.

This document is authorized for use only by Yuanrui Shao in Entrepreneurship-440 F 2017 taught by Naumann, Arizona State University from August 2017 to December 2017.

806-085 Deal Structure and Deal Terms

6

An Example: A Venture Capital Term Sheet

The specifics of a deal are set out in writing in the form of a term sheet, which are the business terms of the deal. These terms, if agreed to by the involved parties, will ultimately be memorialized in a much longer set of legal documents which will be signed by all parties at the closing, where the entrepreneur will get a check to finance the venture, and the investors will legally acquire the securities they have purchased.

The most common form of term sheet is one which is obtained from venture capitalists (VCs)—or other sophisticated equity investors—related to an investment in the venture. Such term sheets are designed to address the important dimensions of the deal. They usually have a few standard sections and components.

Representations, Warranties and Due Diligence: First, the firm vouches for some of the information it has provided to the investors during their due diligence, including a list of the existing shareholders and the number and type of shares of stock outstanding. The firm also agrees to let investors perform additional due diligence prior to the closing, including the inspection of the company’s minutes of board meetings, financial statements, employment contracts, budget, status of R&D projects, lease agreements, and any other details which the investors believe will give them comfort on the assumptions they have made about the business.

The Security: The second major aspect of the term sheet is the description of the security being sold by the firm / bought by investors. Common stock is the classic equity security, and one share of stock is treated like others in terms of participation in the rewards such as dividends and payments upon liquidation. Preferred stock has a preference, which means that it will be paid “first” when there is a liquidation event (i.e., a sale of the company). That preference may be simply the amount of money invested, or it may increase at some rate, by using accrued dividends. That is, the preferred stock may have an imputed dividend that accrues until such a liquidation event, where the amount of the accrual is added on to the original purchase price and this total is the amount of the preference. A convertible security has the right to convert into common stock at an agreed upon conversion price. So, the holders of a convertible security would choose to convert if the company did well and the price of the common stock was higher than the conversion price. If the company did less well, they might choose not to convert, and instead, have the right to “redeem” the security for the price they originally paid, plus some accrued dividend (in the case of a convertible preferred) or accrued interest (in the case of a convertible debt security). All of these terms that differ from straight common are designed to give the investor a more-than-pro rata share of the value of the company (i.e., higher than in proportion to the value they would have received if they owned straight common stock) in a scenario where the company does not perform sufficiently well to earn them their desired return

The term sheet will be very specific about the number of shares, price per share, and other terms, the most common of which include:

− Voting: the voting rights attached to the security. Where only common stock is issued and outstanding, it is easy to treat all securities equally. When convertible and preferred shares are issued, the voting rights of those securities must be detailed (i.e., “The holders of the preferred stock will be entitled to vote their shares as though they had been converted to common”).

− Dividends: Whether dividends are paid, how much (in absolute dollars or percent on the price of each share), and whether dividends must be paid annually or whether they can accrue over time.

For the exclusive use of Y. Shao, 2017.

This document is authorized for use only by Yuanrui Shao in Entrepreneurship-440 F 2017 taught by Naumann, Arizona State University from August 2017 to December 2017.

Deal Structure and Deal Terms 806-085

7

− Participation rights: Participation refers to the right to “participate” in the upside of the company. That is, a preferred security may get its preferred return and no other return, or it may get the amount of preferred return stated, and then also have the right to participate in the upside (i.e., a share of what is left after the preferred return has been paid). Thus a participating preferred stock gets both its preferred return and a share of the upside, and participates in that upside as though it were common stock.

− Conversion rights: a convertible security has the right to convert to common stock. The conversion price is the price at which that conversion will occur. So, if the original price of a share of convertible preferred stock is $100 per share, and if the conversion price is also set at $100, then the shares would convert on a 1:1 basis. If the conversion price was set at $10 per share, then a share of convertible preferred could convert into 10 shares of common stock.

− Redemption rights: Redemption is the “calling” back of the preferred stock and “paying it off” by the company to eliminate it from the balance sheet. An optional redemption right gives the company the ability to decide whether or not it wishes to call the stock in. A mandatory redemption right gives the investor the right to decide if they want to “put” the stock back to the company. The price may be the original purchase price, or it may be a greater amount if dividends have been allowed to accrue.

− Anti-dilution provisions: Investors may also receive anti-dilution protection. That is, if an offering of shares is subsequently done at a lower price, the investors’ desire to protect themselves from the excess dilution that this offering would impose upon their ownership. Without getting into the very complicated specifics of “full ratchet” or “weighted average” anti-dilution provisions, suffice to say that the ratchet provision simply lowers the effective price of shares to the previous investors by forcing the company to issue new shares to these existing investors sufficient to lower their effective cost to the new lower price being paid by the new investors. A weighted average formula lowers the price less, in proportion to the amount of new investment relative to the amount invested by the existing investors.

Control: finally, the document will spell out the rights which the holders have to control, or at least have a voice, in the company. This included the right to attend board meetings, or perhaps, to name a board member. It spells out the overall composition of the board, and in general, who gets the right to appoint directors. Certain actions will be specified as requiring the consent of a majority of the investors (or a majority of the security they hold, or of a majority of the investor-appointed board members). These rights might include the issuance of new stock or the payment of dividends, as well as a sale of the company. This section will also spell out the rights of the investors to receive timely information, including financial statements, annual audits, etc.

Other terms and conditions: The term sheet also spells out certain actions that the company must take either prior to closing, or within 30 or 60 or 90 days. For instance, it could be a condition of closing that the company gets a new employment contract with a senior researcher that lasts for at least 2 years; that the company receives a lease extension from its landlord for at least an additional 5 years. Investors may require that within 90 days, the company hire an executive recruiter and begin a formal search for a new CEO or another member of the executive team, or that it hire to fill a new position (i.e., get a CFO instead of having only a controller).

For the exclusive use of Y. Shao, 2017.

This document is authorized for use only by Yuanrui Shao in Entrepreneurship-440 F 2017 taught by Naumann, Arizona State University from August 2017 to December 2017.

806-085 Deal Structure and Deal Terms

8

Summary

Of course, there are a variety of non-financial aspects to any deal, including the kind of working relationship the entrepreneur has with her new partners and the value they can add to the venture. Indeed, as our colleague Bill Sahlman likes to say, “From whom you raise money is more important than the terms upon which that money is raised.”

It is also worth pointing out the asymmetrical nature of the “bets” that are being made by the entrepreneur and the typical venture capitalist (or other investor who invests in many deals). The investor is playing a portfolio game, and, in such a situation, it can make a lot of sense to take higher and higher levels of risk as long as the possible increase in return is more than commensurate. For the entrepreneur, this is not the case. VCs are often characterized as “swinging for the fences” and this may make a lot of sense for them, but not for the entrepreneur.

Finally, the entrepreneur typically has a great deal of confidence in the venture and the business plan, and has usually done a lot of “selling” during the money raising process, projecting a great deal of faith in the market and the company’s ability to generate revenues and value. A venture capitalist—or any investor—can use that confidence to their advantage. For instance, the terms of a VC investment often include a preferred return up until a certain point. For instance, if a VC invests $10 million, they might do it in the form of a convertible security that earns imputed interest. Upon a liquidity event, they get their money back, plus the imputed interest, and then participate in what’s left on a “pro rata” basis i.e., as though they had owned their equity share all along. The implication of this is that they may get 100% of the value created unless that number hits a certain point. They can make a forceful argument about doing this by pointing to the entrepreneur’s confidence: “If you are so sure your company will be a success and achieve the results you suggest, then there will be plenty of value for you.” Entrepreneurs need to be aware that deal structures and deal terms do have the effect of carving up value differentially under different outcomes. The natural optimism of the entrepreneur can be used against him in such circumstances.

For the exclusive use of Y. Shao, 2017.

This document is authorized for use only by Yuanrui Shao in Entrepreneurship-440 F 2017 taught by Naumann, Arizona State University from August 2017 to December 2017.