I have spoken with many ISO’s who are considering growing their businesses by taking on an investor. The idea here, of course, is for the investor to provide funds which will pay the bills associated with the money-losing period that accompanies any expansion. You can’t create sales growth without salespeople, and salespeople have to be paid before they can produce sales. They also need offices, staff support, equipment, etc. That means expenses will go up faster than revenues for a while, resulting in a loss. Then, revenues will catch up, eventually exceeding expenses, resulting in profits.
The new investor will be entitled to some of those profits, but if the profit stream grew by more than you gave up to the investor, your share grew as well. It’s a beautiful idea and one that has been a vitally important part of the American business world since the beginning.
But there are some important issues to consider which most people tend to ignore on the front end of a deal like this: How to get the investor out of the deal on the back end. Mostly, people are thinking about how to get the investor IN the deal, not OUT of it. But it’s important to consider how the investor will achieve their goals for the investment at the beginning of the relationship before you take on capital and the expectations that go with it. It’s perfectly legitimate to ask “How do I want this to end up?” at the beginning of a deal.
An investment in a company at the equity (stock) level is a promise by the company to use the invested money productively, later returning an amount greater than the original investment. I know that seems obvious, but what’s not obvious is how that amount will be returned to the investor.
A bank is a type of investor, and their deal structure is pretty straightforward – they lend you the money and you pay it back plus a percentage of the total outstanding each month. Banks usually want to be out of your deal in five years or less because they can’t really see what’s coming after that. If you don’t pay the money back, there are going to be problems.
An equity investor is buying stock in your company which has a time frame which is not specifically defined. He expects to get more money (usually lots more) back sometime in the future. There are two basic ways of doing this: Selling his stock to someone else, or receiving a dividend stream for a long period of time. Right away you can see the issues.
If the company’s intent is to create the return on investment through a dividend payout, will the business create that reliable cash flow stream? Will it be sufficient to meet the goals of the investor for return on investment? Will the company be forced to pay dividends when it really should be reinvesting money in productive uses which continue growth or software development? Furthermore, is the tax treatment of dividends the preferable method, or is a capital gain better?
If the intent is to sell the stock, the questions are: “To whom, when and at what price?” Does the investor have the right to sell the shares to anyone at anytime and at any price? What if the management team and/or founders might not want the new investor in their company? Does the management team have the chance to sell stock at the same time and on the same terms?
Getting the expectations of all the parties — the investor, the company and the management — straight is a good start for any venture. Everyone should know what is expected of them and what they can expect in return.
One more thought on this subject. There’s a natural tendency to consider putting investors on the Board of Directors of the company.
This might make sense if the investors are professionals or have some expertise or experience which is important to the future development of the company. It’s not an appropriate thing to do if the investors are just wealthy people who are looking for a place to put their money. They might ask for representation on the Board but resist the temptation to put them there. Young growing companies need expertise and guidance as much as they need capital.
There are lots of issues to consider when thinking about the back end of an investment. I recommend that you consider them thoroughly so that everyone knows what the future holds.
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