I have always asked myself what makes a deal successful, not a company but a deal, or maybe better put, a transaction. Private equity and VC’s alike are merely doing transactions with a longer term horizon than investment bankers, brokers or even angel investors. At the end of the day a deal is a deal because if it wasn’t then there would be no need for “exits.” What is so important about exits? There is an old market saying that goes, “any idiot can buy a stock, its knowing when to sell it that makes him successful.” But I digress. Back to the three pillars theory (which has only been a working theory since the time I wrote it down two minutes ago.) Basically, there are really three parts to any transaction. These are security, structure and exit. I’m amazed at how often we see deals that don’t have these pillars in place. Without them, it is sure to be a failure, so pay attention! Let’s look at these parts separately while keeping the pontification and soapboxing down to a minimum. Before anyone, be it professional or not, looks at a deal the first thing they do is gauge the risk and see how it can be mitigated.
The security aspect of a deal can be broken down simply by the following:
- How much capital have the founders invested in relation to their net worth?
- What hard assets can be encumbered in case of a worst case scenario?
- Does the company have any IP, patents, contracts or customer lists that might have a tangible value to another company? If so, covertly gauge what they would be willing to pay.
The next pillar to this “theory” is the structure component. The following gives the methodology:
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- What type of financial instrument is going to be created that will give the investor the best upside and the most security. Hybrid products such as convertible debt, convertible preferred, senior subordinated self liquidating debt, etc… are no longer the exclusive tools of hedge funds and VC’s.
- The structure should afford the highest upside potential for the investors while allowing the company or the deal to have enough flexibility for subsequent rounds.
- The investment should have tangible hooks into the company. Hooks would be described as earn back provisions based on a schedule of revenues, cash flow or net income. Hooks are sometimes referred to as covenants and can include financial ratio’s that must be maintained or even capital expenditure caps.
- Structure makes sure the investors understand that this money is proactive without necessarily interfering with the operational side of the company.
And finally the most important factor and the last pillar is the “who, why and when,” better known as the exit!
- The “who” refers to the ending purchaser of the company or at minimum the purchaser of the investment. Actually, this is the first step in the investment process. Before anyone ever invests they should know who the logical buyer is going to be or what valuation range for a takeout would garner.
- The “why” is the compelling reason an investor invests in the first place. If you don’t know why then don’t invest.
- The “when” should be figured out prior to the structure ever being created. Make sure that the investor and the company are on the same page when it comes to time frame of an exit. This particular point has caused more headaches and lawsuits than any other specific aspect of the deal.
Typically the difference between a deal and an investment is the perceived time horizon until the inevitable exit. Make sure you know how and when you are going to get out of an investment before you ever get in. It is a matter of comfort level and short vs. long term perspective. Using the pillars described above will give you a great guideline for choosing the right deal for you.
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