Reporter with Silicon Hills News

unnamed“If you take one thing away with you, let it be this: 51 percent does not equal control.” Kevin Castillo of the Baylor Angel Network explained to an audience of about 30 entrepreneurs. “In a public company you can say ‘I own 70 percent of the company, I have control.’ But in a private company control is very much defined by the minority.”

Castillo was the first of several speakers at presentation called The Art of the Deal held Tuesday at the Austin Chamber of Commerce. The program was sponsored by the Spectrum program of the Texas State Small Business Development Center.

The cost of investment is control over your company, Castillo said. If you take investor money, you’re most likely only going to be able to repay it when you sell the company. “So if you don’t want to sell the company, don’t take investor money,” he said. Entrepreneurs often focus too narrowly when thinking about funding. For example, when it comes to term sheets, they zero in on the valuation—what the investor is trying to say their company is worth—and too little on the other terms of the deal.

“A lot of them are looking at the term sheet and only caring about the valuation. That’s dangerous. It reminds me of the story of the entrepreneur who was arguing about valuation and the investor said ‘I’ll give you any valuation you want, as long as I get to set the rest of the terms.’”

Castillo busted some myths about valuations:

  • Valuations are not objective, aren’t necessarily going to comport with other companies in the same stage, industry or area; nor can you look at what valuation your buddy got in “the same space” and expect the same.
  • It’s a waste of time and money to get a valuation from an independent accounting firm. In short, Castillo said, “We don’t care what value that firm gave you.”
  • Valuations are what the investor says your company is worth. Period.

Those Other Items on the Term Sheet

Some things investors will ask for are about economics, Castillo said. Most want preferred stocks. They’re going to ask for dividends but they’re not going to expect a business to pay quarterly dividends. They’d rather keep the cash in the company. They’ll get their dividend payments at the sale of the company. They may ask for conversion rights—to convert preferred stock into common stock.

Then there are the terms that get into control. If they ask for redemption rights, that means that at some point in the future they can make you buy out their shares at a preset price—generally only slightly above what they put in. Rarely do investors actually call in their redemption rights, Castillo said. That’s more of a control move. It’s a foot to put on the CEO’s neck and tell him to get moving. (Which is a little bit of an oxymoron.)

They will probably ask for an anti-dilution provision, known as a “down round” such that subsequent rounds of financing don’t dilute the investors share values. And they’ll definitely get control in voting rights. What those rights entail might make a big difference in whether an entrepreneur wants to go for the investment. They might cover items as broad as “You can’t increase the number of shares without my permission” or as specific as “You can’t write a check above $10,000 without my permission.”

There are a few exceptions to the rule that investors only get their money when you sell the company. Some entrepreneurs can establish revenue based financing in which the investment is paid back as a percentage of revenue. Usually the numbers are three-to-10 percent of revenue and investors expect a 2X to 5X multiple of their original investment.

Don’t Ignore Due Diligence

Before any investment, however, comes due diligence. Castillo quoted a Kauffman Foundation study that the return for investors who perform less than 20 hours of due diligence receive considerably less return on investment.

Most investors have due diligence checklists that include, as Costillo put it “Every legal form you would ever need.” Investments are often held up while entrepreneurs collect these documents from lawyers and accountants. It can speed up the process by six weeks to have copies of them on hand. There’s also a qualitative analysis in which investors talk to the team, customers and suppliers.

If entrepreneurs know they have anything in their backgrounds that could kill the deal—even an old conviction—they should let investors know up front and not hope it won’t be discovered. There’s also the Bad Actor Rule in which, if any member of the management team or shareholders fail to qualify for investment, the whole deal dies.

One factor of the due diligence process is investigating whether the company has protected its intellectual property. But on that note, Costillo said, too many companies ask him to sign non-disclosure agreements at the beginning of a discussion. Investors, he said, aren’t interested in stealing entrepreneurs’ ideas and don’t want to sign NDAs until they get to the place where they’re actually looking at the details of your technology.

Bill Hulsey, partner with Hulsey-Calhoun, spoke about the kinds of attributes investors look for. Integrity, he said, is “permission to play.” Following closely after that is passion.

Christian Forgey, owner of LightBoard Inc., which makes a technology that lights up everything from skateboards to t-shirts, concluded the presentation.

“I’m living the dream,” he joked, “and I wake up every night in a cold sweat.”

Starting with a light-up skateboard, Forgey said, he and his wife put their entire life savings into the business, cashed out their IRA and 401K, maxed out credit cards and sold his BMW to make payroll one time. Ultimately, it turned out that the most profitable business model was to dump the skateboard/longboard business and offer the light-up technology in various verticals. Focus on the technology. They’ve built a team for the company and are leveraging those connections. They’re expecting an investment from Silicon Valley of $3 million-to-$5 million.

Most entrepreneurs don’t have the background to structure these deals favorably, Costillo said. The best advice is to get a good lawyer who specializes in entrepreneurial investments. It will cost a lot, he admitted, but not as much as trying to structure the deal without one.

For entrepreneurs interested in prepping themselves, however, he suggested the book Venture Deals by Brad Feld.