How Sharks Think
A call to a good friend led me to pick up my pen. He told me that he was watching the television show Shark Tank, and he informed me that it was one of his favorite. In case you aren’t familiar, on this show, entrepreneurs pitch investment opportunities in their fledging businesses to a panel of high net-worth individuals, in exchange for equity positions, debt-financing deals, royalty payments, and/or board seats. Some of these businesses are really good ideas; others, um, need a bit of work. But so many have a glaring and common problem. As my friend put it, “Most of these entrepreneurs aren’t even trying to understand these investors.”
Interestingly enough, my friend is right. And his words don’t just apply to a one-hour television show laced with suspenseful music and commercial breaks. Those of us who have lived in the deal space know that my friend’s words basically ring true for nearly every deal we have ever touched.
When structuring a fundraising effort for a company, entrepreneurs have a lot of intricate details to consider. Determining the size and price for the offering of equity, of course, is profoundly important, and often enough, a significant stack of documents must be prepared for the consideration of investors. Indeed, there is no benefit for cutting corners during this process. And while entrepreneurs afford attention to these details, it is necessary to stress that entrepreneurs must give equal attention to the psychology of the investors.
It is important to remember that, all too often, the entrepreneur and the investor come to the table with different perspectives. For the entrepreneur, the company may be the realization of a dream, and his attachment to its success may be driven more by emotion than anything else. Meanwhile, the investor, though committed to seeing the company succeed, has a greater obligation to the money that he has invested in the company.
For his part, whether he is investing his own money or that of limited partners, the investor is basically putting money to work, with the hope that the investment in this company will grow in value and net him a greater return in the future. And in a world where investors are bombarded with so many different investment opportunities — from new business ventures to real estate to cryptocurrencies — returns matter. Investors know that, if they want to make the most of their capital, they must put that capital into opportunities that both seek and achieve alpha.
Consequently, when it comes to the numbers, for an investors, some key questions are very simple ones:
• How much money do you need?
• How will you be using this money?
• What will I get in return for my investment in this venture?
• What are the projections for the growth of this venture?
• What is the exit strategy?
• How much money will I likely make from this investment?
To be sure, the lion’s share of the return on investment may not come until the investor exits the company. However, there are ways that the investor can realize some returns before that time. Here are just a few of those:
• Dividends — The company can routinely pay out to its shareholders any profits or surplus capital not slated to be reinvested in the company.
• Fees — The investor can negotiate a deal to be compensated for effort. For example, the investor can be paid to serve on the company’s board of directors, or he can be paid a management fee to provide services to the company.
• Incentives — Pursuant to the terms negotiated in the deal, the company may be obliged to pay the investor a predetermined percentage of profits (a “kicker”) or a multiple of the investment over a given time.
• Interest — In the event that the funds raised are categorized as a convertible note, rather than as an equity investment, the company shall be obligated to make interest payments to the investor. Contingent on the terms of the deal, the investor may have the option to convert the note into equity at a later date.
When structuring the deal, the entrepreneur must give serious attention to the role of an exit strategy. An investor might shy away from a venture that does not present a clear exit strategy. Therefore, the entrepreneur is well-advised to be adaptable. Don’t be too married to a venture, no matter how much time and effort has been put into it; don’t allow ego to block the bigger picture. To an investor, where there is no exit strategy, the entrepreneur might seem to be more interested in building a vehicle to support his own lifestyle than building a company that could be sold off to return a windfall to everyone involved.
The following are a few of the options for exit strategies that the entrepreneur might consider presenting during the fundraising effort:
• IPO — While an initial public offering might sound titillating, the odds of a business ever selling shares on a stock exchange are quite slim. In fact, only about one percent of the 32.5 million companies in this country are publicly-traded companies. Most others are small businesses that — although successful, in their own right — do not have the capital or preparedness to meet market and regulatory requirements.
• Acquisition — This is the most likely of options, as an exit strategy goes, and there are multiple avenues to consider. For example, an entrepreneur and/or the company can put together a package to buy out an investor. Alternatively, funds from a subsequent and bigger round of investment can be used to buy out the investor. And what’s more, the entire company can be sold off to a financial or strategic buyer.
• Redemption — Prior to placing his investment in the company, an investor might negotiate the right to demand the repayment of his investment (and additional proceeds, where applicable), should the company be found in breach of specified covenants, including, but not limited to, meeting performance expectations. Typically, a redemption is considered a clause of last resort, but it may afford an investor the comfort necessary to take part in a deal.
Unlike a bank, an investor brings a lot more to the table than just capital. He usually avails his know-how, network, and other strategic resources to the benefit of the company, because he has every reason to help the company grow. His money is in it.
Yes, investors may seem to be predatory about the deals they structure. They crisscross their targets, sizing up everything from the company’s operational sustainability and valuation to the entrepreneur’s competence and the growth prospects. Then they strike quickly, refashioning the deal in terms that offer them a greater advantage, while leaving entrepreneurs with little choice but to succumb. Indeed, investors might resemble sharks, but that is only because they have a keen understanding of the risks they face. And they have a responsibility to themselves to manage that right, if they do decide to invest. Consequently, an entrepreneur may benefit greatly when aligning with the right investor for his business venture, so long as he, too, fully understands the motivations of that investor.
So, to close, here is a piece of advice for every entrepreneur: growing your company is one thing; helping your investors to realize good returns on their investments is another. Do both, and know the difference. When you work harder to keep the sharks satisfied, there is less of a chance you’ll get eaten.
