Securing capital based on its prospective or future value to the company is one of the most important decisions for a young, growing firm and a challenge for its CFO. How do you assess not just the price of the capital being offered, but also it’s true worth (including intangibles) over the long term?
If only securing equity or debt capital were more like buying insurance. As the simplest example of financial prospective value, insurance is a well-defined contract whereby a policy holder is willing to pay premiums in exchange for future remuneration when a warehouse burns or some other calamity occurs. The mature insurance market and actuarial science drive a tight correlation between premiums paid today and potential payout later. This ability to quantify and correlate value is very different from debt and equity capital decisions, where measuring future value is a daunting task for both buyer and seller.
The Sage of Omaha, Warren Buffett, is credited with the quote, “price is what you pay, value is what you get,” a notion critically important when making decisions about capital sources. In product or service purchases, there is an inherent financial collar around the potential upside or downside surprise of the decision. But in decisions around business capital, the future value — yet-to-be determined or delivered — can vary widely, for both parties. With an abundance of capital currently seeking the best investment opportunities, CFOs have plenty of choices. However, they often overlook the most important terms without realizing it. Whether debt or equity, it’s important to look at price, but resist the urge to consider it above all else when weighing offers.
In equity transactions, price is about company valuation, and the CFO’s “ask” is invariably greater than the investor’s or acquirer’s “bid.” A tug-of-war ensues, as parties try to narrow the spread and get a deal done at a negotiated price that is acceptable to both. This myopia can be very dangerous.
Witness the entrepreneur defending at all costs his bottom-line pre-money valuation of $10 million, while giving little notice to the super-voting rights or liquidation preference (which investors get paid first in a liquidation event?) on page three of the term sheet. These structural elements of the deal — much more than valuation — can determine distribution of capital upon the investor’s exit, and also provide a window into the alignment between the investor and entrepreneur at the point-of-purchase. Wouldn’t it be helpful, when evaluating an offer, for management to have an appreciation of the level of shared confidence in management or optimism in the market opportunity? Price alone doesn’t tell the CFO that. (Harvard Business Review offers a valuable view on the risks of minimizing prospective value and the costs associated with equity investment decisions in “How to Negotiate with VCs.”)
Beyond structural considerations in a term sheet, the prospective value that a company can obtain from an equity partner may be in the form of intangible actions. These can be clarified at the point the investor injects capital into the firm, and the CFO needs to hold the investor accountable for these actions later. For example, a CFO needs to make certain new investors deliver on promises of introductions to potential clients, vendors or strategic partners. New board members should possess relevant operating experience to provide critical leverage to a thin management team, and the CFO has to confirm their availability as a mentor, given other board commitments. Don’t let price trump a broader tangible and intangible value proposition offered by potential investors.
On the debt side, we can be conditioned as personal and professional consumers of debt to commoditize the borrowing of money. Do you really care who underwrites your home mortgage, if it is 50 basis points less expensive? This conditioning to focus on price begins with widely published mortgage rates and bank prime rates. This is similar to posted gas prices. A driver will cross a raised median to save a couple of cents per gallon. But when pondering commercial debt deals, we are challenged to think beyond the transaction.
The money saved on fees and coupons in a term sheet bake-off can pale relative to the potential forward value provided from the right structure and partner. Similar to raising equity, it is critical to have alignment with the debt provider at “the point of entry” in order to avoid surprises.
The best (or worst) example of misalignment is when there is disagreement on in future operating performance. Suppose you have 90 percent confidence in your 2014 forecast, perhaps due to recurring revenues or a just-inked new contract that adds to your backlog. In that instance, negotiating a less-expensive “stream rate” (the coupon charged on the borrowed money) in exchange for tighter operating covenants could make sense. The borrower and the lender would make a deliberate decision to trade a lower cost of capital for a tighter operating range. Significant deviation from a covenant (say 15 percent), however, would be cause for alarm and reaction from both parties.
Many small and mid-size companies we work with are still exposed to internal and external vagaries inherent in early-stage development and commercialization. These firms require much greater flexibility and ultimately, patience, which translates into no covenant, or covenant-lite structures. While relatively more expensive, these structures enable the management teams to enjoy greater latitude to drive enterprise value rather than burn energy and resources on debt compliance.
A mash-up of both of these approaches would be negotiated pricing or structure grids that are explicit regarding future value for a commensurate milestone. For example:
- A cheaper coupon available following two consecutive quarters of favorable EBITDA;
- Relaxed reporting requirements based on modest borrowings or increasing liquidity; or
- Incremental commitments released upon pre-negotiated levels of performance.
Debt transactions also hold intangible partnership and relationship considerations. Does the lender understand the borrower’s business and industry segment? Can it make introductions to investors, industry peers, potential clients and partners? Can it scale with the company’s growing needs? Just like equity, it is advisable to think beyond price to the broader value.
In decisions regarding equity and debt capital, identifying and negotiating future value today will cost much less than trying to source the same amount of value later on. So choose partners that are aligned with you strategically and structurally, and have a proven ability to deliver true intangibles. They are the best investors for unlocking future value for your company.
Scott Bergquist is the central U.S. division manager for Silicon Valley Bank, overseeing business development and client relationship activities with 2,000 companies and managing more than $1 billion in committed capital. He specializes in financing solutions for high-growth technology and life-science companies.