Managing Your Investors/Shareholders

Patrick H. Gaughan, J.D., M.B.A.Youngstown State University

Coffelt Hall

Youngstown, Ohio 44555

440 829 7010

pgaughan@YSU.edu

Part of the MBA Lite Series: Manage Your Business

The Hudson Library & Historical Society/ Burton D Morgan Center For Entrepreneurial

Research

Date Topic Title/Organization

Oct. 3, 2011 - DONE Innovation (Finding A Niche) The University of Akron

Oct. 10, 2011 - DONE Organizing The Business Balwin Wallace College

Oct. 17, 2011 - DONE Marketing The Idea Kent State University

Oct. 24, 2011 - DONE Finding The Funding Case Western Reserve University

Jan. 11, 2012 Managing Your Shareholders/Investors

Youngstown State University

Jan. 19, 2012 Rethinking Intellectual Property Strategy: The Impact of the America Invents Act

Case Western Reserve University

Feb. 1, 2012 Financial Decision Making Kent State University

Feb. 8, 2012 Mindsets of the Entrepreneur Hiram University

Who am I, what do I do?

• MBA and licensed attorney.• Co-founder of the Garden Club Angels.• Recently Exited East Palestine China Decorating,

LLC (a successfully restarted business).• Offices at

– YSU Graduate Studies, – YSU Williamson College of Business & – Youngstown Business Incubator.

• I work with entrepreneurs and angel investors.• Help structure and facilitate deals.• Work with high and low tech companies.

Before We Start… a few words about the Pros and

Cons of Different Investors.• Friends & Family• Customers / Suppliers• Angel Investors• Venture Capitalists

Friends & FamilyPros:• Informal• Easy Impressed• May invest regardless of opportunityCons:• You’ll see them forever• They probably don’t understand• Investment value likely cash-only

Customers/Suppliers

Pros:• Understand proposed service• Understand market• Have vested interest in successCons:• Have conflicts of interest• May overvalue contribution

Angel Investors

Pros:• May have outstanding contacts• May have relevant experienceCons:• May insist on

participating/controlling• Can be annoying and intrusive

Venture Capitalists

Pros:• Have resources to grow big fast• Have experience troubleshooting• Make Angel Investors appear reasonableCons:• Are certain to professionally negotiate tough

terms• Are impatient• Can and do replace underperforming management• Time wasted trying to get initial deal

For ALL Investors…

• Understand their risk tolerance.• What are their liquidity needs as relates to

investment period?• What do they expect for a return?• What role do they expect to play?• How accountable/responsive do they

expect you to be?• What, besides money, are they willing/able

to contribute? [See Investor matrix].

So, What’s “Managing Shareholders/Investors” All

About…?

1. Personalities2. Goals3. Contributions4. Valuation5. Structure6. Exit Arrangements

1 of 6: Personalities

• Notwithstanding everything else in this presentation, never maintain a Shareholder/Investor relationship with someone you don’t respect and/or with whom you can’t maintain a working relationship.

• Insist on integrity. Look for past examples.• Make sure the respective roles are agreed

upon and respected too.• If respect/relationship is lost – exit.• Repeat the bullets above as necessary.

2 of 6: Shared Goals• At the initiation of the relationship, clearly confirm

agreement on the purpose/goals of the organization. • Possible goals:

– Profit Maximization– Market leadership– IPO– Civic Contribution– Economic Development– Education– Respect and Envy of the Neighbors– Quality of Life

• Once agreement is achieved, be very careful in monitoring how the goals evolve. Seek consensus.

3 of 6: Contributions

• It is a mistake to view the contribution of a shareholder only in cash.

• Alternative potentially valuable contributions:– Cash– Information– Technical Know-How– Managerial Know-How– Contacts (customer, employee, distribution, etc.)

• Agree on the opportunity and how the investor can contribute value to it.

3 of 6: Contributions (part 2)

• Key - Match what the Shareholder/Investor wants and is able to give with what the Company needs to achieve its goals.

• Pay only for what is actually delivered AND that the Company values (while being respectful).

• Think about the Investor Matrix (next slide)• Remember The Step Function Relating

Company Value To Time (slide after that!)

The Investor Matrix

An Example of the Relationship of Company Value To Performance

Benchmarks

3 of 6: Contributions (tie-up)

• Secret is to tie the contributions of the Shareholder/Investor to the increase in value of the company.

• If no delivery, no additional interest.• If delivery, some to

Shareholder/Investor; some to company.

4 of 6: Valuation• No way to cover in 75 minutes!• Theoretical basis:

– Firm Value = NPV (future net profits discounted by

Risk)– Where i/y = minimum return

• Practical basis: – Firm Value =

cost of building/acquiring a competitor (are there barriers to entry stopping this?).

• It depends on the circumstance.

5 of 6: Structure

• Understand your corporate structure

• Understand your deal structure

Your Corporate Structure

• Are you a C or S corporation?• Are you an LLC? Managed or Member operated?• How many authorized shares do you have? How many

are Issued? Voting? Rights of participation? Dilutable?• Are their any liens against company assets?• Have you adopted Regulations/By-laws/Operating

Agreement?• Are there any Buy-Sell Agreements? Non-competition

agreements?

Your Deal Structure (1 of 7)

• Pick A Structure That Fits Both the Company’s and the Investor’s Goals.

• Be consistent on terms across Investors

Your Deal Structure (2 of 7)

• General options– Common equity– Preferred equity– Convertible Notes– Options/warrants

• This are discussed over the next

Common shares are highest risk (3 of 7)

• Last to be paid upon liquidation of the company

• Liquidity totally unknown• Payout generally pro rata to all other

issued shares• However, can be appropriate if buy-

laws/regulations are in place

Preferred Shares (4 of 7)

• Have benefit of preference as to dividends, liquidation, etc.

• Require two classes of shares (impacts S corps)

• Requires a certain level of investor sophistication

• As equity, dilutes ROE calculations but reduces balance sheet leverage

Convertible Notes (5 of 7)

• Treated as debt with right to become equity

• No voting rights until conversion• Preference upon liquidation• Value is certain prior to

conversion.

Promissory Notes w/ Warrants(6 of 7)

• Provides best of debt and equity• Increases leverage on balance sheet• Complicates bookkeeping for diluted

shares (like convertible notes)• Warrants (put or call)

Guarantees, Security Interests and other stuff. (7 of 7)

• Personal guarantees on corporate debt – watch out.

• Security Interests – provide a right to proceeds upon liquidation before all others.

• Loan covenants – place management and financial restrictions

• Full & Half Ratchet Provisions – Adjusts equity valuation for early-stage investors

• Rights of Participation – assures the right to invest in a particular round

6 of 6: Planning The Exit

• Nothing lasts forever; plan the exit before anyone enters.

• Discuss valuation issues upon entry.

• Understand the ways deal structure and management can change deal value.

6 of 6: Address company valuation issues

• What is your company worth?• What is the basis for your valuation?• What will the company be worth as you

hit each benchmark?• What will it be worth if you fail to reach

a benchmark as scheduled?

6 of 6: Ways of Establishing/Increasing Value

• Don’t need investment (seriously)• Comparable valuations• Established strategic purchase value• Believable profit projections• Deal structures minimizing risk• Compelling management team track record• Pre-sold customer ‘orders’• Multiple completed steps in implementation

plan

In Review: “Managing Shareholders/Investors” Is

About:1. Matching Personalities2. Sharing Goals3. Agreeing On Contributions4. Sharing Views On Valuation5. Establishing Structure6. Plan For The Investor’s Exit

Before Entry

Any questions?

Patrick H. Gaughan, J.D., M.B.A.Youngstown State University

Coffelt HallYoungstown, Ohio 44555

440 829 7010pgaughan@YSU.edu