New Capital _ Chap015a

15
Chapter Fifteen
The Deal: Valuation, Structure, and
Negotiation
Results Expected
Upon completion of this chapter you will have:
1. Determined methodologies used by venture capitalists and professional investors to
estimate the value of a company.
2. Examined how equity proportions are allocated to investors.
3. Studied how deals are structured, including critical terms, conditions, and covenants.
4. Examined key aspects of negotiating and closing deals.
5. Characterized good versus bad deals and identified some of the sand traps entrepreneurs
face in venture financing.
6. Analyzed an actual deal presented to an entrepreneur in the “Bridge Capital Investors”
case study.
Teaching Pedagogies
There are four pedagogical options the chapter that you can consider when conducting
class sessions. These notes are organized to enable you to create whatever format and blend of
these teaching plans that you'd like. The four pedagogies are:
1. a lecture or mini-lecture
2. the traditional case study
3. the use of exercises or role plays
4. a combination of the above.
The syllabi earlier in this Instructor's Manual (pages 28-53) also illustrate how some
instructors have blended the pedagogies.
Lecture Outline
I. The Art and Craft of Valuation.
39 Chapter 15

A. The entrepreneur’s world of finance is very different from
corporate finance of public companies.
B. The private capital world of entrepreneurial finance is more
volatile, more imperfect, and less accessible than capital
markets.
1. The sources of capital are different.
2. The companies are much younger and the environment
more rapidly changing.
3. Cash is king, and liquidity and timing are everything.
4. The determination of a company’s value is elusive.
II. What Is a Company Worth?
A. It all depends—the market for private companies is very
imperfect.
B. Determinants of Value.
1. The criteria and methods used to value companies
traded publicly have severe limitations.
2. The ingredients to the entrepreneurial valuation are
cash, time, and risk.
C. Long-Term Value Creation versus Quarterly Earnings.
1. An entrepreneur’s core mission is to build the best
company possible.
2. Building long-term value is more important than
maximizing quarterly earnings.
D. Psychological Factors Determining Value.
1. At market peaks, price/earnings have exceeded 20 times
earnings.
2. During the dot.com bubble from 1999 to early 2000,
valuations were more extreme.
3. Behind this is a psychological wave, a combination of
euphoric enthusiasm exacerbated by greed and fear of
missing the run up.
E. A Theoretical Perspective.
1. There are at least a dozen different ways of determining
the value of a private company.
2. It can be a mistake to approach valuation in hopes of
arriving at a single number.
3. It is more realistic to set a range of values within which
the buyer and the seller need to negotiate.
F. Investor’s Required Rate of Return (IRR).
1. Various investors will require a different rate of return
(ROR) for investments in different stages of
Text Exhibit 15.1
“Rate of Return Sought by
Venture Capital Investors”
summarizes the annual rates of
return that venture capital
investors seek on investments
by stage of development and
how long they expect to hold
these investments.
Also:
Transparency Master 15-1
“Rate of Return Sought by
Venture Capital Investors”
(Text Exhibit 15.1)
Results Expected #2
Examined how equity
40 Chapter 15

development.
2. Factors underlying the required ROR include premium
for systemic risk, illiquidity, and value added.
G. Investor’s Required Share of Ownership.
1. The rate of return required by the investor determines
the investor’s required share of the ownership.
2. Text Exhibit 15.2 illustrates this calculation.
3. By changing any of the key variables, the results will
change accordingly.
proportions are allocated to
investors.
Text Exhibit 15.2
“Investor’s Required Share of
Ownership under Various
ROR Objectives” shows how
rate of return required
determines the investor’s
required share of ownership.
Also:
“Investor’s Required Share of
Ownership under Various
ROR Objectives” (Text
Exhibit 15.2)
III. The Theory of Company Pricing.
A. The capital market food chain depicts the evolution of a
company from its idea stage through an initial public offering
(IPO.)
1. The appetite of the various sources of capital vary by
company size, stage, and amount of money invested.
2. Entrepreneurs who understand the food chain are better
prepared to target fund-raising strategies.
B. The Theory of Company Pricing is simplistically depicted in
Text Exhibit 15.4.
1. A venture capital investor envisions two to three rounds
of financing.
2. The per share equivalent increases with each round: 4 to
5 times markup to Series B, followed by a double markup
to Series B, then again by double markup to Series C.
Text Exhibit 15.3
“The Capital Markets Food
Chain for Entrepreneurial
Ventures” depicts the “food
chain” of sources and amounts
of capital needed at each stage
of development.
Text Exhibit 15.4
“Theory of Company
Pricing” shows a simplistic
depiction of the per-share
pricing expected at each
progressive series of financing.
Also:
“Theory of Company
Pricing” (Text Exhibit 15.4)
IV. The Reality.
A. The venture capital industry has exploded in the past 25 years.
1. Current market conditions, deal flow, and relative
bargaining power influence the actual deal.
2. The dot.com implosion led to much lower values for
private companies.
B. The Down Round or Cram Down circa 2003.
1. In this environment, entrepreneurs face rude shocks in
the second or third round of financing.
2. Instead of a four or even five times increase in the
valuation from Series A to B, or B to C, entrepreneurs
encounter a “cram down” round.
3. The price is typically one-fourth to two-thirds of the last
round, severely diluting the founders’ ownership.
Text Exhibit 15.5
“The Reality” shows how
current market conditions, deal
flow, and relative bargaining
power influence the actual deal
struck.
Also:
“The Reality” (Text Exhibit
15.5)
Text Exhibit 15.6
“The Reality: The Down
Round” shows the loss of
valuation that can occur during
the second round of financing,
the “cram down”
Instructor’s Manual 41

4. In many financings in 2001 and 2002, onerous
additional conditions were imposed.
5. The valuation of a company is vulnerable and volatile.
6. Even strongly performing companies were crammed
down in this market environment.
7. Underperforming companies had difficulty finding any
financing.
Also:
“The Reality: The Down
Round” (Text Exhibit 15.6)
V. Valuation Methods.
A. The Venture Capital Method.
1. is appropriate for investments in a company with
negative cash flows at the time of the investment, but
which anticipates significant earnings in a number of
years.
2. Venture capitalists are the most likely investors to
participate in this type of investment.
3. The steps involved are:
a. Estimate the company’s net income in a number
of years.
b. Determine the appropriate price-to-earnings ratio,
or P/E ratio.
c. Calculate the projected terminal value by
multiplying net income and the P/E ratio.
d. The terminal value can then be discounted to find
the present value of the investment.
e. To determine the investor’s required percentage
of ownership, the initial investment is divided by
the estimated present value.
f. Finally, the number of shares and the share price
must be calculated.
B. The Fundamental Method is simply the present value of the
future earnings stream.
C. The First Chicago Method.
1. The method, developed at First Chicago Corporation’s
venture capital group, employs a lower discount rate,
but applies it to an expected cash flow.
2. That expected cash flow is the average of three possible
scenarios.
3. The formula is presented in Transparency Master 15-
8.
4. This formula differs in two ways:
a. The basic formula assumes there are no cash
flows between the investment and the harvest.
Results Expected #1
Determined methodologies
used by venture capitalists and
professional investors to
estimate the value of a
company.
Transparency Master 15-6A
“The Venture Capital
Method, Part A: Final
Ownership” summarizes the
calculations involved in
determining the final ownership
required using the venture
capital method.
Transparency Master 15-6B
“The Venture Capital
Method, Part B: New Shares”
shows the calculations involved
in determining the number of
new shares.
Text Exhibit 15.7
“Example of the
Fundamental Method” shows
the calculations used to
determine the present value of
the future earnings stream.
Also:
“Example of the
Fundamental Method” (Text
Exhibit 15.7)
“The Formula for the First
Chicago Method” gives the
formula used to calculate
required final ownership using
the First Chicago Method.
42 Chapter 15

b. The basic formula does not distinguish between
the forecast terminal value and the expected
terminal value.
5. Text Exhibit 15.8 is an example of using this method.
D. Ownership Dilution.
1. The previous example is unrealistic because several
rounds of investments are necessary to finance a high-
potential venture.
2. As illustrated in Text Exhibit 15.9, three rounds of
financing are expected.
3. The final ownership that each investor must be left with,
given a terminal price/earnings ratio of 15, can be
calculated using the formula presented in Transparency
Master 15.10.
E. Discounted Cash Flow.
1. In a simple discounted cash flow method, three periods
are defined:
a. Years 1-5.
b. Years 6-10.
c. Year 11 to infinity.
2. The necessary operating assumptions are initial sales,
growth rates, EBIAT/sales, and (net fixed assets +
operating working capital)/sales.
3. The discount rate can be applied to the weighted average
cost of capital (WACC.)
4. Then the value for free cash flow (Years 1-10) is added
to the terminal value.
F. Other Rule-of-Thumb Valuation Methods.
1. Other valuation methods are based on similar, most
recent transactions of similar firms.
2. Venture capitalists know the activity in the current
marketplace for private capital.
3. These methods are used most often to value an existing
company rather than a startup.
Text Exhibit 15.8
“Example of the First
Chicago Method” presents the
First Chicago Method
calculation of valuation based
on the average of three possible
scenarios.
Also:
“Example of the First
Chicago Method” (Text
Exhibit 15.8)
Text Exhibit 15.9
“Example of a Three-Stage
Financing” presents a pricing
worksheet in which three
financing rounds are expected.
“Dilution of Final
Ownership” shows how to
determine the final ownership
that each investor must be left
with, given a terminal
price/earnings ratio of 15.
VI. Tar Pits Facing Entrepreneurs.
A. There are several inherent conflicts between entrepreneurs, or
the users of capital, and the investors, or the suppliers of
capital.
1. The entrepreneur wants to have as much time as
possible for the financing, while the investors want to
supply capital just in time.
2. Users of capital want to raise as much money as

possible, while the investors want to supply just enough
capital in staged commitments.
3. In the negotiations of a deal, each side balances and deal
terms.
B. The styles of providers and users of capital differ.
1. The users value their independence and flexibility.
2. The investors are hoping to preserve their options.
C. There are also clashes in the composition of the board of
directors.
1. The entrepreneur seeks control and independence.
2. The investors want the right to control the board if the
company does not perform as well as expected.
D. The long-term goals of the users and suppliers of capital may
also be contradictory.
1. The entrepreneurs may be content with the progress of
their venture.
2. The investors will want their capital to produce
extraordinary gains.
E. Management styles also differ.
1. The entrepreneur is willing to take a calculated risk or to
minimize unnecessary risks.
2. The investor is willing to accept higher risks for higher
return.
3. Entrepreneurs see opportunities and seize them.
4. Investors are looking for clear steady progress.
F. The ultimate goals may differ.
1. The entrepreneur views success as a process of long-
term company building.
2. The investors will want to cash out in two to five years.
VII. Staged Capital Commitments.
A. Venture capitalists rarely invest all the external capital that a
company will require.
1. Instead, they invest in companies at distinct stages in
their development.
2. By staging capital, the venture capitalists preserve the
right to abandon a project whose prospects look dim.
B. Staging the capital also provides incentives to the
entrepreneurial team.
1. To encourage managers to conserve capital, venture
capital firms apply strong sanctions if capital is misused.
a. Increased capital requirements invariably dilute
44 Chapter 15

management’s equity share.
b. The staged investment process enables venture
capital firms to shut down operations.
2. The threat by investors to abandon a venture is a key
incentive for entrepreneurs.
C. Venture capitalists can also discipline wayward managers by
firing or demoting them.
1. The stock purchase agreement then becomes important.
2. Noncompete clauses can impose strong penalties on
those who leave.
D. Entrepreneurs understand that if they meet those goals, they
will end up owning a significantly larger share of the company
than if they insisted on receiving all the capital up front.
VIII. Structuring the Deal.
A. What Is a Deal?
1. Deals are economic agreements between at least two
parties.
2. A way of thinking about deals over time: William A.
Sahlman from Harvard Business School suggest a series
of questions—presented on page 510—as a guide for
deal makers.
3. The characteristics of successful deals are presented in
Transparency Master 15-11.
4. The Generic Elements of Deals.
a. The deal includes value distribution, basic
definitions, assumptions, performance incentives,
rights, and obligations.
b. It also involves mechanisms for transmitting
timely, credible information, plus negative and
positive covenants, default clauses, and remedial
action clauses.
5. Tools for Managing Risk/Reward.
a. The claims on cash and equity are prioritized by
the players.
b. Tools available are common stock, partnerships,
preferred stock, debt, performance conditional
pricing, puts and calls, warrants, and cash.
c. Nonmonetary tools include:
• Number, type, and mix of stocks.
• The number of seats on the board of directors.
• Possible changes in the management team and
in the composition of the board.
Results Expected #3
Studied how deals are
structured, including critical
terms, conditions, and
covenants.
“Characteristics of Successful
Deals” shows some of the
characteristics of deals that
have proven successful over
time.

• Specific performance targets for revenues,
expenses, market penetration, and the like.
B. Understanding the Bets.
1. Deals are based on cash, risk, and time, and are subject
to interpretation.
2. Various valuation methods contribute to the complexity
of deals.
3. The text presents three examples of term sheets.
4. The entrepreneur needs to identify the underlying
assumptions, motivations, and beliefs of the individuals
proposing the deals.
C. Some of the Lessons Learned: The Dog in the Suitcase.
1. Raising capital can have all the surprises of a “dog in
the suitcase.”
2. Tips that can help minimize many of these surprises:
a. Raise money when you do not need it.
b. Learn as much about the process and how to
manage it as you can.
c. Know your relative bargaining position.
d. If all you get is money, you are not getting much.
e. Assume the deal will never close.
f. Always have a backup source of capital.
g. The legal and other experts can blow it.
h. Users of capital are invariably at a disadvantage in
dealing with the suppliers of capital.
i. If you are out of cash when you seek to raise
capital, suppliers of capital will eat you for lunch.
j. Startup entrepreneurs are raising capital for the
first time; suppliers of capital have done it many
times.
IX. Negotiations.
A. Negotiations have been defined by many experts in many ways.
B. What Is Negotiable?
1. It is possible for an entrepreneur to negotiate and craft
an agreement that represents his or her needs.
2. During the negotiation, both the investors and the
entrepreneur have the opportunity to size each other up.
3. Successful negotiation is one in which both sides
believe they have made a fair deal.
4. The best deals are those in which neither party wins and
neither loses.
Results Expected #4
Examined key aspects of
negotiating and closing deals.
46 Chapter 15

5. Instead of soft or hard negotiation tactics, an approach
based on principle negotiation has been developed.
6. Principled negotiation is based on four points:
a. People: Separate the people from the problem.
b. Interests: Focus on interests, not positions.
c. Options: Generate a variety of possibilities before
deciding what to do.
d. Criteria: Insist that they result be based on some
objective standard.
7. By being reasonable, you’ll have a better chance of
getting what you want.
C. The Specific Issues Entrepreneurs Typically Face.
1. The primary focus is likely to be on how much the
entrepreneur’s equity is worth and how much is to be
purchased by the investor’s investment.
a. Other issues involving legal and financial control
of the company and the rights and obligations of
investors and entrepreneurs.
b. Another issue is the value behind the money that a
particular investor can bring to the venture.
2. Many of the tools for managing risk/reward discussed in
the previous section also apply.
3. Subtle but significant issues may be negotiated;
a. Co-sale provision, by which investors can tender
their shares of their stock before an initial public
offering.
b. Ratchet antidilution protection, which enables the
lead investors to get free additional common stock
if subsequent shares are ever sold at a price lower
than originally paid.
c. Washout financing, which wipes out all
previously issued stock when existing preferred
shareholders will not commit additional funds.
d. Forced buyout, allowing the investor to find a
buyer if management cannot.
e. Demand registration rights for at least one IPO in
three to five years.
f. Piggyback registration rights grant rights to sell
stock at the IPO.
g. Key-person insurance, requiring the company to
obtain life insurance on key people.
D. The Term Sheet.
1. Regardless of the source of capital, the entrepreneur will
want to be informed about the terms and conditions that

govern the deal signed.
2. For example, there are four common instruments:
a. Fully participating preferred stock.
b. Partially participating preferred stock.
c. Common preference.
d. Nonparticipating preferred stock.
3. As presented in Text Exhibit 15.10, there can be up to a
$24 million difference in the payout received in each of
these four instruments.
E Black Box Technology, Inc., Term Sheet.
1. One excellent presentation of the deal structure, term
sheet contents, and their implications is presented in
Black Box Technology, Inc.—Term Sheet.
2. This term sheet is a blue print for successful
negotiations.
Text Exhibit 15.10
“Considering the Economics:
$200 Million IPO or
Acquisition?” shows the
different economic
consequences of using four
common instruments.
Also:
“Considering the Economics:
$200 Million IPO or
Acquisition?” (Text Exhibit
15.10)
X. Sand Traps.
A. Strategic Circumference.
1. Each fund-raising strategy causes actions and
commitments that will eventually scribe a strategic
circumference around the company.
2. The entrepreneur needs to think through the
consequences of each fund-raising strategy.
3. Scribing a strategic circumference may be intentional, or
may be unintended and unexpected.
B. Legal Circumference.
1. Legal documentation spells out the terms, conditions,
responsibilities, and rights of the parties to a transaction.
2. Because these details come at the end of the fund-
raising process, an entrepreneur may arrive at a point of
no return.
3. To avoid this trap, entrepreneurs need to sweat the
details.
a. It is very risky for an entrepreneur not to carefully
read final documents.
b. It is also risky to use a lawyer who is not
experienced and competent.
C. Attraction to Status and Size.
1. Simply targeting the largest or the best-known firms is a
trap entrepreneurs often fall into.
2. Such firms may or may not be a good fit.
Results Expected #5
Characterized good versus bad
deals and identified some of the
sand traps entrepreneurs face in
venture financing.
48 Chapter 15

3. It is best to focus your efforts toward financial backers,
whether debt or equity, who have intimate knowledge
and experience in the competitive area.
D. Unknown Territory.
1. Entrepreneurs need to know the terrain, particularly the
requirements and alternatives of various equity sources.
2. A venture that is not a “mainstream venture capital
deal” may be overvalued and directed to investors who
are not a realistic match.
3. The text uses the example of “Opti-Com’s” ill-directed
search for suitable venture capital.
E. Opportunity Cost.
1. An entrepreneur’s optimism can lead to grossly
underestimating the real costs of getting the cash in the
bank.
a. They also underestimate the real time, effort, and
creative energy required.
b. There are opportunity costs in expending these
resources in a particular direction when both the
clock and the calendar are moving.
2. In the months it takes to develop a capital source, cash
and human capital might have been better spent
elsewhere.
3. It is common for top management to devote as much as
half of its time trying to raise a major amount of outside
capital.
a. The effect on near-term performance is invariably
negative.
b. If high expectations are followed by a failure,
morale can deteriorate and key people can be lost.
4. Significant opportunity cost are also incurred in forgone
business and market opportunities.
F. Underestimation of Other Costs.
1. Entrepreneurs tend to underestimate the out-of-pocket
costs associated with both raising money and living with
it.
a. The Securities and Exchange Commission
requires regular audited financial statements.
b. There are also outside directors’ fees and liability
insurance premiums, legal fees, and so on.
2. Another “cost” is of the disclosure that may be
necessary to secure a backer.
a. Personal and company details may need to be
revealed to people whom the entrepreneur does

not really know and trust.
b. The ability to control access to the information is
also lost.
G. Greed: The entrepreneur may find the money irresistible
H. Being Too Anxious.
1. Another trap is believing that the deal is done and
terminating discussions with others too soon.
2. Entrepreneurs want to believe the deal is done with a
handshake.
3. The entrepreneur may need to create an illusion of
multiple financing options.
I. Impatience.
1. Another trap is being impatient when an investor does
not understand quickly.
2. If the entrepreneur becomes too impatient, they expose
themselves to additional risk.
J. Take-the-Money-and-Run Myopia.
1. This trap prevents an entrepreneur from evaluating to
what extent the investor can add value to the company
beyond money.
2. In this trap the entrepreneur does not adequately
consider the prospective financial partner’s relevant
experience and know-how in the market and the
contacts the entrepreneur needs.
3. Many founders overlook the high value-added
contributions and erroneously opt for a “better deal.”
XI. Chapter Summary.
Answers to Study Questions
1. Why can there be such wide variations in the valuations investors and founders place on
the companies?
The determination of a company’s value is more art than science. Unlike the market for
public companies, the market for private companies is very imperfect. The criteria and methods
used to value companies traded publicly have severe limitations when applied to entrepreneurial
companies.
2. What are the determinants of value?
The ingredients to the entrepreneurial valuation are cash, time, and risk. The amount of
cash available and the cash generated play an important role in valuation. Timing of the deal
plays an influential role. Finally, risk or perception of risk contributes to the determination of
value. “The greater the risk, the greater the reward” plays a role in how investors value the
venture.
50 Chapter 15

3. Define and explain why the following are important: long-term value creation, investor’s
required IRR, investor’s required share of ownership, DCF, deal structure, and sand
traps in fund-raising.
Long-term value creation means building the best company possible. This is the core
mission of the entrepreneur. Creating value for the long-run is very different from simply
maximizing quarterly earnings to attain the highest share price possible.
Investor’s required rate of return (IRR) is the annual rate of return that venture capital
investors seek on investments. The required ROR is a function of premium for systemic risk,
illiquidity, value added, stage of development, and amount of capital invested.
Investor’s required share of ownership is the percentage of the venture which the
investor seeks to obtain. This involves computing the future value of the company. The rate of
return required determines the investor’s required share.
DCF is the discounted cash flow, based on three time frames. This is calculated by using
initial sales, growth rates, EBIAT, and working capital in each time period. The discount rate can
be applied to the weighted average cost of capital. Then the value for free cash flow is added to
the terminal value.
Deal structure is the set of negotiated agreements between investor and entrepreneur.
Most deals involve the allocation of cash flow streams, the allocation of risk, and allocation of
value between the different groups. The deal includes value distribution, basic definitions,
assumptions, performance incentives, rights, and obligations.
Sand traps in fund-raising are the pitfalls a venture can fall into when trying to obtain
financing. These include strategic circumference, legal circumference, attraction to status and
size, unknown territory, opportunity cost, underestimation of other costs, greed, being too
anxious, impatience, and take-the-money-and-run myopia.
4. Explain five prevalent methods used in valuing a company and their strengths and
weaknesses, given their underlying assumptions.
The venture capital method is appropriate for investments in a company with negative
cash flows at the time of the investment, but which anticipates significant earnings in a number of
years. Venture capitalists are the most likely investors to participate in this type of investment.
The steps involved are:
(1) Estimate the company’s net income in a number of years.
(2) Determine the appropriate price-to-earnings ratio, or P/E ratio.
(3) Calculate the projected terminal value by multiplying net income and the P/E ratio.
(4) The terminal value can then be discounted to find the present value of the
investment.
(5) To determine the investor’s required percentage of ownership, the initial
investment is divided by the estimated present value.
(6) Finally, the number of shares and the share price must be calculated.
This method is commonly used by venture capitalists because they make equity
investments in industries often requiring a large initial investment with significant projected
revenues. The percentage of ownership is a key issue in the negotiations.
The fundamental method is simply the present value of the future earnings stream.

The First Chicago Method, developed at First Chicago Corporation’s venture capital
group, employs a lower discount rate, but applies it to an expected cash flow. That expected cash
flow is the average of three possible scenarios, with each scenario weighted according to its
perceived probability. The formula is presented in Transparency Master 15-8. This formula
differs in two ways:
(1) The basic formula assumes there are no cash flows between the investment and the
harvest.
(2) The basic formula does not distinguish between the forecast terminal value and the
expected terminal value.
The traditional method uses the forecast terminal value, which is adjusted through the use
of a high discount rate.
The ownership dilution method considers the discount rates that are most likely to be
applied in succeeding rounds. The previous valuation example is unrealistic because several
rounds of investments are necessary to finance a high-potential venture. As illustrated in Text
Exhibit 15.9, three rounds of financing are expected. In addition to estimating the appropriate
discount rate for the current round, the first round venture capitalist must now estimate the
discount rates that are most likely to be applied in the following rounds. The final ownership that
each investor must be left with, given a terminal price/earnings ratio of 15, can be calculated
using the formula presented in Transparency Master 15.10.
In a simple discounted cash flow method, three periods are defined: Years 1-5. Years 6-
10, and Year 11 to infinity. The necessary operating assumptions are initial sales, growth rates,
EBIAT/sales, and (net fixed assets + operating working capital)/sales. Using this method, one
should also note relationships and trade-offs. The discount rate can be applied to the weighted
average cost of capital (WACC.) Then the value for free cash flow (Years 1-10) is added to the
terminal value.
There are other valuation methods based on similar, most recent transactions of similar
firms. Venture capitalists know the activity in the current marketplace for private capital. These
methods are used most often to value an existing company rather than a startup.
5. What is a staged capital commitment, and why is it important?
Venture capitalists will rarely, if ever, invest all the external capital that a company will
require to accomplish its business plan; instead, they invest in companies at distinct stages in their
development. By staging capital, the venture capitalists preserve the right to abandon a project
whose prospects look dim. Staging the capital also provides incentives for the management team.
6. What is a company worth: explain the theory and the reality of valuation.
A company evolves from its idea stage through an initial public offering (IPO.) The
appetite of various sources of capital varies by company size, stage, and amount of money
invested. In the theory of company pricing, a venture capital investor envisions two to three
rounds. The per share equivalent increases with each round: four to five times markup to Series
B, followed by a double markup to Series B, then again by double markup to Series C.
In reality, current market conditions, deal flow, and relative bargaining power influence
the actual deal struck. Changes in the overall market can radically impact the valuation of a
company. During the dot.com bubble from 1998 to early 2000, the valuations became extreme—
some companies were valued at 10 times revenue. When the collapse came, even strongly
performing companies saw their valuations plummet. In this environment, the price per share of
ventures may actually decline in the second round of financing, diluting the founder’s ownership.
52 Chapter 15

7. What is a “cram down” round?
Ventures typically go through three to four rounds of financing from idea stage to initial
public offering. In theory, the per share equivalent increases with each round: four to five times
markup to Series B, followed by a double markup to Series B, then again by double markup to
Series C. In reality entrepreneurs face rude shocks in the second or third round of financing.
Instead of a substantial four or even five times increase in the valuation from Series A to B, or B
to C, they are jolted with a “cram down” round, in which the price is typically one-fourth to two-
thirds of the last round.
8. What are some of the inherent conflicts between investors and entrepreneurs, and how
and why can these affect the venture’s odds for success?
There are several inherent conflicts between entrepreneurs, or the users of capital, and the
investors, or the suppliers of capital. The entrepreneur wants to have as much time as possible for
the financing, while the investors want to supply capital just in time.
Users of capital want to raise as much money as possible, while the investors want to
supply just enough capital in staged commitments. In the negotiations of a deal, each side
balances capital and deal terms.
The styles of providers and users of capital differ. The users value their independence and
treasure the flexibility their own venture has brought them. However, the investors are hoping to
preserve their options, including reinvesting and abandoning the venture.
There are also clashes in the composition of the board of directors. The entrepreneur
seeks control and independence. The investors want the right to control the board if the company
does not perform as well as expected.
The long-term goals of the users and suppliers of capital may also be contradictory. The
entrepreneurs may be content with the progress of their venture and happy with a single or
double. The investors will not be quite as content with moderate success, but instead want their
capital to produce extraordinary gains.
Management styles also differ. The entrepreneur is willing to take a calculated risk or is
working to minimize or avoid unnecessary risks. The investor is willing to accept higher risks for
higher return.
Entrepreneurs see opportunities and seize those opportunities. Investors are looking for
clear steady progress.
The ultimate goals may differ, also. The entrepreneur views success as a process of long-
term company building. The investors will want to cash out in two to five years.
9. What are the most important questions and issues to consider in structuring a deal?
Why?
Most deals involve the allocation of cash flow steams, the allocation of risk, and the
allocation of value between different groups. To design long-lived deals, Professor William A.
Sahlman from Harvard Business School suggests using a series of questions as a guideline for
structuring deals. These questions include: Who are the players? What are their goals and
objectives? What risks do they perceive and how have these risks been managed? What problems
do they perceive? How much do they have invested? What is the context surrounding the current
decision? What is the form of their current investment or claim on the company? What power do
they have to act? To precipitate change? What real options do they have? What credible threats
do they have? How and from whom do they get information? What will be the value of their

claim under different scenarios? How can they get value from their claims? To what degree can
they appropriate value from another party? How much uncertainty characterizes the situation?
What are the rules of the game? What is the context at the current time?
10. What issues can be negotiated in a venture investment, and why are these important?
Far more is negotiable than entrepreneurs think. The “boilerplate” investors use may not
be fixed in concrete. It is possible for an entrepreneur to negotiate and craft an agreement that
represents his or her needs. A successful negotiation is one in which both sides believe they have
made a fair deal.
The primary focus is likely to be on how much the entrepreneur’s equity is worth and
how much is to be purchased by the investor’s investment. Other issues involving legal and
financial control of the company and the rights and obligations of investors and entrepreneurs.
Another issue is the value behind the money that a particular investor can bring to the venture.
Many of the tools for managing risk/reward also apply.
Subtle but highly significant issues may be negotiated, including co-sale provision,
ratchet antidilution protection, washout financing, forced buyout, demand registration rights,
piggyback registration, and key-person insurance.
11. What are the pitfalls and sand traps in fund-raising, and why do entrepreneurs
sometimes fail to avoid them?
The entrepreneur encounters numerous strategic, legal, and other “sand traps” during the
fund-raising cycle and needs awareness and skill in coping with them. Some of these sand traps
include:
Strategic circumference. Each fund-raising strategy causes actions and commitments that
will eventually scribe a strategic circumference around the company. The entrepreneur needs to
think through the consequences of each fund-raising strategy. Scribing a strategic circumference
may be intentional, or may be unintended and unexpected.
Legal circumference. Legal documentation spells out the terms, conditions,
responsibilities, and rights of the parties to a transaction. Because these details come at the end of
the fund-raising process, an entrepreneur may arrive at a point of no return. To avoid this trap,
entrepreneurs need to sweat the details. It is very risky for an entrepreneur not to carefully read
final documents and to use a lawyer who is not experienced and competent.
Attraction to status and size. Simply targeting the largest or the best-known firms is a
trap entrepreneurs often fall into. Such firms may or may not be a good fit. It is best to focus your
efforts toward financial backers, whether debt or equity, who have intimate knowledge and
experience in the competitive area.
Unknown territory. Entrepreneurs need to know the terrain, particularly the requirements
and alternatives of various equity sources. A venture that is not a “mainstream venture capital
deal” may be overvalued and directed to investors who are not a realistic match.
Opportunity cost. An entrepreneur’s optimism can lead to grossly underestimating the
real costs of getting the cash in the bank. They also underestimate the real time, effort, and
creative energy required. There are opportunity costs in expending these resources in a particular
direction when both the clock and the calendar are moving. In the months it takes to develop a
capital source, cash and human capital might have been better spent elsewhere. It is common for
top management to devote as much as half of its time trying to raise a major amount of outside
capital. Significant opportunity cost are also incurred in forgone business and market
opportunities.
54 Chapter 15

Underestimation of other costs. Entrepreneurs tend to underestimate the out-of-pocket
costs associated with both raising money and living with it. The Securities and Exchange
Commission requires regular audited financial statements. There are also outside directors’ fees
and liability insurance premiums, legal fees, and so on. Another “cost” is of the disclosure that
may be necessary to secure a backer.
Greed: The entrepreneur may find the money irresistible.
Being too anxious. Another trap is believing that the deal is done and terminating
discussions with others too soon. Entrepreneurs want to believe the deal is done with a
handshake. The entrepreneur may need to create an illusion of multiple financing options.
Impatience. Another trap is being impatient when an investor does not understand
quickly. If the entrepreneur becomes too impatient, they expose themselves to additional risk.
Take-the-money-and-run myopia. This trap prevents an entrepreneur from evaluating to
what extent the investor can add value to the company beyond money. In this trap the
entrepreneur does not adequately consider the prospective financial partner’s relevant experience
and know-how in the market and the contacts the entrepreneur needs. Many founders overlook
the high value-added contributions and erroneously opt for a “better deal.”
Notes on Case
“Bridge Capital Investors, Inc.”
Use of the BCI, inc. Case
This is a case that lends itself to a structuring—valuing—negotiating exercise and role-
play in which pairs or trios as founders meet with pairs or trios as investors to come to terms. It
has worked very well with a variety of groups and students, and enables them to get into the
details and guts of the issues.
Positioning and Objectives
The case can be preceded by outside speakers from various financial sources, and/or your
own lecture on the meat in the chapter. Transparency masters of the key exhibits and tables in the
chapter are available in Part IV of this manual. The chapter also ties in with the Appendixes on
the investment agreement, deal structuring, vesting, sample terms sheet, etc.
Preparation Questions
Students are asked to consider the following questions:
1. Evaluate the situation and financing alternatives Hindman is now facing. What is
his strategy?
2. Is the $10 million Bridge investment enough money? How long will it last? What is
Hindman’s relative bargaining position? BCIs? Be prepared to represent both the
company and BCI in a meeting to negotiate the proposed financing.
3. What are the consequences for JLI of the proposed financing? Calculate the
consequences of the “put.”
4. What should Hindman do? What should Bridge do?

In this case study we rejoin Jiffy Lube in November, 1985, two and one half years down
the road from the Hindman case. Briefly describe to students what has happened to the company:
Since March 1983, through some creative arrangements suggested by their accountants, Jiffy
Lube was able to obtain sufficient financing from Hindman's personal assets and current
shareholders. The company has survived and is by far the largest oil franchisor in the United
States. Jiffy Lube now faces another financial crisis.
The class session will involve meetings between teams of students representing Jiffy
Lube and a potential investor, Bridge Capital Investors (an investment partnership), and between
Jiffy Lube's accountants and Jiffy Lube. The purpose of the first meeting, between the
accountants and Jiffy Lube, will be to develop a financial strategy for Jiffy Lube and to develop
an understanding of what the accountants can do to help Jiffy Lube. The second meeting will be
to decide if a deal can be closed in which this partnership will invest in Jiffy Lube.
The actual negotiations can be held during the regular class session (fine if MBA's, 2
hour + class length) or on the outside on their own. Both ways have worked well. A brief
discussion of the case (15-20 minutes) can be helpful to introduce the exercise. The class will be
divided into small groups representing BCI, the company, and the accountants. Their main tasks
are: (1) prepare for the final meeting; (2) develop a strategy and plan; (3) determine what they
will agree on plus any other terms and conditions. Each meeting will last approximately 20-30
minutes. Each team should select two members to take part in the actual meetings. Recommend
that each team spend approximately one hour to prepare for the meeting after individual members
have spent time on their own preparing the case.
Class Session
You may want to preface the team meetings with some or all of the following comments.
First, it is impossible to replicate the people or exactly how they would have behaved. There are
many ways to successfully conduct a meeting. Remember, our goal is to try out our own ideas
and learn as much as we can from doing and from observing each other in action. Second, be as
realistic as you possibly can in your role. Try to put yourself in the shoes of the person you are
representing.
Ask the two representatives from the Jiffy Lube team and the accountant’s team to meet
in the center of the class to start the meeting. It is helpful to use name cards to keep track of the
different teams. Remind the class of the purpose of the meeting: Jim Hindman and John Sasser
of Jiffy Lube are meeting with their accountants because they are facing another crises. By the
end of this meeting, they need to make some progress toward developing a financing strategy and
get a better understanding of what their options are.
Remind the team that the meetings are limited to 30 minutes, and that despite the time
constraints, their objective is to reach some type of closure by the end of the meeting. During the
meeting, you should provide any assistance needed to keep the discussion on track.
When the meeting is over, ask representatives from the other two teams, Jiffy Lube and
Bridge Capital Investors, to come to the center of the class. Before starting, review the
background of the meeting: Bridge Capital Investors, an investor partnership, has proposed that
Jiffy Lube meet its current financing needs by selling Bridge Capital $10 million in unsecured
notes. Jiffy Lube must decide whether the deal is acceptable as is, whether it needs to be
modified, or whether Jiffy Lube will reject it and pursue another alternative. The objective of this
meeting is to determine if the deal can be closed.
After the meeting, begin the discussion session.
BRIDGE CAPTTAL INVESTORS
56 Chapter 15

BRIDGE CAPITAL NEGOTIATING TEAM
INSTRUCTIONS AND TEAM ASSIGNMENTS FOR TEAMS REPRESENTING BRIDGE
CAPITAL INVESTORS
Your team will prepare for a 30 minute meeting with Jim Hindman end John Sasser
(CFO) from Jiffy Lube. Two members of your team should be selected to represent Don Remey
and another officer from Bridge Capital Investors, and take part in the meeting.
YOUR OBJECTIVE DURING THE MEETING IS TO DETERMINE WHETHER
YOUR INVESTMENT PARTNERSHIP, BRIDGE CAPITAL INVESTORS, WILL
COMPLETE AN AGREEMENT TO PROVIDE $10 MILLION IN FINANCING TO JIFFY
LUBE.
Background of Meeting
It is November 1985; Jiffy Lube has rapidly expanded over the last three years and now
has over 270 service centers in operation. Revenue and net income are projected to reach $30
million and $1.9 million respectively in fiscal 1986 (the third straight year of positive net
income). Jiffy Lube's growth (and survival) was made possible by creative financing obtained in
1983.
Your firm, Bridge Capital Investors, is a limited partnership specializing in later-stage
expansion financing of growing companies. Shearson Lehman Brothers referred Jiffy Lube to
you, the investment banking firm. You were one of the parties Shearson contacted in an attempt
to market a $10 million private placement for Jiffy Lube.
Don Remey describes the initial meetings with Hindman:
"On the surface, we didn't think that there was any way we were going to want to invest in
Jiffy Lube. The company was in a terrible financial position. It still intrigued us, though.
"What made the difference was meeting Jim Hindman. When you meet him, you know he
is good. I developed a great personal chemistry with him right away. Their business concept is
exciting and the timing is right. Talking to Jim makes me believe that he can pull it off.”
Preparation for the Meeting
To help prepare for the meeting you should have read the case material and address the
following questions:
1. Review the deal you have proposed for Jiffy Lube. How do the deal structure and
terms fit into your objectives as an investor? Be prepared to explain (end justify)
the terms to James Hindman and John Sasser.
2. What are Jiffy Lube's capital requirements? How much cash do they need? When?
Is the $10 million deal sufficient for their needs?
3. How does the deal you proposed fit into Jiffy Lube's goal and long-term business
strategy? What are the implications for building a successful relationship between
Jiffy Lube and Bridge Capital?
4. Evaluate the other financing alternatives facing Jiffy Lube. What relative
bargaining position does the company have with regard to your proposal, and with
each of the other alternatives?

5. How will you handle the meeting and negotiations with Hindman and Sasser
tomorrow? What possible changes to the deal terms might they propose, and how
will you respond? (What changes are you willing to accept?)
Description of the Proposed Deal
The financing deal you have proposed to Jiffy Lube is almost identical in the structure to
the other deals your firm has completed, and is composed of debt with an "equity kicker.” You
prefer to finance companies using this structure. One of your selling points for Jiffy Lube is the
speed at which you can complete the agreement due to its simplicity and your experience with
this type of financing.
Bridge Capital will not be providing the entire $10 million in financing if the deal is
concluded. As lead investor, you have assembled the following syndicate willing to invest under
the terms proposed:
Bridge Capital $4,000,000
Three Cities $2,500,000
Conn Mutual $2,000,000
Allied Capital $1,000,000
Investcorp $ 500,000
In addition to $10 million in unsecured notes, the financing deal you proposed includes
warrants allowing you to purchase 100M of Jiffy Lube's common stock. The proposal also
includes a put provision (described in Exhibit G). Under the provision, Jiffy Lube's stock must
trade publicly at certain minimum prices by the end of 1990. If the stock never reaches these
minimum prices, you have the right to "put” the warrants back to Jiffy Lube.
The amount Jiffy Lube would be required to pay upon your put of the warrants is
described in the proposal as follows:
The price will be determined by the calculation of the amount necessary to result in a 300M
internal rate of return to the Purchasers, taking into account all interest and principal payments on
the Notes.
The price will vary based upon certain actions that Jiffy Lube takes. You have calculated
the potential price under different scenarios, three of which are listed as follows:
Amount Payable by Jiffy Lube
Scenario If Warrants Are Put
No public offering, Notes are outstanding $ 17.1 million
for entire term
Public offering after 2 years, $5 million of $ 13.1 million
Notes are prepaid
Entire $10 million of Notes are prepaid $ 9.1 million
after 2 years
Under your proposal, if Jiffy Lube's stock never reaches the minimum levels, and
the company is unable to make the payment required under the put provision, Bridge
Capital will have the right to take over control of the board. In Don Remey's words, the
put provision "makes the entrepreneur bet on the future success of his company."
(Details of these calculations are included at the end of this chapter beginning on page
315.)
58 Chapter 15

The Meeting
THE MEETING IS LIMITED TO 30 MINUTES.
You are going into the meeting willing to conclude the deal you have proposed, if Jiffy
Lube accepts your terms. If Hindman and Sasser request a different deal structure, you will have
to decide whether you are willing to negotiate modifications to the deal you have proposed. But,
you are also willing to walk away as you do have other deals on your plate.
BY THE END OF THE MEETING YOU WANT TO REACH A CONCLUSION
CONCERNING THE FINANCING DEAL YOU HAVE PROPOSED TO JIFFY LUBE.

New Capital _ Chap015a

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