Step 4: Getting to Deal Terms
Once you are convinced of the potential of a particular investment, it’s time to nail down the terms with the entrepreneur. There are often still a lot of open questions at this point; however, the conversations you have about deal terms will serve to clarify remaining questions and solidify the terms of your future relationship. There are four main areas on which to focus:
1. Clarify your investment options, based on the laws of the country where your capital is being deployed from and to.
2. Confirm your return expectations, the appropriate type of capital and right size of investment.
3. Get the terms right.
4. Close the deal.
Keeping it simple. Several Toniic members talked about wanting to give very early-stage ideas quick and simple capital in order to allow the entrepreneurs wide berth to develop their models. Experienced investors like Bob Pattillo talked about giving the earliest-stage entrepreneur the first $10-25K as a simple equity investment to essentially buy the right to get to know them and watch what they will do. Josh Mailman emphasized the futility of drawn-out negotiations at this stage, especially over valuation. He quipped, only partly in jest, “It’s simple: if the company can’t raise money for the next round, you paid too much.”
1. Clarify investment options based on country of capital origin and placement. Many of the investors actively investing globally in early-stage enterprises are in the US and Europe. As a result, the body of law in these regions is better articulated and understood. It is not the intent of this document to provide legal or financial advice regarding the legality or tax consequences of investments based on country of capital origin or placement. However, it is critical for all investors to secure professional assistance, preferably in-country, to ensure that the rule of law is followed and that tax considerations are understood and optimized. In India, Toniic investors have experienced dramatically fluctuating laws regarding investment of foreign capital. Other countries, like Rwanda, Mexico or Ghana, seek foreign capital and therefore have policies that make outside investment easier. A good place to start for doing business globally is at the appropriately named DoingBusiness.org.
2. Confirm your return expectations, the appropriate type and size of investment based on your analysis of the business opportunity. Simply put, what is the best type of investment to make in this company at this time. Choice of return expectations, type and size of capital should be based on a combination of factors relating to the entrepreneur (e.g., control, stage of development, business plan, cash flow, exit opportunities), your investment priorities and constraints (e.g., short-term or long-term horizon, risk profile and needs for cash), other investors (e.g., the ability of your investment to help leverage other capital), and local context (e.g., speed to market needs, local norms or constraints and local tax and investment laws).
a. Following are the more commonly used types of investments for financing seed-stage enterprise.
- Grants. Best for earliest stage ventures when there is a clear need for research and development into a business model. You can also utilize grants to hire a local intermediary, many of whom are nonprofit (see Step 2: Sourcing an Investment Pipeline for examples), to help your entrepreneur become more investment-ready. Grant capital can also be used to provide Program-Related Investments – as either debt or equity. The corpus of a foundation can be invested in Mission-Related Investments. For more information on these types of investments go to Mission Investors Exchange.
- Loan guarantees. Can be most useful when there are other investors interested but sitting on the sidelines, due to perceived risks or lack of capital. Foundations and public charities can play a critical role in providing targeted loan guarantees to help unlock investor capital. Acumen Fund, for example, has frequently used loan guarantees to unlock more market rate capital, either as a loss tranche in a layered deal, or as a generic letter of credit for the entrepreneur for a certain amount of time, to give them flexibility and reduce their risk as they find other investors, scale a supply chain, etc. A CGAP document outlines institutional use of loan guarantees in microfinance institutions.
- Debt. The most fundamental question when considering debt is the strength of cash flow inside the company. Can this company take on the burden of debt payments at this time? Can the company afford to pay you regularly and still invest in its growth? Key terms are interest rate, amount of loan, duration and date of payments, and any conversion provisions. See TechStars Open Source Model Seed Financing Documents for a checklist and some generic templates. There is a strong track record for debt in microfinance and community development finance. Both the Eleos Foundation and the Peery Foundation began their impact investing programs with debt investments.
- Demand Dividend. Demand dividend is a flexible investment vehicle, where terms can be adjusted to fit the enterprise business model and the investor’s investment objectives. It matches payments to cash flow, has a ‘honeymoon period’ to allow capital to go to work, returns a multiple of the investment as a fixed payoff amount, and aligns incentives with term sheet covenants and a financial plan focused on cash. This structure is useful, for example, for investors investing in community-based initiatives for which an equity exit is not appropriate, but the ability to share in the profit is warranted. A link to a form to create your own demand dividend term sheet can be found on the Santa Clara University website.
Catholic Sisters Use Debt Fund to Empower Under-Served. Sister Corinne’s Congregation, the Dominican Sisters of Adrian, Michigan, wanted to align their mission with their retirement fund investment needs. To achieve this, they created the Portfolio Advisory Board and became actively involved in filing shareholder resolutions and conducting dialogs with corporations around environmental, social and governance issues. In addition they developed what at that time was described as an “alternative fund” providing loans to organizations in low-income communities. With this fund, the Sisters could invest in a way that not only provided a modest upside for retirement, but also allow the Sisters to support the very communities and causes that many had worked for during their active years in ministry. In 1978, with an MBA and community organizing experience, Sister Corinne and her fellow Sisters began with small, often direct lending. Food banks, credit unions and daycare centers were among their first investees. They struggled to find enough quality deal flow, but stood firm on their requirement that investments be aligned with their investment objectives – to serve under-served, poor communities. Today, Sister Corinne actively manages two portfolios – the Religious Communities Investment Fund (RCIF) and the Mercy Partnership Fund, a program of Mercy Investment Services. She believes that the communities they support through their loan funds are acting as the emissaries of the ministry of the Sisters – many of whom are too frail to continue active work in these needy communities. Sister Corinne described their unique relationship with their investees as a “mutual ministry”. The Sisters pray every day for the continued success of the investees and the investees continue the critical work for the under-served. Indeed, a mutual and powerful ministry.
- Quasi-debt. Convertible debt may be an option when the round is very small or the company needs some bridge financing. It may provide some protection for everyone while offering a reasonable upside. See how convertible debt works at Own Your Venture. One investor shared with us that he believes quasi-debt is not the best deal for an investor. Bottom line, weighing the investment options with your peers is advised.
- Quasi-equity. Quasi-equity financing (also known as mezzanine financing or subordinated debt) is another form of financing frequently used by SMEs. It typically involves a mix of debt and equity financing, which allows investors to achieve gains through capital appreciation and interests on debt-repayment. Read more on quasi-equity at BME Forum.
- Revenue share. Revenue share is usually structured as an investment where financial return is calculated as a percentage of the investee’s future revenue streams. This vehicle can be a useful source of finance when debt financing is inappropriate or too onerous, or where share capital may not be possible due to the investee’s legal structure. Unlike a loan, this investment is dependent on the financial performance of the organization. Sometimes revenue share is also called quasi-equity, though we see it as a subset. See a great case study at CAF.
- Profit share. Same as revenue share, only the investment specifies payments to investor out of bottom line profits instead of top line revenues. This is clearly less risky for the company and more risky for the investor in terms of assuring a significant return.
- Equity. Most appropriate for seed stage where cash flow is uncertain because of the stage of the venture, equity funding also requires that there is significant growth potential for the venture, and that an exit scenario is plausible. The key terms are the pre-money valuation and the post-money percentage of ownership by the investor. Equity investments also give investors the opportunity to be involved in the governance of the company, through board or observer seats, if they desire. See TechStars Open Source Model Seed Financing Documents and the Unreasonable Institute’s term sheet page for some generic templates.
b. Syndication preference: select appropriate investment style. You may decide to make this investment alone, but often there are other investors expressing interest. Consider the following when deciding how best to proceed:
- Individual Investment. The pros are that you are in control of all deal terms and negotiation with the entrepreneur. You can make the deal at your own pace, which might mean very quickly. The cons are that you are alone on due diligence and may miss things that others see, and that you will need to cover all the costs of due diligence yourself.
- Syndicates. Multiple investors coming together in a round with the same terms can be a huge simplification for the entrepreneur once the deal is done and can be a great learning experience for investors. On the other hand, a healthy syndicate requires great soft skills, patience and communication as issues are discovered. From a financial perspective, many investors prefer to invest in syndicates to reduce risk, and some insist on minority percentages of the total round in order to be sure other investors are as committed to the deal as they are.
- Special Purpose Vehicles. Several Toniic members have set up special purpose vehicles, usually LLCs, to allow syndicate investors to invest in a legal intermediary set up for the sole purpose of investment in a specific company. The advantages of these, according to The Eleos Foundation, who has created several of them, is to make it easier for investors to come in with smaller amounts of capital, with set terms, into a US-controlled vehicle for investments in global early-stage deals.
c. Use appropriate legal counsel. Most traditional firms providing legal services for term sheets do not understand the impact investing space and therefore their advice and version of term sheets mirrors more stringent and onerous conditions usually found in the venture capital market.
Several investors warned about the importance of finding appropriate legal counsel. “Do not let your lawyer take an aggressive equity template off a shelf and apply it to these sorts of deals,” said Chloe Holderness, managing director of Law for Change and the Lex Mundi Pro Bono Foundation, which connects impact entrepreneurs around the world with pro bono counsel. Deborah Burand, a clinical assistant professor at University of Michigan Law School and director of the International Transactions Clinic, is working with the ANDE network, bringing together the general counsels of its members to create better templates and tools for investments in social enterprises. She says that another critical factor is alignment with your co-investors, as the lessons from failed microfinance deals show that social and financial investors can clash when it’s time to negotiate workouts (or possibly even liquidations) of the investee company.
3. Get the terms right.
a. Keep it simple. Once the investment vehicle is defined, the term sheets can be drawn up. At this early-stage, most of the investors’ advice was to keep it simple. Focus your time on what the entrepreneur needs to succeed instead of over-negotiating a term sheet.
When it comes to valuations, simplicity is also key. Valuations at this stage include so many assumptions and projections that they are often – as Josh Mailman describes – “silly.” Be realistic about how much time to spend on developing the perfect valuation.
b. Consider integrating impact terms and metrics into term sheets. Some members include impact metrics in their term sheets. They recommend focusing on a small number of key business indicators and sector specific metrics. The ideal is to attach these as an Exhibit or include as a schedule of reporting requirements. See Step 6: Assessing and Achieving Performance and Toniic’s E-Guide to Impact Measurement.
Toniic co-founder Morgan Simon points out that this is a great time to lock in appropriate benefits around ownership of the enterprise, if that is an impact goal for the investor and entrepreneur. For example, SMV Wheels set aside an employee ownership pool in their term sheet, Liberty and Justice is structured so its factory is 49% employee-owned, and New Era, a “green” window manufacturing company, has an all worker-owned minority pool. Ownership terms are highly relevant to the investment vehicle conversation as ownership structure impacts the type of vehicles that are appropriate for investment.
It is not advisable to steer the mission of a company by tacking on extra impact metrics. Cathy Clark from Duke University notes that there is wide consensus among later-stage fund investors that putting too many mission-specific terms into term sheets at the early-stage is a mistake; many funds, especially community development finance funds, did this in their early days and discovered that these terms didn’t help entrepreneurs maneuver effectively, and in some cases, actually limited their ability to raise bridge and other future capital. You want to stick to terms that empower the entrepreneurs to do what they need to do to help the company succeed financially and socially.
c. If applicable, document scope of capacity building needed, estimate of cost and how it will be provided. Many early-stage investments need more than capital. If you have emerged from your due diligence process with a sense of the kind of technical assistance the entrepreneur needs, this is the time to document it.
d. Drilling down with the entrepreneur. Getting to an agreement on the exact terms of the deal is nearly always more time consuming than the investor expects. A few key pieces of advice from the network:
• Collaborate and reconcile with the investee. Often, early-stage entrepreneurs do not understand term sheets, a fact which puts the investor in the driver’s seat. This means an investor may have to spend time to educate the investee.
• Valuation tips. Typically valuation is proposed by the investee, but in seed stage the financial model may be in such flux that the rules of thumb used for more mature enterprise investments may not apply, and the investee may not have experience in how to prepare a valuation. Be aware that some early- stage entrepreneurs may inflate their enterprise valuations.
• Meaningful tranche hurdles. Consider some very simple performance based tranche milestones, both financial and social.
4. Closing the deal.
At the end of the negotiation process, you will hopefully emerge with a deal that both parties can sign and a relationship that is mutually beneficial. But this is not always the case. A fuller set of potential outcomes is:
a. Say yes and sign.
b. Say yes with conditions. What are the conditions that need to be settled as part of the deal you are agreeing to? These should be discussed up front as potential deal breakers and be clear in your term sheet.
c. Say no, but with conditions to get to a yes. What concrete future changes would make you come back and take a second look?
d. Say no, but provide useful feedback. By the time you are developing your term sheet, it is likely that you’ve developed a relationship with the entrepreneur and taken up a significant amount of his/her time. If the deal doesn’t pan out, be sure to provide useful feedback to the entrepreneur about why you decided not to invest. This will allow you to maintain a strong relationship with the entrepreneur.
e. Say no, but pass on to an investor who might be interested. If appropriate, you may also consider passing the deal on to other investors who could be interested. Obviously, this will depend on the reasons you couldn’t get to yes.