Some New Years Resolutions for the Midwest

Well, it’s time to write another article for the Entrepreneurial Advisor Blog. I promised myself I would write one each week but took the Christmas week off. Don’t think it is advisable to skip two weeks – Don’t want to get out of the routine. This seems to be the week everyone does their retrospective of the year and this year, of the decade. I get tired of reading them so I don’t think I will write one. I don’t know what I would say anyway. I could also write about my New Year’s resolutions but why would those reading this really care if I ate less, exercised more or kept my office neater. What I do think most reading this is a list of resolutions for typical Midwesterners. So here I go.



1. We need to have more confidence in ourselves and others. By this I mean we need to stop believing that because we are from Iowa, Nebraska or Kansas we cannot accomplish what others in New York, Chicago (yes I know Chicago is in the Midwest) or Los Angeles can. We need to support others with good ideas instead of criticizing them for taking a risk and labeling them failures when there is a setback.


2. We need to understand that we are in the 21st century and as much as we yearn for the late 19th and early 20th century, it is not coming back. By this I mean we have to stop believing that we can save every small town and continue to maintain every rural road or bridge. Finally, we cannot continue to believe that attempting to recruit the ever shrinking manufacturing jobs left in the U.S. is the best economic development policy for our area.


3. We need to expect leadership out of our leaders – On second thought, we need to demand it. They and we need to understand that short term fixes that might seem the best alternative for today are not necessarily what is best for all of us in the long term. I think this is a problem nationwide but may be more pronounced in the Midwest. It’s easy for us to say no to higher taxes, school consolidation or environmental regulations without know why they might be needed or how it will adversely affect the future. Leaders should explain these issues better and stick to their guns instead of always going with the popular flow. Much of leadership is convincing followers to do the “right thing.” It is not necessarily a popularity contest.


4. We need to pull our collective heads out of the sand and understand that there are worldwide crises occurring and I don’t mean Korea, Iraq or Afghanistan. These crises are hunger, illness and climate change and all of these issues are directly impacted by a global population explosion! How do we feed double our current population on the same or less land with fewer chemicals?


5. We need to realize that corn and soy beans are not the solution to the world’s energy needs and that all of us need to eat less meat for our own health and so that more calories are available for the rest of the world.


6. We have many of the resources in the Midwest to solve these problems but we must first believe they are problems, we must develop a can do attitude, we must take risk or at least support those that do and we must redirect resources from less productive to more productive uses.


7. Finally, we must be more tolerant of those not indigenous to the area or the nation because, especially in the Midwest, this is our future work force. In many rural Midwestern states the number of people reaching child bearing age is decreasing and will for years to come. We must rely on those from outside the region if we wish to grow and prosper.


I know all of this is hard to swallow and that some of you will reject what is here. I may even lose followers, but again this is not a popularity contest and if I can just move a few to action we may change our little part of the world. Happy New Year – may 2010 be a year of change for the good.

Understanding a Term Sheet’s Impact on "Real" Valuation

You think you just negotiated a fair deal or maybe even a sweetheart deal with an institutional investor because you got the price per share you wanted. Sophisticated angel and venture capital investors may agree to accept the valuation you specify or at least negotiate one that is palatable to you, but it may not be as great as you think. In the financial industry the value stated on a term sheet or investment agreement is referred to as the “stated value.” This is rarely the “real value” or the value after all factors are considered.




There are a number of provisions in the typical term sheet that alter the value stated as a per share price. Some may reduce the real value by 50% or more! Let’s take a look at provisions found in most term sheets. First of all the institutional investor will ask for “participating preferred shares.” This is a far cry from the common shares the founders and their family and friends own. The “preferred” means that if the company is sold or wound up in any other way, say liquidation or bankruptcy, the preferred shareholder gets its money out before any common shareholder receives a payout.



The “participating” means that after the preferred shareholders receive their original amount back, they split the remainder on a pro rata ownership basis with the common shareholders. To make this even more dilutive to the common shareholders, the amount the preferred shareholders receive before any other money is distributed is many times a multiple of their original investment. For instance, it is not uncommon for the “liquidation preference” to 150%-200% of the original investment. During the recent recession there have been instances of it being even higher!



Another feature of preferred stock is that it typically carries a dividend. The dividend rate is dependent upon the current credit market but it is not unusual for it to be 7%-8% annually. Usually in venture deals the dividend is deferred until the company is sold, merged, wound up or goes public but must be paid prior to any money going to common shareholders. If you add this to the liquidation preference, the investor could be receiving two to three times their investment back before the common shareholders share the remainder with them. This is no big deal if the company goes public for 10-20 times the original value but if it is just modestly successful it can leave the common shareholders with little or nothing!



In some deals there may also be warrants issued to the investor either for doing certain things for the company or if the company does not meet certain conditions. These warrants may be converted to stock well below the market value of the stock lowering the value of the common stock even more.



Finally, there are usually anti-dilution provisions, usually in the form of “ratchets,” that require the company issue additional shares in the event that stock is subsequently sold at a lower price than the price paid by the original institutional investor. A “full ratchet” basis requires enough stock be issued to bring the value up to that of the new investor. A weighted ratchet basis makes up some of the value lost.



There are other provisions that might indirectly affect the value, as well such as board representation and pre-approval provisions for such things as borrowing and purchasing of certain items. None of this is hidden, illegal or unethical. After all, the venture investor is taking a risk that no one else is willing to take.



It is also a way for the investor to protect their downside and many times used to come to agreement on a difference in valuation. They might pose it to the company in this way: “We are not confident that you can meet your projections and if you do not, the value of the company will certainly be lower but we are willing to accept your valuation if you will allow us to protect ourselves from under performance. If in fact, you truly believe in your valuation you shouldn’t mind these provisions. They will not affect your return significantly if you perform.”



The problem comes when the entrepreneur does not understand the impact of the provisions or is too optimistic about company performance. Much of it is also emotional or psychological. Perhaps your friend’s or your competitor’s company was just valued at $5 million and you are sure yours is worth just as much, or maybe you have calculated how much you need to retire comfortably. In any case, if stated value comes out where you wish you can rationalize it as a fair deal.



It is always a good idea to have a professional that is experienced in valuations and term sheet evaluation look over the offer - Help you understand what it means and how much the company needs to sell for in order for you to get a satisfactory return. Finally, an attorney experienced in securities law should always review the legal aspects of the term sheet or offer before you sign. Venture capitalists and their attorneys deal with term sheets routinely but it may be the only one you ever see!

Action Planning For Early Stage Companies

Some venture capital firms are requiring that a three month or 100 day action plan be put in place as a condition of closing. We also seem to understand the value of planning at the strategic level or at least understand that business plans and marketing plans, and etc. are required for financing. But why an Action Plan or more basic what is an Action Plan?


An action plan is moving business planning from the strategic to the tactical. It breaks down the goals and objectives found in a business plan into action items that must be completed to meet targets. Some of these items may never even be anticipated in the business plan or by more seasoned business people may be assumed.

VCs are moving to action plans as a requirement because all too often the strategies in which they based their funding decision was perfectly fine but the execution was terrible. This is especially important for seed and early stage companies in regions of the country where serial entrepreneurs are scarce and the management team relatively inexperienced.

About a year ago, I was working with a company that had a great product good gross margins and around $5 million in sales all over the globe. They were losing all kinds of money and not until I went in and watched the operations for a few days was it apparent what the problem was. They had no policies in place for travel or purchasing and there were no clear lines of authority or areas of responsibility. Sales people would travel from the Midwest to South America or Europe for a $10,000 sale and they couldn’t seem to find time to hire additional sales people needed to scale the business. One of the founders would allow credit terms he and sales discounts that were not those stated in the company policy or allowed by other sales people.

They started business by developing product and then selling it. That might have worked when the two founders were the only employees and the only owners, but when I entered the scene they had seven employees and 15 shareholders! What they needed was an action plan that stated that a travel policy would be put in place by the 15th of the month, inventory controls would be developed by the 30th of the month.

They needed a schedule that ended the day they needed someone to be on board and work back to when job descriptions needed to be ready, solicitation begun and interviews started. They needed personnel policies, a compensation plan and monthly sales goals by individual. Each of these items needed to have dates attached to them and some one or a team needed to take responsibility to complete them on time. They needed an action plan!

Once these items began to take shape, morale improved, people could work more effectively and the bottom line improved. This really helps at the beginning of a company’s life but the most effective action plan is a rolling one where each time one month is over another is added to the end of the plan.

Could you benefit from an action plan? Do you have a client or a friend in business that could use one? Let me know what issues you need to address or if you could use some help getting started.