Larry and Barry
On the Bad Choices Made By So Many
Early Stage Private Company Owners ©
Larry: Next time we’ll do it differently. We are really going to regret the deal we did.
Barry: You mean the terms or the people?
Larry: The terms were too one-sided and the people so arrogant in thinking that they knew better how to maximize profits than we did. I am also sorry we gave them the right to place directors on our Board of Directors.
Barry: The two terms I liked least were the liquidation preferences where they get a big return before the stockholders get anything, in the event of a sale of the company. I also thought the ratchet terribly unfair, which allows them to increase their percentage of ownership, without additional investment, in the event we don’t make our numbers.
Larry: They were supposed to help us with introductions leading to business and other good things.
Barry: Nothing really happened after the deal closed, except that we had to change some of the benefits we had as owners.
Larry: Maybe worst of all is that I hear they have, in some of their other deals, replaced the senior officers.
Barry: How did they get to do this?
Larry: Apparently by convincing other Board members to go along with their recommendations. They have the capital to finance our next round, so they can require whatever changes they want, and the other Board members may feel that it’s their duty to accept.
Barry: We should have investigated that royalty deal more thoroughly. The money just seemed too expensive, if we increased our revenues to the level we thought possible using their money to increase marketing.
Larry: But they were willing to let us have a right of redemption so that we could terminate the royalty whenever we wanted, before ten years, on terms we negotiated as to the multiples of the investor’s cost, less the royalties already paid.
Barry: Yes, but I thought the five times in five years a lot to pay for money. Of course, I should have concentrated more on the good things for us, such as still owning all of our shares and not giving up control to outside shareholders, as we used their money to build our business.
Larry: And, we could have gone to the investors at any time and tried to buy their royalties on better terms than the redemption right provided.
Barry: Forget the exit money terms, it’s the fact that royalties do not vote or are able to influence us in how we run the business and pay ourselves.
Larry: Yes, and the royalty holders can’t force us to take buyout deals we don’t want.
Barry: Sure, we would have lessened our profit by the amount paid to the royalty investors, but without our using their money we wouldn’t have had the same level of profits.
Larry: In retrospect, the difference in the deals was that the equity investors, with their liquidation preference, ratchet- benefiting, convertible preferred, only bought in with the intention of selling, whereas the royalty investors were long-term investors that we really wanted, and that the company needed.
Barry: You are right. We would have been much better issuing a royalty. Paying a percentage of defined revenues for an agreed period, and keeping control of our business.
Larry: Yes, and we can always get rid of the royalty and do whatever deal we want once the company is bigger.
We could even offer the royalty investors shares or convertible notes in exchange for their royalties.
Barry: He was right. Royalties are the better way to finance a business.