Reading: Introduction to Financial Deal Making

A useful starting point for a discussion about deal making is to think about what the parties of the deal (typically the entrepreneurs and the investor) actually want to achieve with the deal.

So what do entrepreneurs want from a deal? And what do investors (VCs) want?

The following table provides a rough overview of the most important goals that the two parties generally pursue.

The table indicates that entrepreneurs and investors have three common goals:

• Returns: They want to make sure that the company is financially successful
• Control: They want to make sure that the company is well run
• Liquidity: They want to make sure that the financial success can be shared with the providers of capital.

But there are also potential conflicts of interest looming along these same three dimensions. For example:

• Returns:
• For the investor, the basic problem is that her "job" is essentially done once she has paid in the capital. For the entrepreneur, however, the work has only just started. So a concern of the investor could be that once the capital is paid in, the entrepreneur "takes the money and runs." The investor will therefore want to make sure that she receives her return first and that the entrepreneur only participates in the returns once the investor's claims have been satisfied.
• For the entrepreneur, in turn, key questions will be: How much is a fair return for the investor? Who gets how much if things go really well (which, arguably, would be the main achievement of the entrepreneur)? What are the obligations if things do not go well? How to avoid that the return claims of the investor rob the firm the necessary liquidity to carry out its investment plans? How to make sure that the investor actually has an incentive to provide more than "just" money (e.g., expertise, network, etc.)? Etc.

• Control:
  • The issue of control rights ultimately boils down to the question of "who runs the company?"
  • The entrepreneur will want to make sure that the company remains "his" company, especially so if he delivers on the promises made in the business plan.
  • For the investors, the situation could be somewhat more complicated:
    • Often, the investors are minority shareholders (they own less than 50%). Minority shareholders are generally at the mercy of the controlling shareholders, especially in privately held firms. They have limited influence on important business decisions such as the firm's strategy, mergers and acquisitions, employment decisions, etc. And they also have no contractual claim on a compensation. A minority shareholder factually has the "right to hope for a dividend."  
    • This right will not be strong enough for the investor. The investor will want to make sure that she has a say (maybe even a veto right) in important business decisions. She will also want to make sure that she can change the control structure of the firm if things do not go well.

• Liquidity (exit the investment)
  • Liquidity is probably the most consequential bone of contention. 
  • For the investor the ability to exit the investment is a key concern. Professional investors invest for a limited period of time (usually 5-8 years) and they want to make sure that they see a clear path to exit before investing in a company. The desired exit route is the one that generates the highest payoff.
  • For the entrepreneur, liquidity is also important, as he will also want to be able to harvest the fruits of the hard work. However, it might not be the primary concern. Maybe it is more important to him to remain in control, keep the firm in the family, and to make sure that it remains an important employer in the region. These considerations are often not in line with the investor's desire to max out financially. So potential conflicts are pre-programmed.