CandidCapital

Aim of the Chapter

To allow a manager to negotiate effectively with potential investors or lenders.

Key issues in the chapter

• Managers must understand the negotiation process.
• They must understand lenders' and investors' priorities.
• What amendments it is realistic to seek and to offer.
• At what stage to negotiate and on what issue

Introduction

Managers will want the best terms for their shareholders, among whom they are likely to number, from any venture capital or bank finance which they raise for their project or business. This is quite right, they will have confidence in their ability, will believe in the potential of the opportunity and will want to concede as little as possible to the caution, even scepticism, of the potential investor or lender. They are, however, unlikely to be familiar with the process of considering and negotiating the proposed investment. For most managers it is an occurrence that happens once in a career. This chapter describes the path that an investment could follow and the potential that there is for the manager to influence the outcome.

Confronted by the technicalities of a proposed investment, the manager also needs to know where to turn for advice and needs to know what alternative investment structures might be possible to that proposed by the venture capitalist.

When to negotiate

The obvious stage for negotiation over a proposed financing deal is when the investor makes an offer, whether in outline or in a formal offer letter. The investor is, after all, showing some commitment, since he has decided to make an offer and he will be expecting some reaction from the management team. However, by this stage, the investor will have crystallized a deal structure in his own mind and may well have tested it out with the superiors from whom he will need formal authority for the final deal. In these circumstances, the negotiations will be about modifying a deal with an extant structure rather than shaping that deal from the outset.

The management will have lost the initiative unless the investor has made the offer with some clear idea of what is likely to be acceptable to the management. It is therefore essential that the management put over their aspirations and expectations as effectively as possible before any deal structure crystallizes in the mind of the investor. The investor should help in this process since he will want to ensure that the deal he finally proposes is not going to be rejected outright by the management.

It is important, therefore, that a management team should have a clear understanding of the investment process so that they can exercise the most effective influence on shaping the deal which they and investor finally agree.

The four phases of the investment process The attitude of an investor changes substantially during the process from first contact with a project to completing the deal.

At the outset he is selling mode: telling intermediaries and prospective investees of his experience, imagination and commitment to enabling and supporting excellent management teams. Once a business plan hits his desk, however, he becomes a sceptic
and inquisitor seeking out weakness and inconsistency in the plans, presentation and background of a management team. It would seem that his aim is to dissuade himself from investing in the project.

Then a Rubicon is crossed: he decides that he wants to invest, possibly with one or two caveats about weaknesses in or threats to the project, but he is working to make the deal happen rather than fail. He may be negotiating with the management but his principal concern is to convince his fellow directors, or approving authority, that the deal is right for the fund. He is a product champion for the project.

Once the deal is done, the investor should settle into the long term role of supportive shareholder; given that the deal, and especially the management, turn out to be what he thought he was investing in.

Making the most of management's negotiating opportunities Sometimes management teams will be in very good position to negotiate with investors. In the buy out of a mature well run company with reasonably predictable and profitable future performance, it will not be difficult to attract prospective investors. The management may well find themselves in the enviable position of being able to ask the investors to take part in a "beauty parade". As the name suggests, the investors in a "beauty parade" will present the qualities which should convince the managers to select them. Inevitably, the price and terms on which they might do the deal will be among the most important issues which the management will consider. Under these circumstances, the negotiating pressure is thrown onto the investors and managers will have real choices from the outset.

More usually, the deal will be less straightforward, and the project will carry a degree of risk and uncertainty which is difficult to assess. Under such circumstances, it is easy for the initiative to pass to the venture capitalist, especially if there is a limited number of investors who want to take the proposal beyond the first contact. This is when the management must work, with some subtlety, at maintaining, or re gaining the initiative.

Nearly all venture capitalists like to feel that they are good deal makers. Not only in the way they conduct the negotiations for the deal, but also in the way they "tailor" the deal to suit the needs of the investee company (and, of course, the needs of their fund). This means that they will react badly to a proposal where the manager, or his advisers, have devised a deal structure and are saying "here is the deal: take it or leave it." There are circumstances where this may be appropriate, for example where the manager has already raised the majority, or a significant proportion of the funds, under particular terms.

The management's opening gambit needs to be more subtle. Somehow they need to convey their confidence in their projections, their clear understanding of the way the venture capitalist might value the investment and their view of the sensible value which might therefore be placed on their equity. They should flag the
principal features of a deal structure which they feel would be appropriate but it is important to do this at the right stage of the investment appraisal.

Certainly, the business plan should not include the management's opening position on deal structure. After all, it will be read when the investor is still a sceptic looking to be dissuaded from backing the project.

However, it is important that they should get this position across before the venture capitalist's views of the project begin to crystallize, but it would be unwise to shoot in the dark before the prospective investor has given some reaction to the proposal and has indicated where he sees the major strengths and weaknesses lying. Once the management feel that the investor is starting to cross the Rubicon and wants to invest, they can make their feelings about the deal terms plainer.

If management make this negotiating process work, their opening position will have had an impact on the calculations behind the venture capitalist's outline offer or deal structure. So long as management, with the help of their professional advisers, have been realistic in their opening position, the investor will have to take that position into account when he designs the deal, given that his investigation to date motivates him to do the deal. The better his understanding of management's position, the more likely it is that his offer will meet the expectations of both parties.

In the later stages of the investment process the management can still have considerable influence on some aspects of the deal. The investor will be increasingly committed to the deal which he has thrashed out, so far, with the management team. He will not to want to imperil the whole deal over an issue of detail. In particular, the management may well be able to achieve its objectives in some of the details of the deal, especially where the investor's executive does not have to seek approval for any changes. These details might include the process for appointing any nominee directors, fixed or participating dividend rights or, in the case of loans, the repayment timetable.

What to negotiate

Negotiation has two central objectives for a management team. First, to secure the investment or finance which they are seeking on the best possible terms and secondly to ensure that the prospective investor's desire to invest is strengthened in the negotiating process. This means that careful thought needs to be given to ensuring that any negotiating position is realistic and that it is consistent with the view of the business and management which has been presented to the investor.

Successful negotiation is a two way street. The investor, as well as the management, will want to reach an agreement on the best terms available, although he will be conscious of the need not to de motivate management or run the risk of rejection of the terms by the existing shareholders. Moreover, he will want to ensure that actual or potential weaknesses in the plan are addressed and that the deal gives him the degree of control over the investment which he believes necessary.

The two tables below are designed to give managers a feel for the issues for negotiation with an investor, the stage at which to raise them and the possible trade offs which could be considered:

1. Equity investment

2. Lending