Corporate Check-Up Before Funding
Sunday, October 14th, 2007David:
This Memorandum is confidential unless you decide to share it with others.
With your permission I am writing to cover several related topics; namely (i) what I consider to be the strengths and weaknesses of the company with an emphasis on how an investor candidate will likely look at the company, (ii) a recommended structure to use with investors, (iii) the importance of having a Plan B, and (iv) approaching Chinese companies you will meet on the trip who may be interested in investing for equity, as opposed to acquiring fractional interests,
1. Strengths and Weaknesses of the Company as Perceived by Potential Investors.
First the Strengths:
(a) Your commitment of funds and the significant amount thereof.
(b) Your vision as to the importance of bringing some manufacturing back home.
(c) Your insight into the fractional ownership concept.
(d) The attractiveness of the franchise concept to be sold to engineering design firms.
(e) The prospect of expanding the manufacturing options.
(f) Branding the company’s name as a name that carries economic value.
(g) The pending patent.
(h) The possibility of a strategic relationship with industry players.
(i) The prospect of doing business with Chinese manufacturers.
(j) The collegiality of your employees.
(k) Preliminary plans to acquire other companies from related fields.
(l) Your success with your previous company, although it was in a different industry.
(m) An anticipated ‘exit strategy’ based on the possibility of being acquired.
(n) This list is not intended to be complete.
Second, the Weaknesses:
(a) The lack of a significant number of customers to date for the business concept.
(b) A shop floor that is underwhelming due to a scarcity of customers.
(c) Financial forecasts that show the company to be in the low-margin manufacturing sector (net income after taxes of less than 10% of gross sales), as opposed to having found a way to break the mold, so to speak, and create a new economic model, one that shows that customers will pay more than industry prices.
(d) Present uncertainty as to the correct direction for the company to pursue, whether China will be a ‘good partner’ or not, and what happens if the business plan and the revenue forecasts do not materialize.
(e) The age of the team, and without someone from the industry who is the CEO and a ‘stud.’
(f) Lack of a board of directors, or of advisory board members (as of the moment), that otherwise shows the strength of its outsiders.
(g) Need for a ‘Plan B’ that can assuage investors’ need to feel safe with their investment.
(h) Unlikelihood that a lead investor will emerge from conventional sources
such as aligned companies, venture capital funds or other categories.
(i) The geographic location of the company, which is too far from the airport to make it convenient for out of the area investors to schedule one day meetings at the company’s offices.
(j) Some personal health issues that may affect you and in turn potential investors’ comfort.
(k) This list is not intended to be complete.
2. Choices, Best Scenarios and the Alternatives Regarding Funding.
Using a balance scale, and trying to imagine all of the items listed under “Strengths” on one end and all of those listed under “Weaknesses” sitting on the other end, it is my conclusion that we should give unbiased attention to whether we can successfully raise the intended $4M before the middle of December. To do so we may have to be creative in the areas of the structure of the investment, with an emphasis on enhancing the return to the investors.
If after we have worked through all these issues we are not prepared to bet the farm on the likelihood that investors will sign up, and quickly, we should begin the process now to identify possible acquirers of the company. Between just us, this will be known as Plan B.
Due to the upcoming trip to China and the time constraints when the management team is out of the office, we have a challenge in fitting in presentations to potential investors when everyone is around. This only makes it more critical to know what we are doing with respect to the terms of an offering, where there is flexibility and how do we get someone with credibility to be a lead investor.
It may be necessary to focus on potential investors who reside nearby, or those who have other connections to the company and/or its team, and leave out of the equation any potential investors who live elsewhere or who do not have any pre-existing connection to the company and/or its team. Furthermore, it is unlikely that we can attract venture capital funds, even if we were willing to live with their onerous conditions. The economic model does not have the ‘big win’ kind of numbers, without gross speculation on our part, to convince them that this fits their portfolio requirements.
To that end, John, your financial analyst and manager of some of your personal investments, may be an important link to possible investors. Can he recommend, or at least offer to show the Business Plan to some of his clients without violating any rules or disciplines? He will have to make a disclosure of his relationship with you. If he can help and is willing to do so, perhaps the company can compensate him when he brings investors in. If so, we should start the process with him immediately.
All of the above is written with an eye on the calendar. If it was six months ago, the trip to China was behind us, and the franchise plan was well accepted by engineers and design firms, then we would have a different story to present. Time is of the essence. And getting behind the ‘8 ball’ is not allowed to happen.
We have to capture the moment and not worry about negative ‘what if’ events could happen. Time is of the essence, and I apologize if this is a repeat.
3. Proposed Structure for the Investment.
Based on the foregoing, I suggest that you consider approving an investment package that has some incentives you may not otherwise be in favor of. These are as follows:
a) Create a strong preferential schedule for paying the investors back sooner than you will recoup your investment. To do this, consider the following. Give these investors a disproportionate return, not in alignment with their percentage of equity ownership. To this end, how about a structure that says the investors will be paid 60% of the company’s net after tax income until they have recovered 100% of their investment?
Incidentally, if the company is reorganized as a limited liability company, as opposed to a C corporation, it would avoid double taxation. As an LLC federal income taxes only apply on funds when distributed to the equity holders. There is no tax on the income at the LLC level, unlike the liability for taxes on a C corporation on its net income, and then taxes are also levied on the distributions/dividends to its shareholders.
b) Let’s consider using Convertible Promissory Notes rather that try to sell Preferred Shares at this time. The Notes will carry say interest at 8% per annum, and be due and payable after 24 months. Furthermore after two years the company can make a demand that the Notes be converted at a set price per share. The conversion will equate to 33% of the then outstanding equity of the company. The Notes would automatically convert into Class A Preferred Shares (with the preferences as shown below) if the company is acquired (or goes public).
c) There will not be an escrow requirement for the proceeds received from investors if we can keep it out. Otherwise we can offer to escrow the first $2Million and then the escrow goes away.
d) Following conversion of the Notes, the holders thereof will have anti-dilution rights as long as the Notes are outstanding. After that they will have a right of first refusal to invest whenever the company elects to sell additional shares so that they can protect their percentages of equity ownership.
e) If the holders of a majority of the Notes elect to convert at the two-year date, then all holders shall be required to convert their Notes.
f) In the event of a liquidation event after the Notes have been converted, the holders will have a preferential right, before any monies are paid to any other classes of shareholders, to be paid an amount, which when added to the monies previously paid from the annual net after tax income of the company, that together are equal to the amount of their original investment.
g) The company will not hold any redemption rights.
h) The board of the company will have at five directors. As an added inducement I recommend that the investors, as a group, be entitled to designate two members of the board, subject to approval of those nominees by the company. You and two others, selected by you, will be the balance of the board members.
i) If for any reason the investors have not recovered their entire investment within three years, they would be entitled to designate a third director and the board remains at five members.
j) Agree to hold equity-holder meetings at least once a quarter and to provide annual financial statements and quarterly un-audited financial statements and reports.
4. Rationality Behind Proposed Structure.
The purpose in suggesting these clauses and terms is to give investors a sense of safety without indicating that the company has concerns in these areas. Also, I should add that in the presentations we need, at the outset, to establish that the company is just beginning to look for investors. The purpose of this is to convey a dual sense of opportunity; namely that they are getting a first look and that you have not been turned down by other possible investors.
There is a thin line between selling an investment and showing an investment. We must be showing, not selling.
5. Capture the Audience.
Another point to make is to create in the meeting a quick sense of mutuality. Body language from those in the room, or what and when they say something is also a harbinger of how they are looking at the opportunity to write a check. It stands out like a sore thumb, hopefully one that is pointing up. The surest way to make this connection from the outset of the meeting is to find something that is common to those hearing the presentation and those making it. It could be backgrounds in manufacturing, schools attended, where they live in the area, who else they know, etc. Hitting on one of these links, or others is very important.
Whoever is presenting, at any part of the presentation, should not get lost in what they have to say. They need to be on the look out for what is being said by the attendees, how they are engaging, whether they are leaning forward or sitting apart from the others in the room. It also helps to have as much GQ on each of the persons in the room beforehand so that we can address those interests and questions before they are asked.
Venture capitalists like to see “Mo” meaning momentum. Rather than getting bogged down in too much detail early on we should begin the meeting with the latest momentum for the company. Numbers can be boring but news suggests that the company is on to something. Stories from recent trips, unanticipated calls from potentially significant customers, etc., are very good indicators of “Mo.”
6. The China Investment Question.
The Ambassador clearly was pushing the proposition that companies in China may want to become investors in the company. I am recommending that before you and the team gets on that plane that a plan is agreed on as to how this will be handled. So much in China hinges on relationships and culture. It may be important from both of those points to give this careful consideration. If the company has no interest in selling any shares to a Chinese company they will, I believe, take it to mean that we do not see them as being worthy. Based on my belief, I see an opportunity to create a genuine interest on their part the more you and the team engage with your hosts. If it makes business sense to have Chinese companies using the company’s facilities for US customers who need rapid prototyping, then it should also make sense for the Chinese companies to acquire some ownership in the company. The amount of ownership, of course, has to be attractive to them but not a threat to the company or its mission (unless they want to pay an Emperor’s ransom).
If this was my company and my chance to interact with Chinese manufacturers who have the capital to become good investors, I would entertain them and the possibility of working something out. Excuse my openness but I know how well Jin can work with them and if you ask him to explain the idea he will do it.
7. Conclusion.
If it was not for the time constraint and the time of the year, things could be easier with respect to the raising capital. I am very mindful of your commitment to the company and will stay very pro-active with you so that you can rest any worries you have. Call me anytime, day or night. I will travel to the company, participate in presentations and keep providing my best advice, whenever asked.
I look forward to hearing your comments, questions and any criticism. Following those we can advance the fund raising process.
Jacques Nichols (c) September 2007
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