Managing Your Investors/Shareholders

1. Managing Your Investors/Shareholders Part of the MBA Lite Series: Manage Your Business Patrick H. Gaughan, J.D., M.B.A. Youngstown State University Coffelt Hall Youngstown, Ohio 44555 440 829 7010 pgaughan@YSU.edu

2. The Hudson Library & Historical Society/ Burton D Morgan Center For Entrepreneurial Research

3. Who am I, what do I do? • MBA and licensed attorney. • Co-founder of the Garden Club Angels. • Recently Exited East Palestine China Decorating, LLC (a successfully restarted business). • Offices at • YSU Graduate Studies, • YSU Williamson College of Business & • Youngstown Business Incubator. • I work with entrepreneurs and angel investors. • Help structure and facilitate deals. • Work with high and low tech companies.

4. Before We Start… a few words about the Pros and Cons of Different Investors. • Friends & Family • Customers / Suppliers • Angel Investors • Venture Capitalists

5. Friends & Family Pros: • Informal • Easy Impressed • May invest regardless of opportunity Cons: • You’ll see them forever • They probably don’t understand • Investment value likely cash-only

6. Customers/Suppliers Pros: • Understand proposed service • Understand market • Have vested interest in success Cons: • Have conflicts of interest • May overvalue contribution

7. Angel Investors Pros: • May have outstanding contacts • May have relevant experience Cons: • May insist on participating/controlling • Can be annoying and intrusive

8. Venture Capitalists Pros: • Have resources to grow big fast • Have experience troubleshooting • Make Angel Investors appear reasonable Cons: • Are certain to professionally negotiate tough terms • Are impatient • Can and do replace underperforming management • Time wasted trying to get initial deal

9. For ALL Investors… • Understand their risk tolerance. • What are their liquidity needs as relates to investment period? • What do they expect for a return? • What role do they expect to play? • How accountable/responsive do they expect you to be? • What, besides money, are they willing/able to contribute? [See Investor matrix].

10. So, What’s “Managing Shareholders/Investors” All About…? • Personalities • Goals • Contributions • Valuation • Structure • Exit Arrangements

11. 1 of 6: Personalities • Notwithstanding everything else in this presentation, never maintain a Shareholder/Investor relationship with someone you don’t respect and/or with whom you can’t maintain a working relationship. • Insist on integrity. Look for past examples. • Make sure the respective roles are agreed upon and respected too. • If respect/relationship is lost – exit. • Repeat the bullets above as necessary.

12. 2 of 6: Shared Goals • At the initiation of the relationship, clearly confirm agreement on the purpose/goals of the organization. • Possible goals: • Profit Maximization • Market leadership • IPO • Civic Contribution • Economic Development • Education • Respect and Envy of the Neighbors • Quality of Life • Once agreement is achieved, be very careful in monitoring how the goals evolve. Seek consensus.

13. 3 of 6: Contributions • It is a mistake to view the contribution of a shareholder only in cash. • Alternative potentially valuable contributions: • Cash • Information • Technical Know-How • Managerial Know-How • Contacts (customer, employee, distribution, etc.) • Agree on the opportunity and how the investor can contribute value to it.

14. 3 of 6: Contributions (part 2) • Key - Match what the Shareholder/Investor wants and is able to give with what the Company needs to achieve its goals. • Pay only for what is actually delivered AND that the Company values (while being respectful). • Think about the Investor Matrix (next slide) • Remember The Step Function Relating Company Value To Time (slide after that!)

15. The Investor Matrix

16. An Example of the Relationship of Company Value To Performance Benchmarks

17. 3 of 6: Contributions (tie-up) • Secret is to tie the contributions of the Shareholder/Investor to the increase in value of the company. • If no delivery, no additional interest. • If delivery, some to Shareholder/Investor; some to company.

18. 4 of 6: Valuation • No way to cover in 75 minutes! • Theoretical basis: • Firm Value = NPV (future net profits discounted by Risk) • Where i/y = minimum return • Practical basis: • Firm Value = cost of building/acquiring a competitor (are there barriers to entry stopping this?). • It depends on the circumstance.

19. 5 of 6: Structure • Understand your corporate structure • Understand your deal structure

20. Your Corporate Structure • Are you a C or S corporation? • Are you an LLC? Managed or Member operated? • How many authorized shares do you have? How many are Issued? Voting? Rights of participation? Dilutable? • Are their any liens against company assets? • Have you adopted Regulations/By-laws/Operating Agreement? • Are there any Buy-Sell Agreements? Non-competition agreements?

21. Your Deal Structure (1 of 7) • Pick A Structure That Fits Both the Company’s and the Investor’s Goals. • Be consistent on terms across Investors

22. Your Deal Structure (2 of 7) • General options • Common equity • Preferred equity • Convertible Notes • Options/warrants • This are discussed over the next

23. Common shares are highest risk (3 of 7) • Last to be paid upon liquidation of the company • Liquidity totally unknown • Payout generally pro rata to all other issued shares • However, can be appropriate if buy-laws/regulations are in place

24. Preferred Shares (4 of 7) • Have benefit of preference as to dividends, liquidation, etc. • Require two classes of shares (impacts S corps) • Requires a certain level of investor sophistication • As equity, dilutes ROE calculations but reduces balance sheet leverage

25. Convertible Notes (5 of 7) • Treated as debt with right to become equity • No voting rights until conversion • Preference upon liquidation • Value is certain prior to conversion.

26. Promissory Notes w/ Warrants(6 of 7) • Provides best of debt and equity • Increases leverage on balance sheet • Complicates bookkeeping for diluted shares (like convertible notes) • Warrants (put or call)

27. Guarantees, Security Interests and other stuff. (7 of 7) • Personal guarantees on corporate debt – watch out. • Security Interests – provide a right to proceeds upon liquidation before all others. • Loan covenants – place management and financial restrictions • Full & Half Ratchet Provisions – Adjusts equity valuation for early-stage investors • Rights of Participation – assures the right to invest in a particular round

28. 6 of 6: Planning The Exit • Nothing lasts forever; plan the exit before anyone enters. • Discuss valuation issues upon entry. • Understand the ways deal structure and management can change deal value.

29. 6 of 6: Address company valuation issues • What is your company worth? • What is the basis for your valuation? • What will the company be worth as you hit each benchmark? • What will it be worth if you fail to reach a benchmark as scheduled?

30. 6 of 6: Ways of Establishing/Increasing Value • Don’t need investment (seriously) • Comparable valuations • Established strategic purchase value • Believable profit projections • Deal structures minimizing risk • Compelling management team track record • Pre-sold customer ‘orders’ • Multiple completed steps in implementation plan

31. In Review: “Managing Shareholders/Investors” Is About: • Matching Personalities • Sharing Goals • Agreeing On Contributions • Sharing Views On Valuation • Establishing Structure • Plan For The Investor’s Exit Before Entry

32. Any questions? Patrick H. Gaughan,J.D., M.B.A. Youngstown State University Coffelt Hall Youngstown, Ohio 44555 440 829 7010 pgaughan@YSU.edu