The Key Factors That Make Deals Investable

When it comes to investing, there are several factors to consider when determining whether a deal is worth pursuing. Firstly, it's important to understand the different types of investment structures, such as debt investment, equity investment, or convertible debt. Each type of investment has its own risks and rewards, and the right choice depends on the specific circumstances of the business. For example, equity investment involves giving up ownership stakes in exchange for funding, while debt investment is a loan that needs to be repaid with interest.

Additionally, the viability of an investment deal depends on various factors, including the stage, size, and industry of the business, as well as the amount of funding sought and the time frame. It's crucial to strike a balance between equity and control, ensuring that the business owner retains a significant stake in their company while also attracting the necessary investment. The terms of the deal should be fair and reasonable, taking into account the interests of employees and the distribution of profits.

Furthermore, the reputation and integrity of the investor are essential. Honesty, transparency, and legal soundness are key attributes of a good investor. It's important to remember that an investor is a partner in the business, and the relationship should be based on trust. Due diligence is crucial, and it's recommended to have a team of professionals review the deal before making any commitments.

When evaluating a potential investment, it's also worth considering the experience and track record of the founders and advisors, the potential market size and exit strategy, and the strength of referrals or connections to the investor. These factors can significantly impact the success of the investment and the likelihood of a positive return.

Lastly, the deal-by-deal model of investing offers an alternative to traditional investment funds, providing improved visibility, deal access, and reduced fees for investors. However, this model may also come with higher administration costs and timing issues, so investors need to carefully evaluate the opportunities and ensure they have the necessary expertise to make timely decisions.

A balance of equity and control

When seeking investment, it's important to strike a balance between equity and control. Money is vital, but what matters most is equity, or your stake of ownership in the company. When an investor funds your business, they're buying equity of their own, which gives them influence over how things are done.

For many small business owners, retaining control is a top priority. A good investment offer will leave plenty of equity in the hands of the founders, with little or no vesting. Angel investors typically take between 20% and 25% ownership, while venture capitalists may take 40%.

It's also important to consider the impact of investment on your employees. Any clauses regarding how profits are distributed if the company is sold should be closely scrutinized. As Nicole Toomey Davis, a serial entrepreneur and business coach, advises:

> " [A good investment offer] includes a pool of options for current and future employees, and it doesn't include ratchets or extreme preferences that take all the profits when the company is sold."

Before accepting an investment deal, it's crucial to weigh the benefits of the financial injection against the potential loss of control and influence over your business.

Fair and reasonable terms

Equity and Control

Striking a balance between equity and control is crucial. While investment deals provide necessary funding, they also result in the investor acquiring equity or ownership stake in the business. Small business owners often prioritise retaining control, so it's important to carefully evaluate the amount of equity offered in the deal. Angel investors typically seek 20-25% ownership, while venture capitalists may demand up to 40%.

Employee Considerations

Fair investment terms should also take employees into account. It is recommended to include a pool of options for current and future employees in the deal. This ensures that employees benefit from the investment and have incentives to remain with the company.

Profit Distribution

Scrutinise any clauses pertaining to profit distribution, especially in the event the company is sold. Avoid ratchets or extreme preferences that give investors all the profits when the company is sold. Ensure that the deal includes a reasonable salary for the business owner and that they can invest alongside investors on equal terms.

Due Diligence by the Team

Before signing any deal, it is imperative to have your team of professionals and advisors review the terms. This includes lawyers, accountants, and other relevant experts. Their input can raise important questions and identify potential red flags. Investors who discourage this collaboration may have ulterior motives and should be approached with caution.

ROI Demands

Understand reasonable expectations for return on investment (ROI). While investors expect a return, small business owners should be wary of unreasonable demands that could leave founders with nothing. It is not uncommon for investors to recoup their capital and a reasonable return before common shareholders receive their share. However, terms demanding multiples of the initial investment often guarantee minimal returns for founders.

Honesty, transparency and legal soundness

Honesty, transparency, and legal soundness are essential qualities of a good investment deal. An investor in your business is a partner, so it is crucial to establish a relationship based on trust and transparency. When courting investors, it is important to look for honesty and transparency and trust your instincts.

According to Baron Christopher Hanson, an advisor with John Burpree & Associates, "Good and fair investors want to reduce risk and earn a healthy return by being sure both sides of the deal are legally and fiscally sound upfront." They want to ensure that your business is operationally and sustainably run, and that it can deliver on its promises to customers and investors.

Hanson also warns about "vulture investors" who create untenable situations that result in their takeover of your company. These investors prey on entrepreneurs by offering seemingly low-interest rates coupled with dangerously strict repayment terms, making it difficult for you to meet their demands. As a result, they aim for you to default so that they can take over your business or assets.

Therefore, it is crucial to be vigilant and trust your instincts when evaluating potential investors. Look for those who value honesty, transparency, and legal soundness, and be wary of those who seem overly aggressive or demanding.

Visibility and choice

In the traditional investment fund model, no particular investments are identified at the outset. The investment manager raises capital commitments from investors, which may be used to make any investments that match the fund's investment strategy and fall within the stated investment restrictions.

In contrast, the deal-by-deal model provides investors with the opportunity to evaluate a single investment opportunity. This improves deal access by removing constraints related to investment strategy or restrictions, allowing investors to access a wider variety of deals.

The deal-by-deal model also enables investors to "dip their toe" by investing a smaller amount without being locked into an investment fund. This can be particularly beneficial for inexperienced investors, such as family members behind a family office, or those new to a specific asset class. They can use the deal-by-deal investing experience as a learning opportunity, gaining exposure to the investment team and visibility on investments.

Clear potential exit partners and tiers

When it comes to making a deal investable, one of the key criteria is the presence of clear potential exit partners and tiers. Top founders go into their ventures with a clear understanding of which large companies will see potential acquisition value in what they are building. They will have a well-defined chart illustrating why each major player would consider them, at what stage, and for what price. This does not necessarily mean that they will execute such a sale or even plan to, but it demonstrates that they have thoroughly modelled this scenario.

Having clear potential exit partners and tiers is advantageous for both the founders and investors. For founders, it provides a potential exit strategy and the ability to capitalise on their investment. It also allows them to approach investors with a clear and well-thought-out plan, increasing their chances of securing funding. From the investor's perspective, knowing the potential exit partners and tiers adds a layer of security and helps them better understand the potential returns on their investment. It also showcases the founders' business acumen and their ability to strategise and plan for different scenarios.

When evaluating potential exit partners and tiers, it is essential to consider the industry, market trends, and the specific interests of the major players. It is also crucial to be flexible and adaptable, as the business landscape can change rapidly. Founders should regularly review and update their exit strategies to align with the evolving market dynamics and the interests of potential acquirers.

Additionally, while having a clear understanding of potential exit partners is crucial, it is also important to remember that a successful exit is not solely dependent on the presence of these partners. Other factors, such as the performance and growth of the startup, the timing of the exit, and the negotiation process, also play a significant role in a successful exit.

In summary, clear potential exit partners and tiers are a crucial aspect of making a deal investable. It showcases the founders' strategic thinking, provides a potential exit strategy, and helps investors make informed decisions. However, it is essential to remain flexible and regularly review and update exit strategies to align with market changes.

Frequently asked questions