Potential Tricks that Comes With Yes!

Positive response from investors come with challenges. Their individual interests should be managed, delegated and incorporated into your business. Every private investor knows what to invest in, including usage of resources and possibly different tricks. Let’s go through some of them! The first is vendor financing. It’s effective! Let’s implement it in a scenario. If a founder ask for $30 million for 50% equity, and investor wants to pay $25 million – both parties compromise.

If founders only accept $30 million, investors will make a very “generous offer”. They will pay $30 million, but with a condition. It can be something like, “because I am new to your business, and don’t have the same intimate knowledge you have, I will pay half now and the other half in 5 years. The real deal is they paid $30 million, but lend out $15 million. The deal is usually sweetened with paying a very low interest rate. The founders get less than original amounts, while thinking they are getting original amount. The real value will be little less than $25 million – expected fund return/opportunity cost for the funds.

Another trick is contingent earn-outs. Just like the $30 million for fifty percent scenario. The investor will pay first half now and the other in 2 years, if obtaining $10 million EBITDA (Earning Before Interest, Taxes, Depreciation and Amortization). For example, if the business currently obtains $10 million EBITDA without debt and maintain it, then the investor will pay $15 million – 2.3x multiple. However, if the business grows, which shrinks it to $9 million, then investor pays $15 million – 1.6x multiple (15 x 2)/9. Even if the business earns $10 million, it is still the same. Two elements matter – time values of money and contingent payments. This mean investor only pay about half of expected amount.

Another trick is demands for Company-Paid Earn-Outs. It is very efficient for a highly charismatic and skilled investor who knows how to adapt tricks. Concepts of money and contingent payments make it possible for investor to demand the company being liable for earn-outs. For example, if the investor applies a company-paid earn-out and pays the other $15 million contingent upon EBITDA of $30 million a year after a sealed deal. If a founder holds a minority stake, he/she might miss what it means.

With the right negotiation, you could easily miss that the company – not investor – is paying the earn-out. It means if the company gets $10 million EBITDA in revenue, the private equity investor will pay about $7.5 million of the earn-out, because the investor own 50% of equity. The founder pays the other $7.5 million. The investor only pays $15 million + $7.5 million (further discounted) to the business. Another trick is equity clawback and ratchets. It is based on knowing the business owner. They knows that you are very optimistic. Without it, no one wants to invest in your business.

Let’s say the business has $2 million EBITDA, and founder wants $10 million for 50 percent – approximately 10x multiple. The optimistic business owner tells the investor that the business will get more than $4 million EBITDA within a year. They use that to their advantage, and pays the $10 million. But says: “due to information asymmetry, I want equity ratchets. In order to prove that you are confident in your strategy to maintain earnings, the equity ratchet will reduce the equity by 1 percent for every $20,000 the EBITDA is below $4 million.”

The investor is playing on your optimism and want you to doubts your own numbers. You have to agree. If you refuse the ratchets, then it questions your faith. However, if the book only shows $3.5 million EBITDA after a year, then we’d have a problem. Here is the problem: the founder owned 50% of the business, and since he/she agrees to the ratchet terms – investor has overtaken the company. If using the old understanding of EBITDA, it might be $4.1 million, but it is irrelevant. The new one takes home the price.

Investors are financial and legal engineers, who always creates/find loophole when making any business deal.