Question 1: Conception/Formation
You have decided to start a company. You have a wonderful idea and have tested it on friends and done some preliminary market research. It looks very promising, and although you have not yet written a full business plan you feel that you can build a company that will generate revenues of over $60 million and pretty attractive profits within eight years. At this stage, like many first-time entrepreneurs, you have not really thought through “what you want to be when you grow up;” issues like attracting different sorts of financing and, heaven forbid, selling the company have hardly crossed your mind. You have saved $200,000 and your mother has agreed to lend you $50,000 “for as long as you need it, dear,” to start the company.
You think this is just enough to get you off the ground, and you might even be able to squeeze through to profitability with this injection of funds. Although you are very excited about your new venture, you realize that there is lot you do not know, even having taken Professor Lungeanu’s class. In talking to a number of friends, some of whom have started companies themselves, you feel that you need a partner to complement your skills, to be there when things are tough and to share the load. So:
Given your own strengths and weaknesses, what is your ideal partner’s profile (skills, personality, background, experience, resources, etc.), and how are you going to find and get comfortable with him or her? Be specific.
You think that you have found the ideal person, Jeb. He fits your profile, has complementary skills and has already been number two in a successful start-up company in the same general market are. This firm was recently acquired by a larger firm. He is eager to get on board, but he informs you that he will have to work part-time for three months while completing his current consulting contract with his old firm’s acquirer. Jeb indicates that he does not have any cash to bring into the company and he will need a “get-by” minimum salary when he comes fully on board. Jeb has also suggested a 50:50 ownership split. You really want to build a trusting partnership that will last for years. To what extent are you concerned about your new partner’s suggested 50:50 ownership split? Do you think it will provide the right balance and equality to underpin this new partnership, given his other requirements and inability to provide start-up capital? How will you handle this situation? What specific terms would you insist on having in the partnership agreement in order to make a 50:50 ownership split and his other requests feel equitable to you?
Question 2: Survival
You are now 18 months into your new venture. You have made some mistakes but at last you have your first satisfied customers, some new products are nearly ready to add to your first offerings, and you are beginning to attract the attention of the business press. Jeb has taken on a more strategic role in the company while you have focused on operations. He has convinced you that you need to lease some expansion space to accommodate your impending growth. He happens to have an aunt that has space available and that is reasonably priced. Although you have probably taken on more space than you will need for at least two years under even the most optimistic scenario, you both have just signed a five year lease.
You both realize that you will need some more cash to fund the business; in fact it looks like you will need up to a $1 million within six months. Jeb has spoken with the bank and they indicated that they will provide a line of credit for half this amount if a) you and Jeb use your houses as collateral to secure the debt, and b) you raise the other half of the needed cash from equity. Jeb suggests that he approach his Aunt Marie again, as she just might be interested in making an equity investment. You both meet with her. She is clearly a shrewd businessperson and sees that your company may be an interesting investment. She immediately picks up that your weakness is the thinness of the management team, and suggests that you find someone with experience to take over the sales management role while you go back to doing what you are best at – product innovation and mentoring new hires. In fact, she has a close friend, Alex, who may be the perfect fit – she suggests that you take a look at him for the role. Alex is the sales manager for a direct competitor called “Great Guns” located in a nearby town. He is willing to join your company as he is “disenchanted with the management at Great Guns” and your company offers an upside if you are willing to provide him with some stock rights in the company. He is willing to take a salary cut in moving.
Jeb is enthusiastic about this hire; you feel that his judgment may be clouded a little by the need to get the funding. When you meet Alex alone, you are not entirely comfortable with him, but you cannot find any real reason why he could not do good job, and frankly, you are getting really frazzled with the 16 hour days that you are putting in. Alex can relieve the stress immediately.
a) Do you agree to hire Alex? Provide your reasoning. If yes, how would you structure his compensation package at this stage of the company? If no, how would you handle the situation with Jeb? His Aunt Marie? You still need a sales manager; what would you do to find and hire an alternative to Alex?
Whether or not you hire Alex you still need to sell $500,000 of equity in the company, and Jeb’s Aunt Marie hasn’t made any firm commitments one way or the other. A couple months go by, and through a chance meeting at a local fund raiser for the area Humane Society animal shelter you make the acquaintance of Dr. Lucas Furber, a noted orthopedic surgeon who has built a highly successful sports medicine clinic and who has a soft spot for young go-getters trying to carve out their own places in the world. He is incredibly well-connected in the local entrepreneurial finance community, has made a number of Angel investments in the past, likes your story, and is willing to consider investing in your company. However, in exchange for the $500,000 he wants a 33.33% stake in the company and a seat on the board. He argues this equity stake is justified, given the early stage of your company and the risk he’d be taking (and knowing your lack of concrete alternatives and need for an investor in order to get the bank financing). He points out that this puts the valuation of your company at $1.5 million, and that your own $200K investment has just increased in value 150%.
About this time, Jeb informs you that the cash is running out faster than anticipated and the company needs to close on funding within four weeks. The bank seems to be lined up, and Jeb has offered to use his new house as collateral. For the sake of the partnership you have decided, with some trepidation, to match this with your home as an additional pledge against the loan. Your spouse is not too happy about this but agrees to go along. You have both set up a meeting with Aunt Marie at the end of the week to go over your progress and see whether or not she is interested in investing in the company, and what terms she will be seeking.
b) How are you going to handle this meeting? Assuming Aunt Marie is interested in investing, what kind of terms do you offer her? Which potential equity partner is more attractive to you, and why? How will you use the two potential equity investors in your negotiations with each of them? What terms and conditions are you willing to accept from each investor? Are they the same? Explain why or why not.
Question 3: Profitability and Stabilization
Your company is nearly five years old. You have grown to around $15 million in revenues but the profitability over the last 18 months has been falling; competition is becoming fiercer because your services are becoming commoditized. You have personally given much to this company and you feel very loyal to the 100 or so employees that you have hired, trained and mentored. They are in many ways part of your “family.”
As you started the company in a depressed economic area, you were able to finance the growth entirely through bank debt of $3 million, 90% of which was guaranteed by a government Economic Development Agency under a job creation program. You have had a major influence on this small town, there really being no other well-paying, white-collar employment opportunities for your staff. Indeed, last year you and Jack were recognized as “Citizens of the Year” by your local chamber of commerce because of the jobs your company has created.
You and Jack guaranteed the loan “as guarantors of last resort” as co-signatories, meaning that should the company go into bankruptcy or there is a default on the loan, the State Trustees of the Economic Development Agency can sell the assets of the company and what they do not recover must be repaid to the Agency personally by the partners.
When you and your partner Jack signed this guarantee you were, like all first time entrepreneurs, very optimistic about the future of the company and felt that there would always be enough retained assets to cover the guarantee. At the time you also needed the money quickly, and a low-interest, state-guaranteed loan seemed like a good deal.
You and Jack knew each other long before you got into business together. He was an attorney specializing in financial transactions and securities law; you were the one with the unique ideas for the new service. Jack had already accumulated a substantial net worth before you went into business together, and he put in the entire $500,000 seed capital used to start the business, although you have always been 50:50 partners. At the time of founding you executed a partnership agreement stating that should one of the partners want to leave the business, the other partner would have the option to buy that partner out at a valuation of 50% of the prior year’s revenues plus the initial capital the other partner invested in the company.
Your share of the company represents the vast majority of your net worth; indeed, two years ago, before things turned bad, you had taken out a $350,000 second mortgage to buy a beach house for summers and weekends. You are now carrying a total of $750,000 in mortgage debt on your two properties, have about $50,000 in liquid assets and $250,000 in your 401(k) retirement plan (which used to be $500,000 before a recent decline in the stock market).
Although you are a private company, at Jack’s suggestion you assembled a management advisory board which is currently comprised of:
Jack – Chairman and CEO
You – President and COO
Frank – Corporate Counsel (brought in by Jack; he is Jack’s ex-partner in an earlier business)
Martin – an external board member and a board member of two small public companies that had no personal ties with either you or Jack prior to joining the board
Alicia – an old acquaintance of yours, now also on the board of a major public financial services company.
You and Jack have been living well on the company’s earnings until the last six months, when cash flow slowed considerably, and you have both agreed to take half salaries. Nonetheless, the company now has only $100,000 in retained earnings.
You are no longer happy in the work environment. The company seems to have gone stale, you are not generating any really new ideas, and you are starting to hurt financially. You and Jack hardly speak with one another anymore, and he is coming to the office less frequently, preferring to “work from home.”
You are also beginning to have concerns about the $3 million loan guarantee. Although the loan is not yet due, you realize that there will be a repayment day, and that you and Jack are ultimately responsible for the funds. Since this a service firm, most of your “assets” walk out the door each evening. The tangible assets of the company are certainly worth less than $3 million if the company were to fail and be sold off for parts. At this stage the value of your company lies primarily in your reputation, the innovativeness of the service process you developed, and your book of business.
At last week’s board meeting, the outside directors suggested that you consider laying off 25% of your work force in order to cut overhead, since salaries make up approximately 60% of your expenses. This layoff would reduce your overhead considerably and perhaps allow you to weather the current economic downturn. Jack was favorable to this recommendation, but he hasn’t developed the close relationship with most of the staff that you have, and wasn’t as closely involved in their hiring.
An hour ago Jack came into your office and said, “I have some exciting news! I just got off the phone with the CEO of ServCo, and they are interested in buying our company! Given the depressed economic environment, they are only offering one times revenues, but hey, that’s $6 million apiece after we pay off the loan.” You press Jack for more details, and he tells you that ServCo, which is located in another state, is primarily interested in acquiring the process you pioneered so they can employ it nationally through their 300 service outlets, as well as in acquiring your current book of business. They are willing to keep up to 20 of your key employees if they will relocate to the city where ServCo is headquartered. The rest of your employees will be let go and your office will be shut down. You and Jack will each be given consulting contracts paying $250,000/year for the next two years. Your principal responsibility will be to help train ServCo employees in your process. You will also have to sign non-compete agreements that bar you from operating independently in the industry for the next three years. Jack seems pretty gung-ho about pursuing this option.
What do you do? Describe how you would weigh the various options you face. What are the most important considerations to you? Why? What ethical concerns do you face? What role do they play in your decision? Once you have decided on and justified a course of action to pursue, how would you go about implementing it? What steps would you take, and in what order? Be detailed and specific in your response.
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