The term sheet issued by the potential investors in Bob O’Connor’s company would appear to have multiple operative concerns. Because RBS is a start-up investment, the degree of risk is substantially high. The company has no established track record of its ability to accumulate market share or demonstrate sustainable growth over time. The due diligence pursued by the investors’ market analysis indicates potential profitability, but the ability of RBS to expand into a diversity of markets appears to have its limitations. However, RBS also indicates its ability to be a sound investment with regards to the markets toward which it is actually oriented.
Like any set of responsible investors, Walnut Ventures Associates and Mid-Atlantic Venture Fund wish to maximize the potential return on their investments while minimizing the risk potential. The primary concerns of the investors are rooted in the start-up nature of this new entrepreneurial venture, and the niche market towards which the company is oriented (Engwall 56-60). The investors have therefore structured their terms in such a way as to minimize risks to themselves resulting from these two primary challenges. The investors wish to ensure for themselves a reasonable rate of return should the company be liquidated within a few years. Towards this end, the investors also wish to control the operating costs of the company, including compensation offered to senior management, during the developmental stages of RBS as the firm strives towards the obtainment of market share. It for this reason, for instance, that the investors wish to reserve veto power for themselves concerning substantial increases in the compensation provided to board members (Dann 237-240).
The present valuation of RBS at the time of start-up investment is approximately $380,000. This figure is determined through the calculation of the overall value of company stock sold under the terms of both Series A and Series B. The most significant aspect of the term sheet offered by the investors has to do with the ownership structure of RBS should the terms outlined by the two investment firms be accepted by Bob O’Connor, and any junior partners or smaller investors he may have. Under the terms offered by Walnut Venture Associates and Mid-Atlantic Venture Fund, the majority of the ownership of the firm would actually be ceded to the investors rather than retained by Bob O’Connor. Additionally, these two investment firms would actually be the de facto owners of RBS as they would control the majority of the stock held by the investors (Schwan and Remaley 55-58).
Bob O’Connor, his junior partners, and managerial associates would control only forty-eight percent of the company. They would not have controlling interests in the corporation. Further, the compensation provided to board members and senior management would also be limited and regulated according to the terms offered by the investors. Essentially, Bob O’Connor would become an employee of Walnut Venture Associates and Mid-Atlantic Venture Fund. Given the ownership structure and distribution of corporate shares outlined in the term sheet, if the company were to be liquidated the majority of the proceeds from the sale of the company would go to the stockholders possessing shares under the terms provided for under Series A or Series B.
The most troubling aspect of the terms proposed by the investors is the de facto relinquishing of controlling interests in the firm by Bob O’Connor, and the distribution of potential revenue generated by the future sale of the firm. Bob O’Connor should first seek to renegotiate the terms regarding stock distribution. The principal aim should be to ensure that the founders and management of the corporation retain controlling interest in the firm by holding at least fifty-one percent of the corporate shares. In order to ensure a greater return for the founders and management in the event of the liquidation of the company, Bob O’Conner may wish to agree to a larger dividend payment to investors in the shorter term.
Dann, L. Y. “Highly Leveraged Transactions and Managerial Discretion Over Investment Policy: An Overview.” Journal of Accounting and Economics (January-July, 1993): 237-240.
Engwall, R. L. “Designing the Optimal Investment Strategy.” Journal of Cost Management (Winter, 1988): 56-60.
Schwan, E. S., and W. A. Remaley. “Marginal Return on Invested Capital Versus Internal Rate of Return.” Journal of Cost Management (Summer, 1991): 55-58.