Week 5: Structuring

The structure of a deal is a lot like the capital structure of a company. If the company is primarily financed by the dispensation of stock, the capital structure is said to be equity-driven. If the company is primarily funded by loan, the capital structure is debt-driven.

When an angel investor prepares to write a check for the entrepreneur, it’s essentially a microcosm of that dynamic. The deal may invole the assumption of debt or the transfer of equity. In some ways, the scale of this transaction can give the exchange a more personal feel than what you would get at a bank.

Involved might be only one entrepreneur and one angel investor, who with trembling hand writes out the check on his coffee table before giving it to the entrepreneur sitting across. Here, the investor is betting on the entrepreneur because he believes in him on some level. And on the other side, the entrepreneur is accepting the funds because he believes the investor is, if not an oppotunity, then at least the lesser of two evils.

A good deal gives both sides something they want from the other. In any given society we often see people getting by solely through putting their hand in the next guy’s pocket. But usually that practice proves a Pyrrhic victory – particularly where reputation is involved.

This isn’t to say the deal at hand can’t hold fearful and wrenching trade-offs. But a good deal gives each party something they can be content with and justify it to themselves.

Many entrepreneurs prefer to dole out equity for funding when compared with the alternatives. In the pre-IPO days equity is essentially a promise to make good on the funds that have entrusted to the startup, and it is one of the rare enticements a startup has in its arsenal.

Upon starting Amazon, Jeff Bezos traveled the well-worn path of injecting his own money and then tapping family and friends for additional funding. Equity shares were exchanged for the funding.

A short while later, when Amazon needed additional funding from angel investors in the Seattle area, Bezos appears to have exchanged more equity for money. The SEC’s S-1 Filing prior to Amazon’s IPO indicate that Bezos possessed a 48% share of the company by the time it went public.

Looking back, it’s safe to say that the Amazon investors who decided to take equity over a bond made the best financial decision of their lives that day.

These days, a convertible bond is pretty popular, in that it provides the investor with the best of both worlds. Convertible bonds allow the lender to convert each bond into a certain number of shares of common stock. If things are taking off for the startup, the investor continues to enjoy the ride…instead of suffering the indignity of being wise yet poor.

Convertible bonds have advantages for the entrepreneur as well. Convertible bonds sell at a higher price and require a lower interest rate than bonds without this feature. So the burden of the liability is lighter than it might otherwise be.

Lastly, there are times where the entrepreneur or business might actually want to possess a debt-heavy capital structure. Interest expense incurred when borrowing money is tax-deductible, while dividend earnings from stock holdings are not.

Like many things in life, deciding which financial instrument to obtain funding with is situational and should be tailored to fit in accordingly.