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SEPTEMBER 12, 2000

SMART ANSWERS
By Karen E. Klein

Valuing a Partnership in a Startup
Providing funds in exchange for a piece of the business can be tricky. You'll need to take several steps to make sure it's a good deal


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Q: I've been offered a business partnership that would require me to invest funds to obtain 40% of a virtual startup, with the idea-generators getting 60%. The business plan looks good, but I'm afraid it may be too aggressive. Can you give me some basics on how to negotiate for my interests?

--Iwona, Warsaw, Poland
A:  In general, you need to prepare yourself by becoming familiar with the various financing structures and staking out a bargaining position. Do this in consultation with an experienced attorney who can give you guidance on the relative importance of the many issues to be resolved, including salary (if you'll actually be joining the company), stock restrictions, responsibility for debts incurred, and makeup of the board of directors.

Make sure the ownership percentages aren't based on an arbitrary split your would-be partners have decided on. The partnership should rely on a methodology that makes sense and can be calculated, says investment banker William May of Stonemark Business Brokers in Seattle. Arrive at a valuation of all the assets being brought into the deal, and you'll be able to determine how the ownership should be split, he says.

You, and the potential partners, will need to examine both the tangible and intangible assets, and then agree on a logical formula for determining ownership percentage. "Valuation can be arrived at for both tangible assets such as equipment and inventory, which can be most easily appraised, and intangible assets such as patents, copyrights, systems, and processes, and even knowhow and contacts, which can be difficult to determine," May says. "If you value all assets, all work, and other contributions on a dollar basis, the percentage of ownership will appear clear."

UNPROFITABLE IDEAS.  In your case, you're being asked to put up cash for the new company, while your potential partners are putting up a concept. There's nothing wrong with that, if the value of the idea can be shown to equal 60%, while your cash is valued at 40%. "Both parties should remember that ideas are only valuable if someone can turn them into reality. The great majority of great ideas never turn into sales, let alone profits for their owners," May says.

After you've determined the value of the assets involved, if you feel the 60-40 formula is out of whack, you'll need to negotiate for a different split. "The best negotiators base their position primarily on the underlying facts and figures," May says.

Don't forget: When you're investing in a startup company, you have to be prepared to lose virtually everything you've invested if the plan fails or takes too long to achieve its objectives. Your risk -- putting up what may be a substantial sum with no collateral security interests other than the business itself -- and your commitment to the venture should be taken into account, says William R. Peterson, principal of Peterson Investment Banking in Chester, Md. "This is the crucial seed phase of the company, and most seedlings die."

Think about what else you'll have to do to keep the business afloat, whether it's invest a lot of your time or fork out more capital, and ask yourself if this is really what you want to do for the foreseeable future. You should also plan how and when to exit the venture.

"PERSONAL GUARANTEES."  To get more safeguards than you're being offered, Peterson recommends negotiating a loan with interest -- perhaps deferred and with a balloon payment or two over four years -- in exchange for a 40% ownership interest in the company, to take effect at maturity. In the meantime, your loan should be secured by an independent asset, such as real estate. "If the business actually performs according to plan, then amendments to the loan agreement can be structured to accelerate the loan maturity and transfer equity to you sooner," Peterson says.

Set up the loan so that the actual transfer of money from you to the company (make sure the money goes to the company entity, not to the individuals involved) occurs immediately and the security is based on the company, the persons holding the 60% equity, and another independent form of collateral. "Personal guarantees are an absolute necessity," Peterson says.

Structure your return on investment to kick in after the company has established itself and is showing positive cash flows, perhaps in year two or three, Peterson suggests. The balance of the investment should be negotiable, depending on the business conditions in years three and four. "If your would-be partner objects to this idea, simply explain that the cost of funding an untested startup is cash-for-cash plus interest and equity -- [with] a specific price and terms to be mutually agreed upon. This is fair, because you are taking considerable risk at the most dangerous time without any control over the outcome."




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