REMARKS ON VARIOUS BLACK BOOK SECTIONS

Front Cover

The Front Cover defines the Company, deal type and transaction size, and provides contact information.  We generally advise a few pages of color photographs inside the front cover to make otherwise intangible claims more concrete.  These are usually graphics punctuating the core variables identified in the Executive Summary.

1)  EXECUTIVE SUMMARY

Early in the summary, we seek to define the solution that the core product or service addresses.  We try to express this in human terms understandable to any reader.  Investors give higher valuations to companies that provide product-services that solve human problems that they understand.

We also try to identify the five or six core variables that make this Company unique or successful.  This may include (i) a first-time-ever confluence of industry technology, (ii) proprietary technology, (iii) new government regulation creating a new market, (iv) a management “dream team,” etc.  These items form the “hook” that will be later be used by brokers or deal intermediaries that will drive the transaction.  The rest of the Black Book, seeks to fill in the blanks, justify forward projections, and fully disclose risks and mitigating factors.

The Executive Summary includes summary data related to the historical performance, projections and the proposed transaction.  In our view, if a compelling case cannot be articulated for the proposed transaction in one or two pages, the deal’s valuation can never be maximized.

2)  TABLE OF CONTENTS

Most investors do not have time to read entire documents on first pass, but each has a favorite prism through which they evaluate proposals.  Nanosecond access to relevant sections is essential.

3)  THE BUSINESS

Corporate Overview

Here we seek to give an understanding of the organic aspects of the Company such as its evolution, location, size and growth prospects.  Very quickly, we define what business we are in, and paint a picture of “The Problem” in the marketplace that our Company seeks to solve, and summarize “The Solution” that we provide.

The Company's Solution, in turn, is driven by the details of the product-service being offered.  The burden of proof is on us to make this Solution tangible.  Investors want to see demonstration of a robust, mature product.  At each step, we translate each of the facets of the product to direct benefits to the buyer or end user.  Fancy technology is of no use unless it solves a human problem understandable to the reader.

Valuation is maximized if we can demonstrate follow-up products, or the capability to continually update the current product to remain competitive.  This theme is revisited in Employee, Management, and R&D sections elsewhere in the Black Book.

Industry Background and Trends

The depth that we drill down into Industry Background is a function of the prospective reader of the Black Book.  For a strategic investors within the same industry, we need devote less time to describe what is already known to the reader, and quickly zero in on a synthesis of the confluence of industry factors and trends that support our case.  In presentations to general audiences (such as to financial investors or public markets), we use a broader brush and build from the ground up, one brick at a time.  Even for deals proposed only among industry players, we generally try to avoid industry jargon to allow advisors not associated with the industry (investment bankers, attorneys, accountants, etc.) to all be thinking as one mind. 

The key in this section is to provide a context for our “Problem/Solution” discussion earlier.  We unveil the dynamics and trends in the industry.  Usually there is a unique confluence of external events (technology, regulation, awareness) that makes the Company’s product offering timely, and explains why it had not happened before.  This case must be proven, and shown to be enhanced by forward-looking trends.

It is always useful to have objective third-party studies that support our claims of growth, which studies may be presented in the Appendix, particularly if the conclusions are not obvious or pivotal to reducing perceived business risk in our business offering.

Company Strategy

Having defined the product and industry, above, the burden of proof is on us to show how we will deliver that Product.  Each organization has a unique process involving (i) R&D; (ii) manufacturing (supply chain management, inventory controls, offshore); (iii) marketing (pricing, distribution, sales); (iv) human resources (organization, employment, training & retention, management, culture); (v) intellectual property (patents, trademarks), (vi) intangibles (reputation, goodwill, customer satisfaction, branding); and (vii) resources (strategic alliances, networks, finances).  Our goal here is not to detail a laundry list of each aspect ad nauseam (which is important at the due diligence stage, but not in a concise offering prospectus), but to paint a compelling picture of selectively taking the 20 or 30 variables surrounding the company to prove beyond a shadow of a doubt why this endeavor will succeed.  In the interest of full disclosure, we also seek to identify the main choke points that may destabilize us along with mitigating factors whenever possible.  The message is that we understand the industry dynamics, and they are compelling.  We also need to show downside risks, and structures put in place to reduce their impact.

Clients and Marketing

With the product now defined, we can explore the market and how we will sell in that market.  The level of detail in this section is inversely related to the depth that the company already has enjoyed in the marketplace.  The less operating history, the greater the burden of proof is on us to show we understand the market.  For example, HP does not need to show that it understands the marketplace; a new startup company has a higher burden of proof in making an intangible tangible.

What are the relevant market segments (geographical, technological, demographic) for the Company’s product/service?  What products are we selling into which markets?  What are the trends regarding market growth and our market share in each segment?  What are the channels of distribution into each segment?  Where can we expect growth in sales and why?  What is our pricing strategy?  What are the channels of distribution and how will be exploit them?  How important is packaging, branding, and pricing?  What segment will we outsource; which will we do in-house?

While ongoing product lines can point to historical sales, new products need to prove their potential.  Valuation can be maximized by listing selected (even if encrypted) details of strategic partners, backlog, and indications of interest.  The existence of such interest is paramount in “proving” the claim that the product is of commercial grade and meets at least some commercial standards.  In the absence of such backlogs, the next best option is third-party testimony confirming technological milestones, or market needs.

The Competition

Thus far, we have (i) defined the product/service against solving customer problems; (ii) shown our strategic plan to deliver it; (iii) isolated specific market segments; and (iv) shown a certain commerciality.  But cannot others make the same claims?  This section is meant to “prove” our uniqueness in the marketplace, and establishes (hopefully) certain barriers to entry that will keep us in the lead.

Usually it is useful to consider the Company against the top three to eight competitors in a matrix of differentiating factors ranging from resources (often weaker), to product features (hopefully better), distribution channels and price.  We also need to track share-of-market trends, and identify the dynamics that brought them about.  From this analysis will emerge differentiating attributes, and a strategy for growth.  We consider, too, indirect competitors (with substitutable products) or potential competitors (that come from completely unexpected industries).  With a little luck, we can pluck arguments that show (i) a confluence of various technological changes is dismantling the strong position of former competitors; and (ii) related changes are handing the baton of growth potential to our new business model.

Government Regulation

Kindred to the competitive analysis, we look for shifts in government regulation.  Sometimes regulation has a ripple effect in creating new markets that were not there before the regulation, especially in the case of government mandates or shifts in tax policies.  Even when regulations seem punitive or restrictive to our industry, their existence can be leveraged into important barriers to entry that keeps the door shut behind us to others that would otherwise follow us.

Intellectual Property

Barriers to entry can also be built from intellectual property such as patents, trademarks, and trade secrets.  Such exclusive rights are pivotal to maximizing valuations for new enterprises, particularly those whose core is proprietary technology or know-how.  As a practical matter, patents often have limited value since they too often become obsolete before the expiration of the patent term anyway.  However, they are indispensable to argue for maximum corporate valuations, and often a deal is just not feasible without patent protection for differentiating technologies.  As important as the existence of a patent, is its geographical coverage (international versus domestic) and scope (specific claims):  Are granted claims only related cosmetic and peripheral issues, or are they sufficiently broad to block competitors?  If the latter, patents might be best included in the Appendix to anchor the fact.  Even then, we need to demonstrate that our in-house R&D capabilities are sufficiently robust to keep updating patents to forever stay two steps ahead of competitors.

Facilities

Generally, by this point in the “Business” section, the business case has either been made or not.  Facilities are generally not pivotal, particularly in the information economy where place is not critical.  Obvious exceptions may include (i) place-bound industries such as hospitality; (ii) where labor costs or expertise are significant factors to success; or (iii) markets where access to customer or supplier networks are vital.

Manufacturing and Suppliers

Having access to in-house manufacturing is also declining of importance in today's economy due to efficient outsourcing.  It can even be a liability due to process inflexibility.  For businesses that go against this model, there is a strong burden of proof required to show otherwise.

Even in the cases of outsourcing, however, it is important to discuss any inventory control systems, which are useful to leverage the investors dollars to do the maximum good without tying up resources in non-productive assets.  Also critical may be supply chain management wherein suppliers become a virtual extension of the Company's abilities to deliver its product-service to customers.

Employees

Wealth is not created by machines, but by individuals.  This sections unveils how human beings will be organized to bring about the operating plans.  We detail job titles, departments and responsibilities.  It may also be useful to flesh out policies on recruitment, training and retention.  Often intangibles can be made more tangible by disclosing detailed time-phased organizational charts.  These details are never used in SEC-related documents to the public, but are useful for sophisticated investors to visualize Management’s growth plans.

Engineering and R&D operations within the Company may need special discussion.  For technology-driven companies, it is vital to show that technological advantages are sustainable, not likely to go obsolete.  Today’s economy has created an environment with tenuous product life cycles, with products whose competitive advantages can disappear as fast as they arose.  The burden of proof is on us to demonstrate that we have the capabilities to keep ahead of the curve.

Legal Proceedings

This section is necessary in the interest of full disclosure, particularly if any lawsuits have a material adverse affect on the Company.  In many cases, an open-ended lawsuit, even one without merit, can kill investment interest in the most compelling of companies.  If such is the case, the burden of proof is on us to demonstrate (i) mitigating factors (such as insurance); (ii) that current lawsuits are “normal” for the industry, suffered equally by competitors and already built into the cost of sales; or (iii) that the current litigation has no merit.  It is equally important to be straightforward, and adequately inform potential investors of downside risks.

A major mitigating factor may be insurance.  A discussion on insurance is vital when the Company is in an industry where lawsuits are endemic or where contractual protections to limit lawsuits are impractical (such as consumer products or transportation).  While insurance is never useful to achieve one’s business plans for growth, it provides protection against unforeseen downside risks.  In some instances, it is useful to discuss mitigating factors as to why insurance policies will not need to be invoked, or what preventive measures are taken to prevent the rise of lawsuits (such as quality assurance, customer warnings and contractual provisions).

4)  MANAGEMENT

The quality of Management is one of the top four determinants of corporate valuation (others are expected cash flow, risk, and the idiosyncrasies of a strategic investor).  For an untested venture, it is the Number One determinant:  a poor business idea well implemented is better than the best of ideas poorly implemented.  A Steven Spielberg can make a poor screenplay into a blockbuster, better than an unknown producer could implement the most brilliant of plots.  Too often, the Management section in Black Books is neglected.  Before engaging in an offering, valuation can be maximized by either upgrading the quality of Management, or having “sample” candidates hand selected that can be tapped once funding is completed.

Optimized Management has (i) “done it” before (built a company in the same or similar industry); (ii) academic and business depth; (iii) members with different points of view (not all engineers or not all marketing); (iv) worked together successfully as a team before; and (v) driving passion for the enterprise.  “Management” in this context includes (a) the composition of the Board of Directors; (b) senior officers and executives; and, if these two groups are collectively inadequate, they can be supplemented by (c) a hand-picked Board of Advisors with industry heavyweights.  We try to look for weaknesses or holes in the Management composition and look for ways to plug them.

As important as the composition of Management, is how they are given incentive.  To optimize valuation, we look for salaries at 60-100% of market values (low guarantees), but with generous stock and options (high incentive).  Deals too heavy in salaries, particularly if they are to a bloated and redundant Management, reduces valuations.  Similarly, if stock is too generous, it potentially dilutes incoming investors.

Valuations are further enhanced where Board Committees are defined to create checks and balances, particularly by having non-aligned outside directors involved in future salary, bonus, stock or option grants.  Any conflicts of interest or apparent conflicts can reduce valuations.

5)  CERTAIN TRANSACTIONS

The elimination of conflicts or apparent conflicts does not stop at the Management compensation packages.  Any and all contracts between the Company and third parties in which Management holds a beneficial interest a anemic to good housekeeping.  Most often this occurs in royalty agreements with inventors, and outsourcing or leasing agreements with entities controlled by Management members.  We recommend that it is usually better to buy out such arrangements with common stock, and present a conflict-free structure going forward.

6)  DESCRIPTION OF CAPITAL STOCK

Up until now, we have shown that the Business makes sense:  there is a viable product, market, management and methodology.  This section deals with the rights and responsibilities of incoming investors.

Often Companies look only at the amount of the Company given up and for what price, but this is simplistic.  The price per share is governed not just by the intrinsic valuation of the Company as a whole, but also by the specific terms attached to the equity granted.  Generally, the share price, therefore, can be valued upward by creative structuring of the terms.  For this to be optimized, we seek an understanding of the objectives of the existing stakeholders in the Company.   Our goal is to maximize corporate valuation within the context of maximizing the objectives of existing stakeholders.  There is little point in maximizing valuation if the end result will take existing stakeholders where they do not want to go.

Any proposed financing can be viewed like a move in a chess game:  It must be engaged with a forward-looking strategy that involves the next move and the one after that.  Any financing structure has to be done so as not to encumber possible future financings.  Often privileges granted to incoming investors are so wide as to effectively close the door to the next round of financing.

Usually multiple objectives can be best balanced by multiple classes of equity, debt or debt-equity hybrids.  The goal here is to keep the deal as simple as possible (people do not invest in what they do not understand), but yet sophisticated enough to allow multiple stakeholders to each maximize their particular objectives.  For example, many straight cash-for-equity investments are optimized by offering two classes of stock:  Common Stock to existing shareholders, and Preferred Stock to incoming investors.  The incoming shareholders, then, can be assured of certain Board representation, dividend preferences, and control of unreasonable option or salary grants.  At the same time, there are provisions whereby Preferred Stock converts to Common and the privileges disappear in the event of certain performance milestones (such as going public, being acquired or reaching sales of X).  There is no single structure that we apply to all situations, but the starting point is to understand the objectives of the several stakeholders.  From this this foundation is built the financial structure that realizes the maximum valuation.

7)  USE OF PROCEEDS

Maximizing valuation is also driven by how the proceeds will be used.  The deal valuation is minimized if money is being used to liquidate existing shareholders, pay off debt (particularly to current Management), or to finance excessive salaries.  Investors like to see money stay in the Company and be put to useful work.  Unless there is a strong business case for manufacturing in-house, for instance, there is little reason to tie up capital in facilities that could be better outsourced.

If Management is bullish about the Company’s prospects, deal valuation can be maximized by creating investment commitments against milestones… with the valuation going up at each step.  Raising all the money today needed for the next, say, five years is possible, but may require giving up too much equity.  However, if the Company shows better on paper than the likely reality a few years out, or if there is a risk of a business glitz (which usually occurs), it may be best to get all the money one can as early as possible, but beware that the liquidation of a more mature business would yield higher valuations:  A business is like a tree; it is worth when it is bearing fruit than when it is just planted. 

Use of Proceeds not only involves how money will be deployed if the offering is fully subscribed, but should also anticipate the minimum threshold investment that would be acceptable.  Most business models have a minimum critical mass to be effective, and raising below that threshold may be viewed by incoming investors as throwing money away.  For most transactions, maximum valuations are achieved when the amount being sought is not excessive beyond what is actually needed, and that the minimum threshold is not less than 70% (or so) of the total offering.  Obviously each business model has its own dynamic, but the burden of proof is on the Black Book to show otherwise.

8)  CAPITALIZATION  and  9)  DILUTION

These sections are fairly standard and fall directly from the existing capital structure and proposed transaction.  It is often expected that incoming investors may be severely diluted, and valuations are often more based on future prospects than historic capitalization.

10)  RISK FACTORS

In the course of drafting the Black Book, we identify the "juggler vein" issues that can destabilize the Company.  We identify these by analyzing (i) the dynamics of the business and industry, to determine which assumptions and “facts” are on the critical path of logic as to why the Company would otherwise be successful, (ii) conflicts of interest, and (iii) other related transaction in the public domain where risks have already been enumerated.   Risks are highly subjective, and it is not unusual for the Company’s attorneys, security attorneys or the investment banker to add risks factors of their own.

Generally risk factors fall into three categories:  risk related to (i) the business (internal), (ii) the industry (external), or (iii) the proposed transaction.  It is important to be as complete as possible in each category.  While risk disclosure may lower short-term valuation, it is a valuable insurance policy against downside risks.  An investor who was foretold of possible adverse events is more likely to be a happy investor in the long term.

For less sophisticated investors (such as any public offering), it is vital to put risk disclosures toward the front of the Black Book.  We generally place it here at the end for sophisticated institutional investors that need to focus first on the substance of the deal.  Many times security attorneys have well-justified reasons to highlight risks to avoid conflicts later.  Regardless of the type of investor, it is vital that investors acknowledge that they understand each and every risk before investing.

11)  THIS UNDERWRITING

This section defines the precise nature of the offering at hand:   The price, number of shares, any commissions, who may invest and on what terms.  Usually this section is driven by the investment bankers involved with a transaction.  For maximum valuation, it is vital that the Black Book is written at a  disclosure level consistent with the type of investors approached (level of sophistication, whether financial or strategic institutions or individuals).  People do not invest in what they do not understand.

12)  APPENDIX I:  Financial Data

Historical Income Statements and Balance Sheets.  It is important to have historical financial statements going back at least three years.  Non-current years can be in summary format.  If the current statement is audited and by a Big Four accounting firm, it lowers perceived risk, and drives valuations higher.

Managements’ Discussion.  This section details and explains various business elements as to why year-to-year historical statements have changed.

Proforma Income Statements, Cash Flow Analysis and Balance Sheets.  For most business models, the projections should be three to five years into the future, broken down by month the first year, and by quarter thereafter.  (Certain projects, like public utility companies, require longer time horizons.)  Projections should be broken down in sufficient detail to expose all of the assumptions.  Any models that show excessive revenue growth, extraordinary bottom line profits as a percentage of revenue, or aggressive share-of-market assumptions may undermine the credibility of the whole offering if assumptions are not detailed and “proven.”

Usually projections are omitted from Black Books for less sophisticated investors such as in public offerings because of the high risks involved in meeting projections.  But even in these cases, their development is essential to convince market makers such as investment bankers and analysts.

Break-Even Analysis.  Our Black Books disclose the profit level and cash flow at various levels of revenue.  Most important is to pinpoint the revenue level which yields neutral cash flow, and at which level debts can no longer be serviced.

What-If Analysis.  Here we take selected critical assumptions such as industry growth, price-demand tradeoff curves, government regulations and costs.  If our key assumptions in the Proforma projections change, what happens to the bottom line?  This analysis is vital to (i) convince investors that the Company has thought through contingency plans, and (ii) identify key areas for closer analysis.

13)  APPENDIX II:  Technical Issues

Usually Black Books are written for diverse audiences, each using a different “filter”: CEOs, CFOs, marketing professionals, technologists and others.  Consequently, business sections are properly written with generalist information, with more detailed data for specific readers placed in Appendices. 

14)  APPENDIX III:  Supporting Documents

In making intangible concepts more tangible, risks are reduced and valuations increased.  Considered here are materials as required substantiate assumptions on the critical path:  sample brochures and advertising, third-party industry studies, journal articles, patents and trademarks, blueprints and plans, testimonials and backlog.

15)  APPENDIX IV:  Due Diligence

Due Diligence items, include the items above (which “prove” a business case), plus other items related to business infrastructure such as employment agreements, leases, sales contracts, royalty agreements, articles of incorporation, bylaws.  Each investment banker and security attorney will have his or her specific requirements.  We can work with your team to collect and distribute the appropriate documents on an as-needed basis.  For an outline of our Due Diligence approach, click here.