Write Soon Regardless of whether your investors' intentions are honorable, you can make sure their letter of intent is.

When you finally hear the magic words "We want toinvest," temper your enthusiasm just a bit. That means nothingcoming from an investor's mouth until you successfullynegotiate the letter of intent.

The letter of intent, or LOI, is the first official document youreceive from an investor after the handshakes are over and the realwork on the deal begins. Though 99 percent of LOIs are not binding,don't underestimate the document's importance, says JayMcEntee, an attorney and venture capitalist with Harron Capital, aprivate venture capital firm located in Frazer, Pennsylvania."The letter of intent will serve as the blueprint of the dealand moves negotiations from an indication of interest to theclosing table," says McEntee.

Most deals die at the LOI stage because that is where youfinally spell out the precise terms and conditions of theinvestment. In the lighter moments of making a presentation andaccommodating investors' due diligence, BIZ Experiencess oftenfail to discuss the finer points of the deal with their potentialinvestors. When those details are spelled out in the letter ofintent, disagreements may surface. Many BIZ Experiencess aredisappointed when their deals go off track at the LOI stage, butthe truth is, the letter of intent is doing its job by preventingdeals that are doomed in the long term. On the other hand, if youcan get a signed letter of intent with an investor, the deal willprobably happen, and you're on your way to getting capital.

The letter of intent is really a tool for your own protectionand benefit, so don't take it lightly. Here are some commonerrors BIZ Experiencess make when creating letters of intent and howto avoid them.

1. Absence of time frame:McEntee says BIZ Experiencess should avoid signing letters of intentthat do not have a specific time frame for consummation-typicallyabout 90 days-or a so-called "drop dead" date by whichthe deal must be finished and the company should have its capital."When you combine this with prohibitions against theBIZ Experiences seeking other sources of capital-often in the letterof intent as well-the result can be disastrous," says McEntee.Specifically, BIZ Experiencess sometimes find themselves bound by LOIsnot to seek other financing deals, but, at the same time, havelittle or no power to force a consummation or termination of thedeal in any sort of time frame. Thus, they not only have nofinancing, but they also have no way of getting it anywhereelse.

For companies that already have other sources of capital,letting investors drag their feet may be uncomfortable butpalatable. For an emerging company that is not yet bankable and hasno other sources of financing, however, a letter of intent thatpermits dithering on the part of the investor can be a death knell."Remember," says McEntee, "you do not want to putinvestors in a position where they have an open-ended right toinvest but not any obligation."

2. Letting the investor take over thehunt: Say you need $8 million, and a venture capitalistagrees to put in $3 million but makes the deal contingent uponsyndicating the rest among other investors he or she does businesswith. "Strategically," says McEntee, "it would be amistake for an BIZ Experiences to sign a letter of intent with theseterms."

The mistake is that you're staking your destiny on theventure capitalist's ability to raise additional funds. "Iwould not want to give up control to a third party," McEnteesays. "Founders and majority shareholders are most qualified,and most motivated, to make sure a financing gets done." Youshould only make an exception, he says, if the venture firmyou're dealing with happens to be a marquee name. Otherwise, ifyou receive a letter of intent that says the investor will kick in$3 million contingent upon raising another, say, $5 million,McEntee's advice is: "Do a deal for $3 million, and agreeto keep raising funds to get the other five. Just don't makegetting the other five a condition of the first $3million."

3. Not taking ratchet provisions intoaccount: In neoclassical venture investing, the investorand the BIZ Experiences both try to ensure that each round offinancing puts a higher value on the company than the one before.However, LOIs often contain provisions that put the onus on theBIZ Experiences if a later round is done at a lower valuation.Specifically, says McEntee, "ratchet provisions" meanthat if the value of a company goes down, the ownership stake ofthe VC goes up to compensate for the loss they've experienced.Of course, if their stake goes up, guess whose comes down?

"Ratchet provisions will hurt you exponentially if you areunsophisticated about them while negotiating the letter ofintent," says McEntee. "While eclining values may be afact of life, especially in [today's] market, taking 100percent of the hit is not. The best tactic is to make sure allshareholders, VCs and founders take a weighted averages portion ofthe decline in value, if there is one.

As you've probably already guessed, you'll need legalcounsel to get you through an LOI. You and your lawyer may haveseveral comments to make on any letter you get from an investor.McEntee says you can save time by having the attorneys hash out theeasy agreements. "At the end of the day, there may be one ortwo major sticking points the BIZ Experiences and the investor need toaddress as principals," he says.

"But by all means," adds McEntee, "make sure yourattorney has experience. If not, they will dig in their heels onissues they shouldn't. With all the deals I have on my desk,I'll gravitate to the ones that can get done and stay away fromthose where the other side is presenting problems."

David R. Evanson is aprincipal at Gregory FCA , an investor relations firm.

Contact Source

• Harron Capital
  jmcmcentee@harron.com