Investing time instead of money in order to get equity? Sounds like a good plan to me. If things go wrong, I've not lost any money. Or is it a good plan? What are the pitfalls for the sweat equity provider, future investor and the entrepreneur? What questions should they ask each other and what should they be aware of?
Often a two company opportunity presents. I’m asked to invest in company B which has a license with company A to use it’s technology. I turn them down immediately. Why? In this blog I explore some of the issues raised with these “two company” structures. So if you’re ever see one or are thinking of creating one this blog will make a good read!
The typical proposition goes something like this. An inventor has patented a great idea and transferred it to company A that he owns. Company A then licenses the technology to Company B for exploitation. The license may be exclusive and will have some cost associated. The inventor would like funds for company B so that it can build an infra-structure to make a success of the invention. Those that provide funds for company B will receive shares in the company. The inventor will have shares in company B and divide his time between the two companies developing more IP. Company B will be massive and pay huge dividends to it’s share holders and/or will be hived off and sold in the future.
Why would I possibly turn this down?
Let’s consider some of the new questions and problems that need to be resolved in the due diligence:
- What is the license agreement for? Is there exclusivity and if so, what is it’s nature? Territory based, sector specific, etc. If totally exclusive, then why have two companies? If territory or sector exclusive, what other territories or sectors has the IP owner identified that are better than what’s being portrayed?
- What happens to the new IP that is developed in company A. What rights does Company B have to it? If any? Can it exploit the new ideas or is another license agreement required? How do you know who’s time the IP was developed in (since the inventor is working for both companies)?
- What are you buying shares in? Is your money increasing the value of an asset that you will have a share of? Or is your money is demonstrating the quality of the IP (increasing it’s value) owned by Company A. If so, how do you benefit? And if your company goes under… what assets are there?
- How much time does principal spend in each company? How it is policed? What are they contributing to each company?
- Has the inventor done this before (with this technology or other technology)? If so, what happened? Why are they doing it again?
Now let’s look at what additional negotiations are required.
- Lets look at money flows. At what point is money paid to the license holder? What are payments based on? Gross Profit, Net Profit, Turnover? How are these policed? How often? What about future changes five years out? What if targets are not met?
- What happens on exit? If a buyer wants company A & B, how is the value attributed? What is the danger that the Inventor will hold the deal to ransom by refusing to sell company A?
- What happens if the intellectual property is copied by a competitor? Who pays to protect the asset? If successful, who receives the damages?
Phew! That’s a lot more work that needs to be done and issues that need to be cleared up over and above the usual list for an investment.
At the end of the day, it’s difficult for an Business Angel to resolve all these additional issues in a reasonable time scale and it leaves a Business Angel asking a simple question: “If the inventor thinks company B is so likely to fail that he wishes to protect his IP, then why should I invest my hard-earnt cash in it?”