Seven Lessons Before Entering into a Bad Agreement

Look before you leap, do your home work before the commitment

Jose, the President of Software Development Group (“SDG”), was desperate to expand his business. He saw many opportunities of exploiting the market for products to enhance the data security of medical devices. Recent changes in the law underscored that medical devices, such a  implants, which generated medical data, were vulnerable to hacking or manipulation.  Jose had a  product in mind to help address this vulnerability but simply  did not have the capital to make it a  reality.

After many false starts, Jose was introduced to Medical Devices Maxima (“Maxima”), one of the largest device manufacturers in the world. Maxima  was intrigued with some of Jose’s  ideas and decided to back him, but for a price. In exchange for a  $3 million  investment, Maxima wanted an  equity stake of 25% in SDG and, moreover, 50% of the profits for the first  five years generated through sales of the devices developed by SDG in the medical devices area. Maxima’s  profit share, thereafter, would decrease until it stabilized permanently at 5%. Finally, if dividends  remitted to Maxima failed to reach the $3 million invested within five years, Maxima  would be able to foreclose on SDP’s relevant intellectual property and thereby come to own it.

Jose did have some qualms about the deal, but he expected the market rapidly to expand  and   envisioned sales in the hundreds of millions of dollars. He thought that at such a scale there would be plenty of money for everyone, i.e.,  50% of $200,000,000 was  still $100,000,000, many times what SDG  was currently worth.  Convinced that Maxima  presented the best opportunity SDG could  hope for, Jose executed the Investment Agreement  with Maxima. Owing to his belief that nitpicking the agreement would only slow the deal down and that  it was  necessary to get Maxima  to make a quick commitment before too many questions were asked, Jose decided that he did not want to use an attorney and that  it was  better for him to go it alone.

What unfolded, however, was different from what Jose imagined.  First, research and  development costs  exceeded projections so that  additional monies needed to be dedicated to developing the new product lines. Second, when SDG’s products were launched, sales volumes did reach millions of dollars but not the hundreds of millions of dollars Jose envisioned. Third, the clock was ticking on SDG’s obligation to re-pay Maxima its $3 million investment or risk losing the project’s underlying intellectual property.

In the end, instead of SDG’s  having sufficient capital to launch its new products, the Maxima  arrangement made SDG even more desperate for capital, but now it was in an even worse position to attract new  investment owing to the fact that  50% of SDG’s profits had to be remitted to Maxima. The profit share also resulted in SDG having to rely on its own share to reinvest  in the company,  which  not only proved to be insufficient but also substantially cut into its own profit margin.  Moreover, to add insult to injury, Maxima , which became a customer of SDG,  suddenly announced in year four  that it was  reducing it purchases of SDP products, thereby reducing SDG’s  sales revenue and adding to the fiscal crunch.

 SDP was never able to reimburse Maxima for its $3 million investment, lost control of its intellectual property, which was perforce assigned to Maxima. Maxima went on to develop a  billion dollar market for the products originally developed by SDG. As for SDG, it abandoned the medical devices security market in consideration for Maxima’s agreement to terminate the Maxima Investment Agreement.

Here are the seven lessons:

1. Never give away the store for investment capital. One should not plan around the best case scenario but around the worst case scenario.
2. One should have confidence that one’s product is investment worthy so that multiple avenues for attracting investment are in  On the other hand, if one has   concerns about the marketability of one’s  product, the answer is not to sell-out to an  investor at any  cost, but to take stock of the product itself and assess whether there is really a demand for it.
3. The right to profits should be linked to certain milestones. For example, instead of being obligated to pay Maxima 50% of the profits on sales of the new product lines, the right to profits should have been conditioned on certain sales volume thresholds being reached and/or the amount of available capital meeting a certain target. Some thought should also have been paid to requiring Maxima  to reinvest its profit share in the enterprise for a certain term so that the enterprise has the financing to scale its operations.
4. When an investor is also a customer for the product being developed, the investor should be obligated to purchase a certain threshold amount of product for the duration of the relationship linked to certain sales milestones.
5. Only as a last resort should an enterprise mortgage its IP in consideration for investment capital. But even if a product line does not prove to be that profitable, the underlying IP could  still have significant value. This is because IP can have many uses, including providing the foundation for developing related products. As we see from our illustration here, even though SDG was not able capitalize on its IP, Maxima could and did. But even if an entrepreneur feels compelled to mortgage their IP in favor of a major investor, it does not have to be an all or nothing proposition. For example, the investor could still be required to license the IP back to the entrepreneur and/or pay the entrepreneur a royalty if the investor hits it big in the market place within a  certain period of time after it has assumed ownership of the IP. The point is to discourage bad behavior on the part of investors who might try to capitalize upon the limited resources available to entrepreneurs.
6. In negotiating with investors, the entrepreneur should be represented by counsel experienced in the area of new enterprise development. For an entrepreneur to take up negotiations without any guidance is a recipe for disaster. When entering into investment contracts, entrepreneurs should  spin out multiple scenarios to see what  the results could be.
7. Finally, bad agreements can have disastrous business consequences, so entrepreneurs need to think ahead, obtain the help from attorneys and business development specialists necessary for them to be able to anticipate a range of outcomes, and be willing to walk away from a deal if too many strings are attached that could threaten the prospect of the company’s being able to garner the capital it needs to  meet its business objectives.

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