Archive for the ‘Fundraising’ Category

Do Venture Capitalists Fund A Company With An Intent To Steal It?

Q: My client is looking for a 5 million dollar investment from a VC firm. What can he do to protect himself if he is worried that the VCs will acquire the rights to his product and then try to fire him and keep those rights? Does this happen often?

In addition, he anticipates that the new entity will generate tax losses in the early years and wants to share them with the VC. What can he do here? Finally, he would like to be able to force the venture to buy back his shares if after 5 years the company is still private. Can any of these things be done?

A: (Jason) Reputable VCs don’t engage in this type of behavior – funding and then stealing a company.  For one, it’s not a repeatable model.  If a VC acted this way, they wouldn’t have any deal flow to consummate future deals.  More importantly, VCs invest in folks to run companies – we have no interest in running your company for you, as we have other investments that we monitor. 

Also remember that VCs don’t acquire any rights to your product, they simply invest in the company that owns the rights, presumably.  So the corporate entity is what controls the rights, not any particular person.  If you question is how many CEOs leave the employ the company that they’ve created and raised money for, it’s a relatively small number.  More interestingly, the vast majority of CEOs that leave companies do it by their election, not that of the VCs.  Many CEOs are serial entrepreneurs and prefer starting companies, not running them after they become larger and more successful.

To answer your other couple of questions, neither of these will work.  Since you will have to incorporate your entity as a c-corp, these loses won’t flow through to the VCs and even if they did, VCs can’t use these types of loses.  As for the VC buy back – forget about it.  That’s a non-starter.  If I fund a company and can’t get liquidity, the founder certainly doesn’t have the right to get me to put even more money in to buy him/her out.

Should I Outsource My Fundraising?

Q: I’m the founder of a small internet start-up. Among my duties are editing and posting content daily, creating media partnerships, and bolstering our growth with creation of widgets, facebook apps, etc, but I’m also doing all of the fund-raising which feels like it should be my full-time job…if I could. I’m finding it hard to do everything and so my fund-raising is not going very well/quickly. My question for you is: as an early stage company looking to raise a seed round of under $500k ASAP to help us grow, what are your thoughts about outsourcing fund-raising to a place like Vfinance so I can focus on running the business? Are there any drawbacks?

A: (Brad) This is a bad idea.  You should not do it.  Even though fundraising – especially for an early stage company – can turn into a full time job, it’s an important one for the founders to do. 

You need to treat fundraising as a priority.  Presumably the reason you are raising $500k is to be able to hire a few people to help you leverage your time better as you are trying to get your business up and running.  If you don’t put enough energy into this, you fall into a classic chicken and egg problem where you don’t have the money to build out your team, but you don’t have enough time to go raise the money because you are busy doing everything because you don’t have the team.

Take a deep breath and realize that fundraising has to become the most important thing you are doing at this stage.  Find an early investor or advisor that knows you, likes you, and has credibility and hopefully a network of other investors and advisors.  Ask this person to help you with introductions to other angel investors.  Manage these introductions like a sales process – once you have a pipeline of potential investors spend the most time with the ones that appear to be most interested.  At the earliest stage they are investing as much in you as they are in the business and idea, so make sure you are on the front line of this effort.

Start every day off with this.  Fundraising should be the first thing you spend time on each day until you get it done.  Once you take 100% responsibility for it and make it your priority, it’ll get easier.

What Happens If Convertible Notes Are Called By Angel Investors?

Q: Convertible notes are popular instruments for angel investors when a future VC round might occur. But, if it takes longer to get to the venture round than you thought (doesn’t it always?) what happens when the note comes due? Can one investor call the note and put you out of business?

A:  (Jason).  Yes, technically they can, but in practice this rarely happens.  Normally, one of two situations exist:

1.  the company is doing “okay” just behind in it’s fundraising and it will get funded; or

2.  the company is not going to get funded and it’s realistically done.

In case one, the investors would be irrational if they called their notes, as they would get pennies on the dollar (remember the company is spending their money along the way) and preclude any chance of funding and thus them getting an attractive return.  Even in cases where funding seems remote, most of the time investors will give the company the maximum opportunity to get funded and continue on. 

In case two, the company is going to shut down probably, so it’s probably not too traumatic to call the notes.  In any event, the investors will get back pennies on the dollar, so it’s still in the best interests of the investors to let the company run as long as possible before throwing in the towel.

One thing to note:  don’t personally guarantee angel notes.  In that case, the calling of the notes will attach to the entrepreneur’s personal assets and may indeed incentivize investors to call their notes sooner than later.

Should You Exaggerate Your Size?

Q: Is it wise as a small company (1 person + advisors) to give the perception of a larger company?  I had done this for a while when I presented at conferences and talked to VC’s and have since stopped.  I have to bite my tongue when people tell me “we’re amazed that you’re able to do this with a team of 5″, when in reality I done most of it myself.  The team of 5 was just to make the company look larger than we really are.

A: (Brad) As with most things in life, it’s not useful to exaggerate.  You’ll eventually be found out and it’s usually awkward (sometimes more awkward than others.)  In this specific case, you are doing yourself a great disservice.  I think most VCs will be much more impressed with what you’ve accomplished when they hear that it has been done by just you! 

Given that you are talking to VCs, I assume you are raising money.  In addition to undermining your accomplishments, you are breaking a cardinal rule of any new relationship – don’t lie.  Once a prospective investor learns you have lied about the number of people in your company, everything you say that doesn’t sound quite right will be suspect.  By doing a small think like exaggerating the size of your company, you set yourself up not to be trusted.  Since trust is a key part of the relationship you want to develop with a prospective funder, you’ve now created a very ineffective dynamic.

You can also look at this from the reverse perspective.  If your prospective VC can’t get excited about what you have accomplished on your own, why would you want to develop a relationship with him?

How Can An Entrepreneur Fundraise Without Getting In Trouble With the SEC?

Q:  If an entrepreneur is out meeting with people in order to find investors in a round of financing, is this “soliciting” investments in the eyes of the SEC? 

It is my understanding that the SEC doesn’t permit solicitations” unless there is a pre-existing relationship.  Therefore, if the entrepreneur doesn’t have a pre-existing relationship before he starts making the rounds looking for financing, he could be in trouble. 

I have a colleague who say that this is not a problem.  He said that it would be ok for the entrepreneur to hold these meetings–and even to use a “finder” to expand his network– as long as he wasn’t giving the prospective investors a private placement memorandum or suggested term sheet.  As long as the prospective investor comes back with a term sheet, he is not involved in an offering or “soliciting” an investment is, my friend’s logic.

A:  (Jason)  There is a simple legal answer to your question: this type of behavior that you and your colleague are discussing is an illegal solicitation under the law.  Note, that I’m assuming that people you are contacting are not accredited investors.  If the people that you are contacting are not accredited investors, you don’t have an exemption under the SEC’s interpretation of the law.  It’s irrelevant whether or not you have a pre-existing relationship with anyone and irrelevant whether or not you have a PPM or term sheet present in the discussion.  Your intent is to solicit investment and that’s sufficient to be considered an offering. 

Now if you are seeking venture financing, or angel investors, they should all be accredited and you have no issues.  If you are asking folks who don’t fall under this standard, then the question is whether or not the SEC will notice your activities.  Probably not.  You would most likely fall under the radar, but the biggest issue is that any money you take in would probably be subject to a right of rescission – in other words, any investor you take on would at any time be able to change his / her mind and take their money back. 

All of this, too applies to any finder you use.  Using a finder does not insulate you from any of these problems. 

**Per all posts on this blog regarding legal advice, we aren’t your lawyers – seek your own counsel.  **

How Does One Structure a Business to Pursue Other Business Lines?

Q:  We’ve developed a web-based security product whose primary application was intended for the financial industry. Since inception we’ve since began pursuing two other business lines, also based on the software, that can be considered conceptually different from the product we initially brought to market.

We’re debating whether we should pursue these product lines under the same LLC or create two separate LLCs and license the software to them, while being majority shareholders in each of the companies. Our concern is that this might be a bit too convoluted a structure for VCs to consider once we go for funding in a couple of months. Alternatively, there’s the liability perspective with regards to having three separate businesses under the same umbrella. I would appreciate your thoughts on this issue.

A:  (Jason)  Your instincts are correct – don’t divide your business among product lines.  Any venture capitalist that invests in your company is going to want to invest in “everything,” not just a product line or two and the complexity and legal costs of setting up all of these entities and having proper licenses for property and people is prohibitive.

From a liability standpoint, one could argue that you are better off dividing up all of your lines of business (if one gets in trouble, it doesn’t hurt the others), but this is mostly a theoretical legal argument.  This argument only holds water if you truly run each business separately, capitalized separately, etc.  It’s not worth the bother.  As a startup, you have more important things to worry about. 

Finally, per our prior post, realize that that VCs don’t normally invest in LLCs. 

Does My Company Have to Exist to Get Funding?

Q: Does your company have to exist in order to get VC funding? I have an idea for a Web 2.0 company for which I have a business plan and a mockup, but I have not launched it to the public. Do VC firms even consider funding businesses that have not actually gone live?

A: (Jason) If you are an early-staged venture investor, you shouldn’t have a problem funding a company that doesn’t “exist” yet. Plenty of times we’ve invested in folks that have a small team a great idea and some PowerPoint slides. Upon investment your venture will need to be incorporated and will exist after that.

What’s the Climate for Venture Fundings In China?

Q: How difficult is it to get venture financing in China? What is the general climate?

A: (Jason) Seemingly after “everyone” setting up a China office / strategy and investing overseas, according to one report by NVCA and Deloitte and Touche, it’s not as easy as one thought.

Certainly, it’s more common for foreign start ups to attract U.S. VC money. As the global economy continues to truly become “global” it’s much easier to get one’s head around investing in a time zone different by more than 3 hours. That being said, I think that many U.S.-based VCs are cautions, as the report indicates. The amount of cycles it takes to monitor and add value to a company on the other side of the world is distinctly more than here in the U.S. In addition, different regulations make doing deals in other parts of the world inherently more complicated.

In general, those U.S-based VCs who have full-time people on the ground abroad are much better in dealing with these types of investments.

Raising Money From Venture Capitalists Versus Investment Banks.

Q: We’re a small startup with an innovative product in the social-networking / communications / UGC monetizing realm, at a pre-alpha stage of development. We have a number of potential deals on the table, the most attractive of which is to raise a large sum ($4mm) through a private placement with an investment bank. This deal has no strings attached, comes with a very high pre-money valuation and would cover two years of operating costs – SOUNDS GOOD TO ME!

Every VC we’ve met with expresses what seems to be prejudice against investment banks and the strategy we are considering, pointing out that they, the VCs, are the “smart money” with the “contacts” and “experience” as well as some other arguments as to why we should give up WAY more of our company to THEM for WAY LESS money.

What’s your word on this conundrum? My partner and I have talked to a number of entrepreneurs and they all say “stay away from VCs, take the money and run your business!” In fact, most of the people we talk to have had very negative experiences with VCs and question the notion of “smart money” altogether.

A:  (Jason)  It goes without saying (but I’ll do anyways) that I think reputable VCs are indeed smart company builders who will provide learned guidance in how to build your business and provide much more to your success than just money. 

I’m not here to bash raising money from investment banks – plenty of our companies at some point in their lifecycle do just that, but consider some of the advantages raising money from a VC versus an investment bank:

- Venture Capitalist will add a lot more value as board members being professional small company board members;

- Venture Capitalists will price your deal accordingly for the funding round.  Banks have been known to price early rounds too high and thus making future rounds very hard to consummate without diluting your first investors;

- Venture Capital financing will normally bring 1-3 shareholders to your company, whereas investment banks tend to bring many different individuals.  Consider information requests, annual meetings and issues involving dealing with individual shareholders if your business does not scale as planned; and

-  The bank may not be able to raise the money.  It’s not investing personally, rather attempting to find others to invest in your company. If they fail, you’ve wasted a lot of time and money drafting a PPM, etc. – documents that you wouldn’t create if funding via a venture capitalists.

As for “no strings attached” – I’m not sure what you mean, but banks only get paid if they get the deal done, so make sure they have your interests in mind, not just theirs.

One last point: I’m not sure where you are located, but in our neck of the woods, I think most entrepreneurs have had positive experiences with the VCs.  Again, you need to make sure they are reputable, but most professional VCs dealing with sophisticated entrepreneurs have good experiences together in both successful and problem-esque companies altogether.

How Much Should I Pay Lawyers To Complete My Financing?

Q:  I understand from your term sheet series that Venture Capitalists get their legal fees paid for by the company they are funding.  I have a term sheet with a legal fee cap, but now my VCs are trying to increase the amount saying their legals fees are running higher than expected.  What do you see as standard VC / investor side legal fees for Series A and Series B deals?

A:  (Jason).  I’m probably going to live to regret this post, as I’ll end up angering some lawyer friends of mine, but here goes…

I think a good number for a Series A financing is $25,000 or less for the VC lawyers.  While hourly rates have increased significantly over the past decade, so has the sophistication and standardization of financing documents.  Therefore, the prices for financings have not increased that much over time.  If the company’s and VC’s lawyers are experienced and aren’t over aggressive, negotiating the documents shouldn’t be too hard.

The most time goes into the due diligence process, so it’s important that  the company has its house in order and pertinent documents well organized.  If they company is sloppy, legal fees will definitely be higher.

All of this being said, we’ve only seen one or two deals in the past 4-5 years that have gone over the cap.

I’m sure this post will raise other questions regarding legal fees, so let me anticipate a couple of them and answer them below. 

Q:  How much should it cost of later rounds?

A:  Given that you are most likely going to use the prior round documents as starting points for drafting, all you are paying for is updated due diligence fees, so it shouldn’t be anymore (and maybe less) than the earlier rounds.  If you have a new investor coming into the round as the lead, they may want to do all the diligence from scratch, so it could still be a $25,000 or so proposition. 

Q:  How much should it cost for recaps / down rounds, etc?

A:  More.  Think $35,000+.  These are complicated deals, with shareholder mailings, consents and a lot more “hoops” to jump through.

Q:  How much for debt / bridge financings?

A:  Less.  Think $15,000.  These are even easier deals to do and the diligence is much less.

Q:  What do I do if my VC is trying to increase the fee cap along the way?

A:  Find out why they are asking for this.  When we’ve increased the cap mid-financing it has been because either the company wasn’t well prepared for the financing, there was something “abnormal” found in the diligence, the deal turned out to be a lot more complicated than expected, or the company counsel were pains in the butt.  Find out what is going on besides inefficient cost overruns of investor counsel.

Q:  How much should the company pay its lawyers for financings?

A:  This is much harder to estimate.  Depending on how much “heavy lifting” the company lawyers have to do to prepare the company for the financing and how involved they are in responding to diligence requests, there can be a range.  Additionally, the company lawyers draft the documents.  The documents should all be mostly “off the shelf” but expect to pay at least double what your VCs are paying for your own counsel to run the process and respond to all of the comments and inquiries.