Archive for April, 2012
This important variation on “money talks” is an important consideration for entrepreneurs when seeking an investment from professionals such as VC’s. Something like a marriage (and often lasting just as long statistically), your investment partner can be a great cheerleader, coach and resource. But the moment things turn sour, including missed plans, some investors on company boards go into a predictable mode of dictating terms for emergency loans or additional investment.
These include forcing early investors to “pay to play,” or invest their pre-rata amounts to keep their original percentages, or suffer the consequences of being diluted to the extreme and losing preferences in a liquidation.
The reaction to bad news by VC’s controlling the board by virtue of their power to supply additional money, often includes the threat – or reality – of starting the process to find a replacement CEO. So the combination of bad news and VC or professional investors on the Board can be volatile for the founders or management. Angel investors tend to be much more understanding, and usually resort to coaching rather than replacing the CEO during bad times.
[Email readers, continue here...] These are only a few of the considerations that have caused an increasing number of early stage entrepreneurs to draw business plans for companies that can be grown with angel and friends-family capital. It avoids the increased risks and pressure that come with subsequent VC investments.
On the other hand, if a business needs large amounts of capital in order to succeed, the entrepreneur and board should contemplate the advantages gained against the increased risks, making a conscious decision to go for the growth with such funds or to grow organically – or to grow with a smaller round from internal investors.
Professional investors laugh when they hear an entrepreneur state, “We have no competition.” That statement has killed more investment deals than almost any other. It is a failed litmus test for the entrepreneur, even if the plan is for a totally new device or service that could take the world by storm. Well, come to think of it, this is especially true in such an instance.
The statement shows a lack of research or previous thinking that is a red flag for investors. Whether the entrepreneur has not been able to find companies doing “something like” the plan, or s/he has not considered the most obvious killer of new ideas – doing nothing, it is a faux pas that should never be allowed to happen.
Doing nothing is the main competitor for most products and services, whether a compelling new idea or a seasoned product long proven to be effective. Remember that the buyer must commit resources, money and time, toward the purchase of your product, and even if the product repays its investment in a few months, there may be issues you know nothing about that make no decision the right decision for this and perhaps many buyers.
[Email readers, continue here...] Consider the state of the economy. Perhaps buyers cannot obtain attractive financing in the current market. Maybe there is advance knowledge of new technologies around the corner that makes any decision today a risky one. It could be that a larger competitor has met with its customers, promising to extend its product line into this very niche. There are thousands of variants of the theme, where no decision is the right decision.
So, do your homework especially well by putting yourself into the minds of your potential customers. Widen your search to include companies with products peripheral to yours, where extension of their product would seem logical, especially if you plan to be successful early in making sales into their market. If you are raising funds, list “do nothing” as a viable competitor in your slide deck. If you are training your sales staff, work especially hard on responding to emotional and factual counters to a final close of a sale. Practice overcoming the potential objection long before standing in front of investors, customers or even your board. After all, fooling yourself should never be an option.
There is a natural fear of giving too much information to investors after the initial investment is received. CEO’s worry that investors will not keep the information confidential and that financial data will find its way into competitors’ hands. Others worry that investors will latch onto individual line items within financial data and engage in inquisitions regarding telephone bills, marketing costs and other tactical line items in detailed financial statements.
First, let’s cover the absolute minimum legal requirement a company has to provide to its investors. There must be an annual meeting of the shareholders, and that meeting must be announced with a written notice at least twenty days prior to the meeting. (There is a provision that a waiver of notice may be signed preventing this need, but it requires that all shareholders sign).
[Email readers, continue here...] At the annual meeting (which can be attended by phone), there are actions that require a vote of the shares present either by proxy or in person. These include election or re-election of board members if required by the bylaws of the corporation, approval of any increases to stock option plans (which would dilute the worth of shares outstanding), and approve any additions to the capital stock authorized to be issued. Shareholders may vote on other issues during the year by written consent, including acquisitions, stock issuances, changes to the articles of incorporation and bylaws, and more.
But the question that is most often asked is: “How much financial information must be divulged?” The answer is that the minimum requirement is to provide an income statement and balance sheet to all shareholders annually. There is no requirement that either be detailed by general ledger account, and those statements should rarely be that detailed anyway. Summarizing income statements with a line for revenues, cost of revenue, general and administrative expenses, sales and other direct costs – all leading to net income, would satisfy the legal requirement for statement of income and expense.
When a company accepts an investment from professional or organized investment groups – such as angel groups, venture capitalists or corporations, there is usually a document signed called an “investors rights agreement” that calls out additional financial and narrative reporting requirements due to that class of shareholder. These could include the need for audited financials, monthly financial and narrative reporting and more. That burden is an ongoing cost of taking the investment, much as a public company takes on the additional burden of governmental reporting, both adding to costs over time.
Good relations with investors can be maintained only by keeping current with information between the company and the investors. If there is a concern over some investors gaining a competitive advantage, the amount of information may be reduced to the minimum for some classes of investors. A good example of this is the information provided to common stock holders, many of whom may be former employees who have exercised stock options and moved on to join the ranks of the competition.
Of course, a public company is not entitled to pare its information to reduce exposure to competitors. That is one of the many costs of becoming a public entity as many CEO’s have found and dealt with over the years.
Some businesses just can’t fit within the angel capital or friends and family model for raising funds. Sooner or later these businesses will have to seek venture capital and accommodate the needs of the venture community in negotiating the terms of an investment.
First, VC’s in general cannot invest in ‘S’ corporations or limited liability companies (LLC’s). This is only a minor problem in that both forms can convert easily into ‘C’ corporations at low cost and little consequence.
More importantly, VC’s will worry over a number of issues when looking at a company and deciding about an investment. Is the price paid for shares by previous investors excessive, creating a post-money valuation too high for the actual value of the company? If so, the VC will contemplate a “down round” – that is: offering an investment where previous investors find their investments instantly worth less than their original value, even if the investments were made at high risk and years earlier. No one wants to face this, but the need for money and the possible overpricing of the first rounds may have created an unsustainable valuation.
[Email readers, continue here...] Second, it is important in the first investment round to face the issues that may be required later by subsequent, more sophisticated, investors such as VC’s. These include “tag along rights” which allow investors to sell some shares when others, such as management or founders, sell any shares. Also included are “drag-along rights” in which minority shareholders may be forced to obey the vote of the majority in such important votes as to sell the company or take a round of financing at lower share prices.
Most VC’s today are becoming enlightened (as are organized angels), correctly forcing many decisions that might have been dictated by investment documents instead to the corporate board to decide. This allows for a discussion – and perhaps a negotiation – between inside and outside board members in such instances, all for the good of the corporation, not just one class of shareholder. You may recall that board members have a “duty of loyalty” to the corporation, not to their constituent investors. This enlightened thinking reinforces that duty, even sometimes at the expense of profit to the VC’s.