Some businesses just can’t fit within the angel capital or friends and family model for 
raising funds. Sooner or later you may need to seek venture capital and accommodate the needs of the venture community in negotiating the terms of an investment.
What VC’s can and cannot do
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.
And what VC’s worry about
More importantly, VC’s will worry over several issues when looking at a company and deciding about an investment.
First: 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.
How did you structure your first round?
[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.
The enlightened professional investor
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, and not to their constituent investors. This enlightened thinking reinforces that duty, even sometimes at the expense of profit to the VC’s.
the importance of accurate current financial statements cannot be overstated. If there is no record of revenues, see the “The Berkus Method” available with any search query for valuing the business before revenues.
investment to liquidity event. Later stage investors sometimes look for less, since the business has already proven its capability to stay in the game and has already completed its product development cycle, eliminating more risk for the investor.
Your potential investor will include the full number of shares reserved for your present or future option plan – usually 15-20% of total equity – making your personal equity 20% less when calculated as “fully diluted,” or including a reserve for options. Therefore, in the example above, you would control less than 50% of the company at funding if you received $2,000,000.
A great idea often fails from the inexperience or inability of management to bring the idea to market. Similarly, great management often can manipulate an original idea or business plan into one much more attuned to the market, adding tremendous value that might have been lost sticking to the original plan. This is sometimes labeled “execution risk” addressing whether management can create and run the company producing the product acceptable to the marketplace.
of the early questions you are asked is “How have you financed the business so far?” Investors love to see entrepreneurs who have used their own money to ignite their businesses. But often, entrepreneurs turn to others for initial capital. Describing that capital using the phrase “friends, family and fools,” or “FFF,” has become as common as to be just plain trite.
SEC standard for making non-public company investments. Currently that standard requires a minimum of $200,000 in annual income or over one million in net assets, including the value of the investor’s principal residence. Since many small investors in a young business do not meet that standard, there is a chance that the company has taken money that it should not have taken, according to SEC rules.
position of additional risk that is not spread among the shareholders.
promise it contains. As the amounts get higher or as banks get into the picture, the negotiation around a personal guarantee becomes more of an issue with the lender and the entrepreneur. As a rule of thumb, a company with a majority owner in control will be required to provide such a guarantee for most any borrowing of significant size in relation to assets.
and increasingly inexpensive methods of development, prototyping and marketing. Second, almost no professional investor will consider putting that much into a startup until there is proof of market demand, product viability or some other mitigation of failure.
investment because of an uneasy feeling about the entrepreneur, even if the business plan seems able to capture the market. Speaking for others, I see VC investors jumping into deals knowing that soon they will push to replace the entrepreneur with a professional, experienced manager that the VC has vetted and trusts.
What if you were the investor and someone walked into your office handing you a business plan executive summary that floored you with its brilliance? And what if that person admitted immediately that he or she had no team and was not the person to take this plan to market? Would you, as an investor, plow money into the plan and help to incubate the idea into a real enterprise? I would not, nor would most all of those I co-invest with. There are millions of great plans that failed over the years for want of a great management team. And I am sure there are many, many average plans that developed into great companies with the help of a great team.
negotiate to obtain our wants and needs. As we grow, we negotiate constantly with our parents, then with our peers. As we enter the business world, we negotiate with our bosses and our subordinates. We negotiate with our suppliers, customers, investors, and even our auditors. At home, we certainly negotiate with our spouses or significant others.
I recall one such instance, when delegated to be the lead in negotiating a sale of a company on whose board I sat, I asked the entrepreneur to name his expected price in an ideal sale, which he did immediately as if he’d been thinking of this for some time. Surprising him and the rest of the board, I asked him to go home and not to attend the negotiation session set for that evening at a local hotel, promising to call him immediately with the outcome. I am sure he worried over losing control of his most important business negotiation ever, but he did cede the task to me (and another board member).
insignificant percentage of a previous business? Certainly, the buyer’s asset purchase documents included a non-compete clause, usually valid for two years from the date of the closing. And because there was consideration paid to you in the sale, that clause is binding upon you and is effective almost everywhere.
Many entrepreneurs have new and better ideas for a similar product and wait out the non-compete by watching the clock. Others find opportunity in repurchasing rights to your product from the buyer who has been disillusioned by low sales from your product, or distracted by taking an alternate strategic path during those years.
Entrepreneurs tend to remain in the business niche they know best. Usually that means one they once or recently spent time in as an employee or manager within a company where they had little or no ownership.
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