Think ahead when raising your early investments

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.

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Posted in Raising money | 2 Comments

How much of my business do I have to give to an investor?

If you’re looking for growth capital, this one’s for you. We’ll cover what information you’ll expect to provide, your range of expected values and amounts of investment to expect.  All to help you set your expectations.  OK?

Financial History and Projections

Let’s start with the basics. If you are a going business with a track record of revenues, then 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.

And you should “know your numbers and be able to defend them” during early meetings with candidate investors.  At the least, historical numbers must include the latest income statement and balance sheet, showing activity through the latest period.  If the business is not a startup, expect to supply income statements for the past several years as well, to emphasize trends in revenue and costs.

Projections for your future

You should expect to present detailed projections for the next 12 months as a basic minimum.  Beyond that, plan to prepare projections for two additional years, but not necessarily in account-by-account detailed format.  Sophisticated businesses will also create a cash flow projection for the same period, showing cash used and remaining at the end of each period.  And note that projections showing “unbelievable” rapid growth are always suspect. Careful about “hockey stick” forecasts.

How much money can you get?  

Well, here is a question with a circular answer.   To grow your business to a size that will be attractive to a VC or angel making an investment now, you’ve got to show that the business will be large enough at the time of the investor’s liquidity event (cashing out) to make the investment attractive at all.

[Email readers, continue here…] Most VC’s look for a 10x opportunity – that is – a ten times increase in the valuation from 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.

So, you’ve got to play with the numbers to determine your level of comfort. The more you ask for – the more equity you give up.  Completing this exercise often leads you to lower your expectations about the amount of money to be raised.

It is also a factor that early stage investors don’t want a controlling interest in your company.  It is a disincentive to you and a burden to them.  “Engineer” your needs if possible so that you give 20-35% to investors on the first professional investor round.

Here’s a valuation example for you based on amount to be raised

Try this example:  You want to raise $2,000,000 today.  Your projections and the analysis we’ll undertake below lead to a possible valuation of $40,000,000 in five years, assuming that you meet your plan, and allowing for a 50% discount to your projected numbers during the investor’s evaluation.  That means – using the investor’s 10x expectation for return – making the business worth $2,000,000 today at best.  To raise $2,000,000, you must give up 50% of the post-investment equity (the current value of $2,000,000 plus the investment of $2,000,000).  The post-investment value would be $4,000,000.  When multiplied by 10x, the target valuation at exit would be the $40,000,000 quoted above.  It is a fact that very few businesses reach the $40,000,000 valuation hurdle. And it is probable that you’ll need more money to reach that target, muddying the calculation and reducing your equity percentage.

Remember your employee option allocation

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.

Given your strong desire to keep controlling interest in the early stages of growth, the amount that can be raised must be lower than $2,000,000 in order to accomplish this goal.

So, the circular reasoning exercise returns.  Raise your projections (and sell your investor on the increased projections as a result) or lower the amount of capital you raise in this round.  Your future rounds should be at higher valuations if you meet your plan, making dilution of your equity less onerous at that time.

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Posted in Raising money | 3 Comments

Can you overcome five risks and create wealth?

Of course, we are speaking of increased valuation of your company when we speak of “wealth.”  Especially if you are in the early stage of growing a business, these five risks can and often do derail entrepreneurs before realizing the riches of a great exit.

So, let’s examine them and mitigate them.  Make you wealthy someday.

The carrot and the stick

In the creation of your enterprise, there are five principal risks you’ll need to navigate

around. Professional investors will probe these five risk areas and make the decision to invest based upon their comfort with each.  So, it is important for you to identify, address and mitigate each of these in order to increase valuation and decrease the risk of ultimate loss of the business.

First:  Product risk. 

Is the product or service possible to produce at all, let alone economically enough to compete in the marketplace?  One way to mitigate this is by using early money to create a prototype, to perform market research, to complete the first generation of the product, or to deliver the service to a satisfied customer.

Second: Market risk. 

[Email readers, continue here…]  Are you ahead or behind the market with your product or service?  Will the public respond in numbers to buy, license or rent your offering?  This risk can be mitigated by finding a customer willing to purchase as soon as a proven model is completed, and willing to state this in writing.  Another is to gain the support of a core vendor who is willing to offer special extended terms to the company as its investment in creating the product in a finished state.  A third demonstration of overcoming market risk is by holding controlled focus groups and gathering information from unbiased potential customers supporting the acceptance of the product or service.

Third: Management risk. 

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.

Fourth: Financial risk.  

Any new enterprise is at risk if there are not enough resources to get the company to breakeven, which is a proxy for stability.  If a company truly needs five million dollars to get to breakeven, investors that provide the first million are greatly at risk of the company failing to raise the remaining capital or of subsequent investors valuing the company at a lower price than the first investors, causing a “down round” in which the early investors are punished for taking the first risk.

And fifth: Competitive risk. 

If there are high barriers to entry with such protections as patents, long development time already spent or contracts with the major potential customers, then the risk of a competitor with more resources jumping into the frothy pool and taking advantage of the demand created by the company is minimized.

The lesson: Reduction or elimination of one or more of these risks increases the valuation of the company and certainly improves its chances of survival and growth.

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Posted in Positioning, Protecting the business | 3 Comments

Could you have created a “dirty cap table?”

Oh, I know. When you started the business, you took investments from friends and family in small amounts just to get you started.  Of course, that worked at the time.  But…

Enter the need for larger investments

When you seek professional investors, whether organized angels or venture capitalists, one 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.

Crowd sourcing as a tool

More recently, “crowd sourcing” has become one more way to finance a business, whether by forming a single investment vehicle (“AngelList.com”) or non-equity financing (“Kickstarter.com.”)  These are newer ways to find relatively small amounts using these Internet tools and combining groups of many investors at a small amount per investment.

What would the SEC say about your investors?

[Email readers, continue here…] The problem with taking friends and family money rests in the legality of taking money from non-accredited investors, people who do not meet the 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.

An important exemption

There is an exemption for members of the entrepreneur’s family and in some cases for close friends with intimate knowledge of the entrepreneur and of the plan and, of course, for employees of the company.  It is worth checking with an attorney to see if such investors are truly exempt.

Does creating a PPM mitigate the risk?

Some small companies work to create “private placement memorandums,” attempting to protect themselves against this problem, couching the proposed investment in legal language stating the risks involved in making the investment.  The PPM does nothing to mitigate that problem when the investor is not accredited.

To compound the problem, often stock is issued by the entrepreneur without filing any report of such issuance with the state of issue.

The risk of the “dirty cap table”

The sum of these problems is that a disaffected investor can sue the entrepreneur or the entrepreneur’s company for a rescission of the investment and return of the money invested if the money was taken improperly, especially when the business has failed and the investment lost, putting the entrepreneur at risk for the loss of additional personal assets.

And the cure…

The cure for this, when professional investors enter the picture, is for the company to craft a “rescission offering” to those shareholders who invested illegally, offering to repurchase their shares at full value invested.  This is sometimes difficult since it often happens just at the time a company needs new money most and is in the process of seeking that money for growth.  If a previous investor does not accept a rescission offer, there is some insulation provided to the company against a future lawsuit by that investor.

How this could affect the future for you

So, plan to take money only from qualified investors. Check with your attorney if there is any doubt.  The risks of a problem rise with unmet investor expectations, and fade with success.  But sometimes, such behavior will cause a subsequent angel or venture capitalist to pass on an otherwise good opportunity, and that would be a shame, one that could have been avoided by diligent process in the early investment cycle.

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Posted in Ignition! Starting up, Raising money | 3 Comments

Would you sign a personal guarantee if you have investors?

It’s a fact of life that a banker, lender or lessor will ask for a personal guarantee from the founder or entrepreneur most every time. But what if you’ve diluted your interest from 100% to something less than 50%?

Should your investors expect you to carry 100% of the risk?

The short answer is “yes.”  Seems unfair, doesn’t it?

To most lenders, the guarantee is still a requirement, putting the entrepreneur in a position of additional risk that is not spread among the shareholders.

Recently, one of my companies offered the founder with a 20% remaining interest after several rounds a reward for signing two large personal guarantees necessary to grow the business – in the form of a warrant to purchase common shares at today’s common share price.  A win-win for the investor and entrepreneur assuming the company does grow and have a liquidity event someday.

The eye-opening process of borrowing for a small business

Starting and running a small or growing business can be a challenge to the most confident and optimistic entrepreneur.  And the process of borrowing money or financing asset purchases can be an eye-opener for those who are not used to today’s lender and seller aversion to grant easy credit.

The easy solution when entrepreneurs have controlling interest

[Email readers continue here…]  Most any entrepreneur with a clean credit record can obtain a bank card with a $50,000 limit, if s/he is willing to give a personal guarantee and has enough assets to back the 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.

Some thoughts on elimination of personal guarantees

All entrepreneurs assume risk when starting and growing a business.  It is only smart to consider ways to mitigate risks when opportunities to do so arise.  Approach your banker when times are good and discuss whether the increased collateral from growth is enough to eliminate the guarantee.  Approach your co-investors to negotiate some mitigation of personal risk, such as a backup guarantee in return for warrants.  Consider approaching another bank or lender with your increased strength and negotiate a “take-out” loan that eliminates the original lender without requiring a personal guarantee.

Most of all, keep your line of credit clean.  Communicate with your lender if a payment is going to be late.  And of course, here’s that old adage: “Never run out of cash.”

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Posted in Ignition! Starting up, Protecting the business, Raising money | 2 Comments

Oh, go ahead and ask for a five-million-dollar investment in your startup.

I cannot tell you how many times I have seen executive summaries of business plans in which the entrepreneur seeks $5,000,000 to build the business.

Four reasons you should reconsider.

First, few startups can use that much money today with all the virtual services available 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.

Third (if you’re keeping score), it is not wise to dilute the founder’s ownership greatly in the first round of financing.  The investors want a motivated entrepreneur, and it is certainly more difficult to motivate a twenty percent owner than a sixty percent owner.

Fourth, there is the matter of control.  Entrepreneurs have a vision for what and how to create and build a great business.  Giving control over that vision to others early on often dilutes the vision and is a disincentive to the entrepreneur.

How does this comport with “skin in the game?”

[Email readers, continue here…] Professional investors love to see companies where the first round of financing came from the entrepreneur, showing “skin in the game” and more motivation to succeed because of money invested as well as time and creativity.

There are so many resources for early money to validate an idea, turn it into a product and increase the value of the company before professional investors come into the picture.

A much more rational approach to starting up.

Starting with credit card debt or a personal loan and working through money from friends or family, or simply consulting to earn money for investment, entrepreneurs should consider early resources for capital to produce a prototype, do market research or start to build a team.  Once there is progress in any of these critical areas, raising professional investment is easier and the likelihood of a higher valuation makes for retention of more equity during the first important professional round.

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Posted in Ignition! Starting up, Raising money | 5 Comments

Once again: Is it the jockey or the horse?

Early stage investors have been arguing over this for years.  Do they bet on the entrepreneur (jockey) or the business idea and plan (the horse)?   This is serious stuff.  If you are looking for money, this question will certainly come up in one form or another when you approach professional or organized angel or VC investors.

A more complex answer

My answer always varies as I examine each deal, sometimes deferring and passing on an 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.

Sometimes there’s a real surprise after the fact

I have bet on the entrepreneurial jockey numerous times and been blind-sided by after-investment behavior that completely reversed my opinion about an entrepreneur’s ability to manage growth to breakeven.  Other times, the entrepreneur went on to assemble a great team and execute the plan as it inevitably changed again and again.

[Email readers, continue here…]  Although this debate will continue for ages, I tend to fall on the side of betting on the jockey, simply because it has been a rare business plan that did not change again and again seeking a successful model in the marketplace.  And great management can morph a company to adopt without destroying the culture of the company in the process.

What if you see a great idea but no team to execute?

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.

Concentrate on a world class team

So, if you are one of the entrepreneurs without experience or ability to take your great plan to market, admit this early and form a team that investors can trust to do this, personally stepping into a position that fits your core skills, be it marketing, sales, development, or other areas required by a young company.

It would be refreshing as an investor to meet an entrepreneur with a great plan and a pre-formed management team fronted by the strongest possible leader, even if the entrepreneur offers to take a back seat in order to make the vision a grand reality.

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Posted in Depending upon others, Ignition! Starting up, Surrounding yourself with talent | 4 Comments

Can you become a master negotiator?

Think you don’t use negotiation most every day of your life?

From the time we learn to manipulate our parents from the crib to today, we learn to 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.

Learning and practicing the art of negotiation

If we are constantly negotiating to obtain an advantage or just a win-win attempt at parity, we should try to learn and then practice the art of negotiation (although I prefer to think of it as a science then delivered in its final form as art.)

It could be as simple as reading the right book

Because I believe that negotiation is so important to our success in the business and in the social world, I re-read my favorite book on the subject again every couple of years, just to keep myself aware and sharp using the tools and techniques so important to a successful negotiation.  The book, You Can Negotiate Anything, by Herb Cohn was first published in 1980 and is available today as the best and easiest to read of all the books on the subject.  I implore you to read this book and internalize the three crucial variables, the many styles of negotiation, and the fourteen powers you can call upon or recognize when used by others in a negotiation.

Removing the emotion from a negotiation

[Email readers, continue here…] Over the years, I have been delegated by more than several entrepreneurs and boards to negotiate critical agreements, sometimes to sell the company or merge it with another.  I was selected because I did not have an emotional stake in the outcome as did the entrepreneur, or the continuing relationship with a buyer as would others in management who might remain after the sale.  With that freedom, I was able to use the tools of negotiation to achieve a result better than if I worried each moment about disrupting the deal when making each move and countermove.  There is a lesson there, one the same Herb Cohn quoted in a later book, in which he entreated his readers to negotiate with care, but “not that much care” as to lose perspective.

A story of a big win-win

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).

Doing your homework before the event

Doing my homework ahead of time, using one of Herb Cohn’s principles (please read the book), at the start of the negotiation I placed a paper in front of the negotiator representing the intended buyer, showing how our company would be accretive to their public company valuation, properly valuing our purchase at three times the ideal amount as stated by our entrepreneur-CEO.  The buyer looked over the numbers for a few minutes, recognizing the accuracy of my statement from his due diligence and knowledge of his own financials.  In a sincere response so transparent as to be an obvious truth, he stated, “Oh, but I only have authority from the Board to offer two-thirds of that” which of course was twice our entrepreneur’s the asking price.

And a successful outcome

After forty-five minutes of further negotiation, we walked from the room with an agreement to sell the company for cash at twice the asking price.  And as the entrepreneur still tells the story, we two board members walk on water for having delivered such great results.  In fact, we had done our homework, presented a logical case, and created a win-win by leaving enough value for the buyer to add to its market capitalization as well as doubling our sales price.

Since we negotiate daily for things large and small, wouldn’t it be high on your list to learn to use the tools and be aware of the elements of a great negotiation?

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Posted in Growth!, Positioning | 7 Comments

Non-competes, gray areas, and salvaging a failed purchase

Last week we introduced the subject of non-compete agreements.  Let’s dive a little deeper and present some “gray area” scenarios to consider.  Then we’ll address the success or failure of the buyer with your product…

First the obvious case in point

What if you are the seller of a previous business or shares amounting to more than an 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.

Now we add complexity to the issue: bankruptcy of the buyer

Well, what if the buyer is now bankrupt?  That does nothing to regain your right to its purchased information.  The estate of the bankrupt company retains and can resell those rights into the infinite future.  (Patents expire after 14 or 20 years – depending upon type – and publicly disclosed patent information is no longer subject to your original agreements after that expiration, as long as you use only the publicly disclosed information as filed within the patents themselves.)

Abandonment of your product line or your later new inventions

What if the buyer abandons your previous product?  That does not change their purchased rights to it.  What if you invent a substantial enhancement or change to the product?  As long as you did not use patented processes or trade secret material from your previous company, you should be protected, but you might be prepared for a fight.

After the non-compete expires

[Email readers, continue here…]  How about after the two-year limitation in your non-compete agreement?  Just separate confidentiality from non-compete, and obey the confidentiality clauses, which do not expire.  The non-compete agreement does expire when stated.

But watch it. Some clever buyers try to slip in an unlimited non-compete, and some courts have upheld this.  And there are gray areas for former key employees who signed a non-compete with a limited life as part of the sale but remained on with the buyer for some time thereafter. Does the non-compete start anew upon the departure of each continuing employee?  Courts tend to apply only the reasonableness standard to these gray area cases, looking to see how much the person now competing gained from the original sale.

The safest advice is to avoid using any materials from the previous company, and compete only after the expiration of any written agreements or clauses signed with the buyer.

About starting over or repurchasing your business

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.

If you are one of those watching the buyer’s success or failure with your baby over those first years, you will need to decide if you could revitalize the wayward business, or start over with a new, better product with non-obvious advances and without using any of the technology from your previous product.  Many have done one or the other with great success, but only after analyzing the lessons from failures by the buyer.

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Posted in Depending upon others, Protecting the business, The liquidity event and beyond | Leave a comment

What about your previous company non-compete?

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.

Are you one of those?

Some of these entrepreneurs starting a new company are alumni from companies that would be a competitor to the enterprise being created or joined.  And some are former selling shareholders of just those businesses.

Rules about non-compete agreements 

So, what are the rules about those pesky non-compete agreements signed upon your discharge, or upon the sale of your previous company?

The good news is that if you were not a significant (usually 5% or more) selling shareholder of a previous company, most states specifically exempt non-compete agreements signed between companies and their employees or minority shareholders.  In that case, you must worry only about information and trade secrets taken from the previous company which are both certainly subject to protection by almost all laws and courts.

The obvious admonition

 [Email readers, continue here…]  So, to you and to everyone: do not take customer lists, design documents or any document considered a trade secret from any previous employer or previous consulting customer.  Digital or analog!

Yes, some companies were sloppy and did not have you sign a confidentiality agreement, but that procedural slip-up does not protect you from their legal wrath.  Further, there is no expiration date on these poisoned documents. You cannot complain that the document or information in question is more than five years or two employers old.

It makes good sense not to be in a position to be accused, let alone guilty of taking gray or bright red “borrowed” digital files or documents from a previous employer.  We all have enough worries in our business lives not to be threatened by an emotional, upset previous employer.

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Posted in Protecting the business | 1 Comment