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WE WERE ON A PLANE RETURNING TO ATLANTA after closing an acquisition for a client in Texas. It was 1985 and I was a young partner in a business law firm sitting next to my boss in first class. He was catching up on the day's news in the aisle seat and I was reviewing a draft of a manuscript I was working on for an entrepreneur's guide to the terms and deal points commonly negotiated in venture capital transactions. When he finished his paper he looked over at what I was doing and snatched the manuscript. He wasn't much for conversation. "What are you doing?" he said. "Working on a book I hope to publish." He took a sip from his drink and then flipped through the manuscript, tossing it back to me when he was finished. I expected a comment, maybe some encouragement, but instead he got out of his seat and headed to the toilet. Half way there, he stopped and turned around. Looking me straight in the eye and with a voice that could be heard by everyone, he shook his head and proclaimed "that's the dumbest f*!#ing idea I ever heard of." And then he turned around and walked to the bathroom. If I was wavering in my resolve to complete the manuscript or face the gauntlet of publisher submissions and rejections, this was now my great motivation. No way in the world was I going to give my boss the satisfaction of my failing in this endeavor. No matter how long a shot this was, somehow, someway it was going to succeed. You know the rest of the story if you read my earlier posting called "I can't possibly know anything about venture capital." The book published as The Venture Magazine Complete Guide to Venture Capital in 1987 and sold out quickly. Since then, we have published four additional editions under the Growth Company Guide moniker. The Guides, available through Amazon.com, have been in print now for nearly three decades. Entrepreneurs and angel investors have used the books, as have business schools and business accelerators. U.S. and European venture funds have used them to train associates and in help with planning. Even the Soviet Union purchased case quantities for their business training courses during Glasnost. If you are curious, here's what readers have had to say about the book. So, what's the point of the story? And, what does my personal publication story have to do with entrepreneurs or growing businesses? Two things, actually. First, other people are going to routinely misunderstand or under appreciate your entrepreneurial efforts. My boss was an accomplished lawyer who had negotiated numerous deals. Even so, he could not see the value in what I was doing. Second, it's only a dumb idea until you prove it isn't. Once you succeed, many of your greatest detractors will remember themselves as proponents. Many will wish they had the gumption and patience you had to strike out and make something new happen. Some will want to emulate you. That's what happened to me. Just months after publication of the book was announced, the boss man stopped by my office to let me know he had secured a contract to write a treatise on corporate law. He was going to assign lawyers in the firm to write the chapters and I was going to organize the effort and ghost write his book. Now that was the dumbest idea I ever heard of. I was polite. I didn't express an opinion. I just said no. I was too busy following up on my own dumb idea to help him with his. IS IT BETTER TO USE STOCK OR CASH with an important vendor when your business is cash strapped and in it's development stage? This was the subject of a recent discussion with a local medical device developer whose first blockbuster product was ready for clinical testing and regulatory guidance in obtaining required FDA approval. After seeing the product in development, one of the firms he was vetting to possibly run the nearly $1.0 million testing and application process offered to exchange some of their services for equity in his company. What should he do and how should he think about the process of deciding? Like most enterpreneurs in his position, the founder/CEO was already deeply involved in fundraising. He had to be. There were limits on his personal funds and the business could generate no product sales until it had an approved product to sell. He had investors lined up and committed for a first fundraise to keep his business running through the end of the year and a key inflection point in his product development. He was finding success selling promissory notes that converted into equity in his next substantial round, defined by a minimum amount raised within a given period. The factors we discussed included:
After discussing these and other relevant issues, we turned our attention to the convertible note terms being used successfully by the company and how bring potential investors to a decision point. We also talked about when and how you change the terms of those convertible notes as the company's progress de-risks the investment. We discussed some ideas on both topics that might help better rationalize the fundraising process. In the end we left the discussion open but noted that a structure like the convertible note might be used with the vendor if other criteria were met. Those criteria included removing the debt feature, as some companies do when they use SAFE documents in lieu of convertible notes, and linking both the vesting/grants and the conversion provisions to the timing of services delivery. Fishing for the right answers? Above, an ancient Sarmatian coin from the 6th century BC. Subscribe to Venture Moola through this link. I AM CULTURALLY IMPAIRED. DEFICIENT BECAUSE OF WHERE I LIVE, where I engage in business and practiced law. I know this for a fact. It was told to me in no uncertain terms by someone who should know. I learned this important fact in 1987, while trying to find a publisher for my first book. I had a stack of rejection letters. It really does not hurt to receive one. Twenty five, maybe, but not one. But one publisher, one of the biggest business book publishers on the planet, did not send the letter saying no thank you. Instead, they reviewed the book and thought. Month after month they thought. Never accepting. Never rejecting. Over time, a relationship developed with the editor assigned to take my regular status calls. She was patient. She was kind. And, eventually, she delivered the news. After more than a year of serious consideration they would not take the book. She could not tell me why. Company policy. But she faltered. Took pity and told me. They liked the subject and the content a lot. It was fresh. It was unique. But it was about venture capital and they just could not take the risk because "no one will believe that anyone from the South knows anything about venture capital." There you have it. My fatal flaw. I live in the South. Time to give up. (There are no businesses in the South, no investors and I could not possibly have traveled to Boston, Silicon Valley, Texas or Europe to close venture fundings for client companies.) But wait. Novel ideas like new companies are not easy to launch. They can be painful to get off the ground. And there are other publishers and magazines and . . . . Then, four days later (I kid you not) it happened. The editor-in-chief of a leading magazine for entrepreneurial companies called. He had seen the manuscript. He wanted it and would find a publisher. Just one condition he said. The magazine name had to be in the title. I said give me a day to find a publisher and he laughed. I timed it. When I called, the No One Will Believe publishing company took less than 5 minutes to accept the book and agree to publish it. It's first printing sold out quickly, making the author, the magazine and the publisher happy. And that is how The Venture Magazine Complete Guide to Venture Capital, just the second book ever published in a category now filled with titles, came to be. So, what did I learn? Maybe I inherited a little persistence from my dad. I like to think so. He grew businesses. And it was not work for sissies. He always said, half jokingly, that he would rather be lucky than smart. But maybe Gary Player had it right when he said "the harder I work the luckier I get." And, what have I learned since? Something that thousands of successful southern businesses have proven over the last 30 years. Southern entrepreneurs create great and sustainable businesses, venture backed or not. ONE OF THE MORE CHALLENGING THINGS a new entrepreneur must deal with is fundraising. It is a time consuming distraction from business operations that is made more difficult by the challenge of setting a realistic company valuation and the expense of complex funding documents.
This reality has led many to try and use convertible notes instead of stock in their early funding rounds. But using convertible note to raise funds presents its own challenges as I was recently reminded by two separate entrepreneurs at Georgia Tech. First, there is the question of whether you use a convertible note or a SAFE (simple agreement for future equity) document of the sort developed at the Y combinator. The advantage of a SAFE document, when investors will use it, is that it gets rid of the fiction that the seed stage company using it will be in a position to repay the money if it does not raise needed funds in a next financing. Instead, if a fundraising does not occur, the holder of the instrument converts to equity at a predetermined formula. Whether it is a SAFE document or a convertible note, several questions remain about how it should be structured. A partial list would include:
Photo of the 'post office' on the Galapagos Islands. Copyright 2008 by Clinton Richardson. THE ACRONYM REFERS TO the Latin phrase quod erat demonstrandum, which translates roughly into that which has to be proven. Sometimes you see it at the end of a mathematical or philosophical proof as a statement that the matter has been proven.
The reason it is mentioned here is because the phrase appears in a useful blog entry from Bill Gurley, a general partner at a West Coast Venture firm that helped fund Twitter, Uber, Snapchat and others. The blog is entitled In Defense of the Deck. It's worth a read. The entry presents the venture investor's view on why it is important to prepare and accompany your fund raising proposal with a convincing slide presentation that provides the Q.E.D. that the company's opportunity is significant and its plan is solid. It also mentions one scenario when you may want to avoid using a deck with a potential investor. The argument for the deck revolves around a number or factors, First, there is value in working with your team to create a coherent presentation of your company's value proposition and plan for succeeding. It also enables entrepreneurs to present their proposition in an organized fashion that builds to a conclusion that appeals to investors. Also, decks make it possible in ways conversation cannot to present the important numerical piece of the business and its important metrics. From Bill Gurley's perspective, the presentation deck enables entrepreneurs "to walk the listener through an argument as to why this is going to be an amazing business." A good deck and presentation "will gradually transport the listener to the desired conclusion – this will be a great investment.” Check it out at http://abovethecrowd.com/2015/07/07/in-defense-of-the-deck/. IF YOU EVER HAVE SECOND THOUGHTS about engaging good and separate counsel when raising capital, consider the following real world case involving a biotech entrepreneur who found an experienced venture fund to finance his fledgling business.
The investor committed to provide $4.0 million for which the investor would receive 51% of the company’s stock and the right to elect two of the company’s three directors. The entrepreneur would fill the other spot on the board. Troubles started at the closing when the investor announced that he wanted to stage his investment. Instead of putting in the $4.0 million as provided in his term sheet, the investor instead would provide $2.0 million at closing and a second $2.0 million in one year. The only requirement to receive the second $2.0 million was the passage of time. Without viable alternatives (or independent legal counsel to advise him about risks or ways to mitigate those risks), the entrepreneur acquiesced. Twelve months later when the second $2.0 million came due, the investor had cooled to the company and refused to provide the second $2.0 million. Notwithstanding the investor’s legally binding and unconditional funding obligation, the entrepreneur's options were limited. Cash was tight and there were no alternative investors. With the investor unwilling to fund, the company had little prospect of attracting a new investor. Suing the investor to force funding was problematic. A lawsuit would be expensive and time consuming. Even a favorable result would come too late to save the company from financial ruin. Not only that, the investor threatened to use its majority position on the board and as the 51% shareholder to liquidate the company if the entrepreneur tried forced it to put in the second $2.0 million. The investor had purchased a preferred security with his original investment that entitled it to take the first $2.0 million of new investment back in a liquidation before the inventor saw a penny. Did the investor violate its contractual obligations? Absolutely. But the investor had more on his mind than his duty to the company. He also had duties to his investors and was convinced that putting in the $2.0 million would result in losses to his investors. The entrepreneur contributed to his own woes as well. Having no lawyer of his own at the initial fundraising and then using the investor's lawyer to advise him later, the entrepreneur missed fundamental issues that exacerbated his situation. For example, when the investor reduced his initial investment by half, the entrepreneur should have insisted that the investor take half of the stock originally promised and reduce his board representation until the deferred portion of the investment was received. He could have also negotiated for a penalties that would have made it more costly for the investor to renege on his promise to fund in one year. Using the investor’s counsel for his company lawyer after the closing was also a mistake. Owing duties to both parties likely prevented counsel from proactively advising the entrepreneur about the risks inherent in his deal structure. When the issue did surface, counsel resigned the company account but continued to represent the investor, further complicating matters for the company and the investor. How did it end? The entrepreneur eventually engaged qualified counsel to advise him. But the damage was done. After much back and forth with the entrepreneur's new and independent counsel, the investor agreed to sell the entrepreneur all of the investor’s stock in the company for $1 plus a waiver of the entrepreneur’s rights as a shareholder to sue the investor for failing to provide the funding. Not having the time or money to sue the investor in any event, the entrepreneur took this settlement in hopes of raising money from new sources. It was small comfort though. The company's prospects were badly damaged and likely funding sources, if they could be found at all, were sure to value the company below its valuation in the first round. The entrepreneur and his company were free to move forward but the cost of that freedom was high. For more on this topic, check out the entry on Real World Conflicts in Fundraising in Richardson's Growth Company Guide 5.0 - Investors, Deal Structures, Legal Strategies at www.growco.com. Image by imagerymajestic courtesy of freedigitalphotos.net. RECOMMENDED READING. Christina Bechhold, co-founder of Empire Angels in New York, offers some fundraising advice from the angel investors perspective in a recent Wall Street Journal article. She recommends entrepreneurs be forthcoming and transparent when they raise money noting that investors talk with one another and don't like surprises or to hear varying stories from other investors about a company's pitch.
"Fundraising is a slog. I advise first-time founders to double the timeline they budget to raise, because it will always take longer than anticipated. Seasonality—summer vacations and year-end holidays—will undoubtedly slow down response times. Product and market are evolving simultaneously, so numbers and discussions change in real time. If you shared projections for April and it is now May, proactively send the April actuals to the investors with whom you’re actively engaged. Share an update on the partnership discussions you hoped to conclude in March but which are pushing into late spring." Check out Christina's Three Reasons Entrepreneurs Need to Be Transparent With Potential Investors for more of her advice. Empire Angels, a member-led, angel group of young professionals investing in early stage technology ventures. The image is courtesy of Wikipedia.org. OR, THE WORST WAY TO SELL STOCK IN YOUR COMPANY. In 1969, Mel Brooks won the Oscar for best screen play for his irreverent and outrageously funny movie The Producers. An unscrupulous producer and his mild mannered accountant team up to profit from raising more money than they need to produce a play on Broadway. For their scheme to work they need only to produce a total flop of a play that will leave the investors expecting no return. Then, they can keep the extra they raised for the play. The producer targets little old ladies, selling them each a fixed percentage in the profits of the play. When they open their musical - Springtime for Hitler (the "mother load" of sure flops) - the initial audience reaction is horror and disgust, raising the expectation of a quick profit from a total flop and early closing. But something unexpected happens and the play becomes a great success, dooming the producer and his accountant to financial ruin. So, what's the reason for the producer's impending doom? After all, a successful play should generate plenty of profits to share with investors.
The answer is in their fundraising process. The producer sold percentage interests in his play instead of selling fixed units of ownership. Expecting a flop, he sold percentage interests adding up to more than 100% meaning for every dollar of profit they would owe more than a dollar to their investors. For the entrepreneur, selling percentage interests instead of ownership units can be just as dangerous. The effects are more subtle - unless, of course, you sell more than 100% of the company - but can be very damaging to a company's prospects. The process makes it harder to raise more money. This is because it protects the percentage investor from dilution in future rounds at the expense of other shareholders, which usually includes management and the founders. This means, literally that the company has less ownership to sell in later rounds. It also means future investors will be disproportionately diluted in rounds after they invest. This is not something most thoughtful investors will agree to. It also makes it harder for management to retain enough ownership interest to motivate themselves or attract needed talent. This can put an expanding company with growing cash needs in a crunch. The company's success, like the producer's play, can spell the doom of the venture. Not because the company has to pay out more than it makes to investors but because the ability to raise needed investment to fund growth is impaired by a capital structure modeled on The Producers. The cure is to sell the investor who wants to by X% a number of ownership interests that equal X% of the company at the time of the sale. But when the sale is a percentage of the company that won't change when more ownership is sold, the company has mortgaged its future to raise current cash. Remember, Mel Brooks is not your venture investor and selling percentage interests in isn't a good idea even if Will Farrel and Uma Thurman are promoting your product. Sell units of ownership instead of percentages. Image and video clip from promotional photos for the movie The Producers. KNOWING SOMETHING ABOUT VENTURE venture capital fund managers can help you plan your venture fundraising campaign. It can also help you negotiate and work more constructively with investors in your business.
Consider the following factors that influence the average venture capital fund manager:
There is more about this topic in Richardson's Growth Company Guide 5.0 but even this partial list provides some insight into your potential venture fund investor and future board member. A few observations pop out from this partial list. Do your homework and screen the funds you can as best as you can. Do they invest in your market or your stage of investment? Do they have money or are they in fundraising mode? And, have you prepared a convincing deck and a worthy written plan to back it up? Think about how can you tailor your approach to stand out among the many who apply? Do you know someone who can make and introduction and increase their interest in considering your company? Image from Roswell, NM. Copyright Clinton Richardson. RECOMMENDED READ. It is not a recent blog but it addresses a very real phenomena in venture investing that is worth any angel investor's consideration. It's basic stuff, really, but if you want to avoid being the goat after an investment, its worth your consideration.
Check out this blog from YCombinator addressed to start up entrepreneurs. They provide a thoughtful and balanced narrative about the subject, noting several reasons why investment opportunities become hot. They also note the following: "But frankly the most important reason investors like you more when you've started to raise money is that they're bad at judging startups. Judging startups is hard even for the best investors. The mediocre ones might as well be flipping coins. So when mediocre investors see that lots of other people want to invest in you, they assume there must be a reason. This leads to the phenomenon known in the Valley as the "hot deal," where you have more interest from investors than you can handle. The best investors aren't influenced much by the opinion of other investors. It would only dilute their own judgment to average it together with other people's. But they are indirectly influenced in the practical sense that interest from other investors imposes a deadline. This is the fourth way in which offers beget offers. If you start to get far along the track toward an offer with one firm, it will sometimes provoke other firms, even good ones, to make up their minds, lest they lose the deal." Image courtesy of Wikipedia. |
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