Bank of America has a website called Small Business Online Community, the mission of which is to “create a thriving online community that empowers people in building a successful business.”  A few weeks ago, a gentlemen called me, after reading some of my posts on IndianaStartup.com and interviewed me regarding the raising capital and potentially giving up control in the process.  The article, which you can find in its entirety here, is pretty good, and give some interesting perspectives (other than just mine).

Here are some excerpts quoting yours truly:

Still, Indiana business attorney Brian Powers, who also runs the blog http://Indianastartup.com, points out that such a power-sharing arrangement can work-it just depends upon the individual circumstances of the parties involved. “Investor control is not necessarily a bad thing, especially if you have a young business that will be gaining partners that have greater industry expertise and business connections than you do,” he explains. But if a business owner can’t take an emotionally detached look at his company’s real long-term needs, he or she might be better served by bringing in a third party to help facilitate offers and find the best match. “That’s what I often do,” Powers explains. “I end up helping companies through the process of figuring out that what they’re usually being offered is a pretty good tradeoff for the money.”

What helps Powers assess what is or isn’t a pretty good tradeoff is the fact that he’s been on the other side of the table. “In 1998, I was part of a dot-com startup company that raised $1 million in capital through an equity round,” he explains. “Back then, though, we got ridiculous valuations and didn’t have to give up control to get it. Those days are long gone now.” For a short primer on these valuations and their role in determining equity investment, check out Powers’ blog: http://indianastartup.com/business-funding/raising-venture-capital/raising-venture-capital-how-much-should-you-give-up/.)

I recently read a good post on Venturebeat.com about 6 common legal mistakes startups make.  Some of these have been covered elsewhere on this blog – some not.  Here is the cliff notes version- check out the post itself for more details:

• IP Ownership – make sure it can be transferred to the startup.
• Choice of Entity – choose carefully.  They recommend a corporation instead of an LLC.  I disagree on a certain level, as I have stated before on the blog and my Indiana Law Practice Blog.
• Place of Incorporation – they say Delaware.  Again, I disagree to an extent (see this post).
• Vesting Restrictions – make sure founders stock vest over time, otherwise you run the risk of a founder leaving early on and keeping all of his /her stock.
• Securities Law Compliance – beware of not complying when issuing any securities to anyone, no matter who they are.
• Legalzoom – avoid like the plague.  Hire an attorney!

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One of the exemptions from the federal securities laws regarding the registration of offerings of securities comes in Rule 506.   Rule 506 contains no limit on the amount of capital that can be raised in an offering. Similar to other exemptions, an issuer using Rule 506 cannot use general advertising or general solicitation to market its offering.  Rule 506 is available to an unlimited number of accredited investors and up to 35 non-accredited investors.  Unlike Rule 505, all nonaccredited investors, either alone or via a purchaser representative, must be sophisticated, that is, they must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.  Just as with Rule 505, nonaccredited investors must receive a substantive disclosure document that includes financial statements, although even if only accredited investors are involved, care must be taken such that the anti-fraud requirements are met and that there are no false statements, no misleading statements, and no omissions that might make what you have disclosed misleading.  Purchasers must receive restricted securities, meaning that the securities may not be sold without either registration or an exemption.

As always, make sure you get the advice of a securities attorney with private placement experience. There are lots of complicated regulatory requirements to comply with, both on the state and federal level.   A private placement attorney can help you navigate the regulations and to draft your private placement memorandum.

One of the exemptions from the federal securities laws regarding the registration of offerings of securities comes in Rule 505.  Rule 505 allows a company to raise an aggregate amount of $5,000,000 over a twelve-month period.  Similar to Rule 504, Rule 505 does not permit an issuer to use general advertising or general solicitation to market its offering.  A Rule 505 offering is available to an unlimited number of accredited investors and up to 35 non-accredited investors.  Unlike a Rule 504 offering, nonaccredited investors must receive a substantive disclosure document that includes financial statements, although even if only accredited investors are involved, care must be taken such that the anti-fraud requirements are met and that there are no false statements, no misleading statements, and no omissions that might make what you have disclosed misleading.   Purchasers must receive restricted securities, meaning that the securities may not be sold without either registration or an exemption.

As always, make sure you get the advice of a securities attorney with private placement experience.   There are lots of complicated regulatory requirements to comply with, both on the state and federal level.   A private placement attorney can help you navigate the regulations and to draft your private placement memorandum.

One of the more common questions I get from clients interested in raising capital is “what is an accredited investor?” The answer is spelled out in fairly plain english in Rule 501 of Regulation D:

a bank, insurance company, registered investment company, business development company, or small business investment company;

an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;

a charitable organization, corporation, or partnership with assets exceeding $5 million;

a director, executive officer, or general partner of the company selling the securities;

a business in which all the equity owners are accredited investors;

a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase;

a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or

a trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes.

In addition to understanding what it means to be an accredited investor, it is also important to understand how accredited investor status relates to the most common exemptions from the registration requirements of federal securities law. In a nutshell:

• Rule 504 permits allows a business to sell up to $1 Million in securities during a 12 month period to an unlimited number of non-accredited investors. Additionally, Rule 504 does not require the issuer to provide any specific disclosure to the offerees, regardless of whether they are accredited (but keep in mind the anti-fraud requirements).
• Rule 505 allows a business to sell up to $5 million in securities during a 12 month period to an unlimited number of accredited investors, and up to 35 non-accredited investors.  The big problem with selling to non-accredited investors is that the disclosure requirements are significantly more difficult to meet – very similar to the disclosures required in a public offering.
• Rule 506 allows a business to raise an unlimited amount of capital via the sale of securities to an unlimited number of accredited investors, and up to 35 non-accredited investors.  In addition to the substantial disclosure requirements discussed above for Rule 505, any non-accredited investors must also meet a “sophistication” standard, either themselves or via a qualified purchaser’s representative.  The status of an investor as “sophisticated” is a fairly high standard; investors who are merely knowledgeable about the particular industry are not necessarily sophisticated.

As you can see, raising capital from non-accredited investors puts a start-up in a much more tenuous position in terms of disclosure – which means substantially more legal and accounting fees.  Non-accredited investors also tend to be more difficult to deal with in the long term.  Consider carefully the decision to raise capital using non-accredited investors – and of course consult with a securities attorney.

One other thing to keep in mind is that the burden of establishing whether an investor is an accredited investor falls on the issuing company.  At a minimum, the issuing company must reasonably believe that the investor falls into one of the 8 categories in the definition of “accredited investor.”  This is typically accomplished using a carefully drafted investor questionnaire – make sure you use one and that you consult a securities attorney.

ChubbyBrain.com, a fascinating site who’s mission is to democratize startup and investor information to make it more widely available, recently published its Q2 2009 Venture Capital report – and the results are very encouraging if you are a start-up in the market to raise venture capital.  Overall, the report shows a 61% uptick in investment capital flowing from VCs to entrepreneurs compared to the prior quarter.  Some highlights from the report include:

• Total deal value in Q2 of 2009 was $5.329 billion – up from $3.314 billion on Q2 2009.
• VC’s are investing across a wide geographic base – including Indiana.
• Venture Capital IS available for early stage companies – in fact – 35% of the deals in the report consitsed of seed funding or Series A rounds.
• Healthcare investments were – well – healthy.  Healthcare investments made up 37% of the deals in the report.

You can read the entire blog post here, or check out a PDF of the entire report below.

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According to the website for the  21st Century Research and Technology Fund:

The 21 Fund provides financial support to highly innovative Indiana-based companies, thereby helping these firms make the transitional leap from general research and development to product development while also creating high-wage, high-skill, high-tech Indiana jobs and diversifying the state’s economy.

The site also says:

The 21 Fund seeks technology-based companies conducting business in Indiana and provides financial support to make the transitional leap from research to product development. By supporting high-tech companies during this crucial stage, the 21 Fund encourages entrepreneurial success and keeps Indiana’s most promising technologies in Indiana, leading to the creation of the high tech, high-paying jobs of tomorrow. The 21 Fund does not focus on a particular technology or application area in selecting awards. This allows Indiana’s strengths to identify themselves through successful completion of the 21 Fund’s rigorous review process. Avoiding pre-selection of technology focus areas ensures that the 21 Fund plays an unbiased central role in diversifying the State’s economy, a goal outlined in the 21 Fund’s legislation.

Sounds great, right?  Encouraging tech companies to start-up in Indiana, as well as stay here, has always been a minor challenge when compared to the tech start-up hotbeds around the country.  The 21 fund was supposed to be part of the solution to that problem.  Unfortunately, on July 1st, the budget for the 21 fund was cut by $35 million over the next two years.  David Castor, who’s Business and Culture Blog I subscribe to (and link to from the homepage of this site), sums up my feelings on this news:

This is an extremely short sighted move.  It has a negative impact on both attracting and promoting growth for emerging technology businesses – businesses which have proven to be high growth and high profit.  Promoting the success of these businesses leads to an increase in jobs, increase in average incomes, increase in consumer spending, and increase to tax dollars back to the state.  That is economic improvement.

It is odd that in the year of economic stimulus dollars being granted to the state to boost infrastructure and economy, our state takes a position to decrease funding to businesses that truly impact economic improvement.

Short sighted indeed. If anyone out there has some insight on this decision, or an opinion one way or another, please chime in below with a comment.

From the title of this post, you are probably assuming it refers to the chunk of your company you will be giving up in exchange for an infusion of capital.  You would be right – mostly.  In addition to giving up equity, start-up founders also give up some measure of control when they raise venture or angel capital.  Therefore, the first part of this post will deal with equity; the second part will deal with control / governance.

How Much Equity Should You Give Up?

Don't expect a free lunch.

Unfortunately, the answer is not something you will typically have control over.  Generally, an investor will give a value to the business based on the net present value of future cash flows, then setting its desired ownership percentage based on its target internal rate of return.  A big component to this determination will be the level of risk associated with the investment.  So if you want to give up less, you’ll need a good valuation…and you’ll need to minimize risk.

How Much Control Should You Give Up?

Unfortunately, this is someting you will also not have much control over.  A venture capiltalist will want board seats.  They probably will not require control of the board, but they will likely require supermajority voting provisions on certain issues such as spending capital, raising capital, and selling the business.  The venture capital board members will also likely require directors fee and reimburesement for travel expenses.   Make sure that the number of seats the investor is entitled to adjusts based on percentage ownership; so as that percentage goes down, so do the number of board seats they are entitled to.  Also keep in mind that venture capitalists typically bring very valuable wisdom and exprience to the table – so having them on your board is not necessarily a bad thing.

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Raising venture capital / private equity requires more than just pitching your idea and business plan to a group of people with money to invest – although your pitch is obviously a crucial component.  There are lots of documents that will be required, and those documents will usually require the careful scrutiny of a venture capital attorney. Below is a short, but not inclusive, list of what you might expect:

1. 

   Don't expect a one page agreement.

   Venture Capital Term Sheet - These are typically non-binding outlines of the terms of a venture capital deal.  Don’t let the “non-binding” portion fool you, though.  Terms laid out in a term sheet serve as the basis for all future negotiations, and any attempt to deviate from those terms will not be met kindly during deal negotiations.

2. Stock Purchase Agreement – This is the definitive agreement setting forth the terms of the venture capital investment, such as the purchase price, the closing date, and the conditions surrounding the issuance of stock – which more likely than not will be preferred stock.   There will also be numerous representation and warranty provisions, among other provisions, that will need to be carefully crafted by a venture capital attorney.
3. An Amendment to the Bylaws – Assuming the company is a corporation and that the VC is conditioning its investment on the receipt of preferred stock (which it likely will), the bylaws of the corporation will need to be amended.  This amendment will create a new class of preferred stock and will include anti-dilution provisions. dividend rights, liquidation rights and conversion rights.  Some states require a “Certificate of Designation” to accomplish this, rather than an amendment to the bylaws.
4. Right of First Refusal / Voting Agreement – This agreement will grant the VC a right of first refusal to purchase any shares in the company that come available for sale.  It will also likely contain a number of restrictions on the transfer of common stock, as well as tag-along rights allowing the VC to participate in the sale of any common shares.  Finally, there will likely be a voting agreement requiring that the common shareholders elect the VC’s nominee(s) to the company’s board of directors.
5. Consulting Agreement – Often times a VC will require payment of a monthly fee by the company in return for certain management services provided by the VC.

These are just a few of the documents that a company might normally expect to see during the process of raising capital.  As always, you should consult an attorney with knowledge of the venture capital process.

Business lawyer Brian V Powers represents businesses raising venture capital.  dn47hivf8b

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Have a great idea and plan on starting a business? Thinking about raising venture capital at some point in the future? You should think twice about forming an LLC. Venture capitalists typically require a “C” corporation when investing in a business. Here are a few reasons why:

• Venture Capitalists like preferred stock, they are familiar with preferred stock, and will usually have already perfected terms for preferred stock.

• Venture Capitalists typically don’t care about / don’t want pass through losses from an LLC.

• Venture Capitalists will invest with an exit strategy in mind. That exit will likely either be an IPO, which is generally only available to “C” corporations, or sale of the company, which would preferably occur via a tax-free reorganization. Only corporations can participate in tax free reorganization.

So why not an “S” corporation? First, “S” corporations, under most circumstances, may not have a shareholder that is not a natural person; most Venture Capital funds are organized as limited partnerships. Second, “S” corporations may not have more than one class of stock. As I mentioned above, Venture Capital funds love preferred stock, and they can’t get it from an “S” corporation.

My business law practice can help you set up your business and plan for raising venture capital.

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