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/.)

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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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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