ECC Talk #10 – Getting Funded – Part 2

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We had a great Lunch & Learn this week!  Regions Bank and Elevate Ventures briefed on various funding options, and answered questions from the attendees.

The Regions presentation was very informative, and outlined that startup and engineering were two of the bank’s strategic growth areas.  Very favorable terms for capital and investment were discussed, as well as the requirements for collateral.

The Elevate Ventures presentation was quite impressive, and Mr. Pfenninger delivered a very candid talk on – If, When, and How to raise funding.  We have shamelessly copied most of his presentation below.

When do you raise capital?

  • Ideally – When you don’t need it so you can command a premium company valuation
  • Realistically – When you need resources to move your business to the next milestone

Who should you raise capital from?

  • The IDEAL solution is ‘Smart Money’, that is individual investors who bring more than money to the table (connections, expertise, etc.)
  • The OK solution – Experienced Investors – Individuals who have invested in early stage businesses before and understand at a macro-level what it takes to succeed
  • The Sub-Optimal solution – Dumb Money – Inexperienced venture investors, or investors you are fielding lots of unintelligent and wasteful communications from.

Deciding what kind of capital to raise is always a balancing act – An entrepreneur must always weigh pros & cons.  Typical options are:

  • Loans
  • Venture Capital Investment
    • Common equity
    • Preferred equity
    • Convertible debt
    • Depending on who is investing they may prefer one over the other
    • None are necessarily bad but you need to know what to look out for

Business Valuation is typically done by investors, but you need to do your homework too.   If possible, try to get multiple term sheets to understand what the market appetite looks like.

  • This leads into the important part – valuations are temporary, but control is not.
    • Be cautious how much control of your company you give away.  Once control or rights are sold, they most often can’t be gotten back.

What should you look for in a Term Sheet?

  • Liquidation preferences
    • Perhaps the most common request, 1x is very common
    • At 1x, basically means the investor gets their money back first and then the remaining money is distributed on a pro-rata basis with common shareholders
    • Helps ensure an investor gets their money back in the event of an exit since they generally do not have control over such events
    • Similarly serves to protect an investor from an overpriced round
  • Board seats and/or observation rights
    • Very common
    • Typical early stage board composition would include 1-2 investors, 1-2 independent directors, 1-2 management for a total of 5 people
    • Generally reserved for the largest investor(s) in a round
  • Veto power
    • Over indebtedness over a certain amount
    • Over issuance of subsequent equity offerings
    • Over issuance of additional options
    • Over who knows what else
    • Professional investors often ask for Veto power
    • Be careful as Veto power can provide outsized control
    • One compromise is to allow an investor to maintain this right assuming they continue to participate in future funding rounds
  •  Anti-dilution
    • Triggered in the event of a ‘down round’
    • Adjusts the conversion formula from preferred to common to ensure the investor does not lose their pro-rata share of the business
    • Common provision
  • Dividends on preferred stock / Interest on convertible notes
    • Very common
    • Seldom paid out as cash in an early stage business
    • Often accrued and then converted into additional shares of stock
  • Financial reporting or other information
    • Many investors will ask for regular updates on the financial condition of the business
    • They may also ask for regular updates on things like sales pipelines
    • Key is to maintain confidentiality and to provide it in a frequency that is not overly burdensome to the company
    • This is a good practice as it forces the company to maintain discipline

CONCLUSION:

•There’s no right or wrong answer
•Unfortunately its all situational
•The key is to have good advisors who don’t have a stake in a transaction
•Make sure you have an experienced attorney review any documents before signing them
•Sometimes things sneak in we don’t expect