Monday, January 10, 2011

Quora | Raising Venture Capital

I answered a question on Quora, and have reposted the question and my response here:

What advice can you offer an entrepreneur with regard to when to raise capital, how much capital to raise, and from which sources?

In answering this question please give some thought to perceived risk, control issues, cost of capital, moral, legal and contractual obligations of taking outside money.

There is no formula that will fit across the board. Whether to raise capital, how much capital to raise, and which investors to use will depend on many factors, including (1) the current value of the company and the kind of valuation that it could hope for with investors, (2) the need for a capital infusion, and (3) the need for strategic partners and relationships.

(1) Value & Valuation
The first point is a pretty basic one. The earlier that you go out for funding, the lower the valuation, the more of the company you give up. And conversely, the more value that you are able to add to the company before seeking funding, the greater the valuation, and the smaller the percentage of the company that you give up.

(2) Need for Capital
Depending on the industry and the type of business, as well as on your own personal resources, you may be able to bootstrap the company to get to a beta of your product or even to a public product launch, or the company may require a large capital infusion long before the first prototype is ever created. If you can put off taking capital, there are advantages to doing so.

(3) The Rolodex
When you take on investors, you are taking on partners. If you are taking money from friends and family in an angel round, unless your friends and family are Ron Conway (and the like), you are just getting money. But if you are financed by sophisticated industry players, they are bringing with them their connections and their experience. And they are motivated to make good use of their connections for your benefit. If you need the connections to get your business of the ground, you will want to seek investors sooner. Among other things, they may help to bring in experienced industry professionals to augment your team.

Turning now to the specific points you asked to be addressed:

(a) Perceived Risk
I think this is answered in (1) above. If a company has a product out, maybe has a few paying customers, and needs funding to gain more traction in the marketplace, there is a lot less perceived risk than in a company that is seeking funding to build out an idea. This is not to say that the latter company will not get funded. In biotech, unlike the web and mobile application space, it is all but impossible to get to a product without significant investment. But the perceived risk is higher in the second scenario so the idea has to be really great (or perceived as really great).

(b) Control Issues
Whether an investor will seek control (such as a board seat, registration or voting rights) will depend on the investment amount and on the type of investor. The more money that you take it, and the more that your investor is starting to look like a venture fund or a very sophisticated angel, the more that you can expect them to seek a board seat or protective provisions. It's a standard practice in venture deals. If an investor is proposing control terms, you should make sure you understand them and their implications (and consult with a startup attorney or another industry player to make sure they are fair and market), but this is not something you should be afraid of or try to avoid like the plague. :-) Money comes with strings attached, that's life.

(c) Cost of Capital
The cost of capital will depend on the perceived valuation of your company. If an investor values your company at $10 million pre-, and wants to invest $5 million, the value of the company will be $15 million post- and the investor will own 1/3 of the company. If the same company is valued at $5 million pre-, the same investment will give the investor a 50% stake in the company. This is an over-simplification, because VCs always want to set an option pool at a percentage of post- (usually ~ 20%), but they price the shares as if the new option pool was part of the pre-, which skews these percentages. And there may be other intricacies involved with how convertible note discounts and warrants affect the per share price. But you get the idea.

I've also heard the view that, valuation aside, VCs come in with a general idea of what percentage of the company they want to buy, and that asking for more money (in a justifiable, business plan supported way) may get you a higher "valuation". But I will let the VCs comment on whether that's ever the case or not. :-)

(d) Moral, Legal and Contractual Obligations of Taking Outside Money
From a moral perspective, don't take the money if you don't believe in your venture and in its ultimate success. Period. In dealing with friends and family, make sure they can afford to lose their entire investment and understand the risks.

From a legal and contractual perspective, there are several ways you can structure the deal. The two primary ways are convertible notes and preferred stock financings. The former (in its purest form) allows you to defer the valuation of your company until such time as you are further along and can seek a better valuation. Investors in a bridge or a convertible note financing receive a debt instrument (convertible notes) for their investment, which they can convert to preferred stock (usually at a discount) at the time of an equity financing. In a very founder-friendly round, a bridge loan might be just the perfect vehicle to fund the company until it is further along in its development and is ready to seek an equity round. But not all convertible note financings are made equal, so watch out for onerous terms and price caps on shares, which may serve as an effective low valuation.

Also, please note that bridge financings are loans which accrue interest, and if they don't convert, they need to be repaid at the end of the term. How does this play out? If the company has not become sufficiently profitable and has not obtained a qualifying equity financing (in which the notes would have converted) when the notes come due, it is unlikely that the company will have the money to repay the note holders. If the note holders continue to believe in the company, they may extend the due date or even put more money in to sustain the company until an equity financing or a sale. But if the note holders have lost faith, the company will likely have to default on the note and the note holders can pursue the matter in court. Long story short, this can put a company out of business.

Preferred stock, sold in an equity financing, entitles the holder to a pro rata distribution of assets in the event of liquidation, after all debts of the company have been repaid.

If your company is at a point where you are seriously contemplating looking for funding, I am happy to talk to you offline in more detail about the options available to you.

Inna Efimchik

Disclaimer: This post does not constitute legal advice and does not establish an attorney-client relationship.

Emergence Law Group  Emergence Law Group, specializing in assisting emerging technology companies in Silicon Valley and beyond, provides incorporation, financing, and licensing services as well as general corporate counseling.

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