“Nothin’ from nothin’ leaves nothin’.” Billy Preston

“42.7 percent of all statistics are made up on the spot.” Stephen Wright

Know your ownership position. In our last post, we discussed being prudent about what you say to the venture capitalist or fund management. This post, however, is about being careful about how the raising of capital affects share of ownership and business success.

Don’t sacrifice your start up to the false god of majority ownership. It’s a common mistake to view ownership and control in a one-dimensional framework. What could be simpler, there are hundred percentage points and if you have more than 50 of them, you’re the boss, right? And that’s a good thing, right? To which I respond: “no” and “maybe.”

The venture capitalist’s model capital structure is not based on a simple division of ownership (we’ll talk about that next time). There are plenty of good reasons for this, and it’s mutually beneficial to investors and entrepreneurs. For example, you might own 51% of common stock, but when you take into account anti-dilution rights, preemptive rights, adjustments to conversion rates, participating versus nonparticipating preferred, clawback’s, vesting schedules and other parameters, it’s very hard to know what your share of the ultimate pie might be. Furthermore, owning 51% of the fully diluted common stock does not guarantee control. With the VC investment will come new board members, and rights to take control of the board if the company misses milestones. That’s not to say percentage is not relevant, just that it’s not simple. All things being equal, (which never happens), a higher percentage is better than a lower one, but when the bargaining starts it is easy to make too much of that.

Entrepreneurs need to keep in mind that the fundamental economics of venture capital funds constrain VCs in setting the terms and size of their investments. Based on the size of the fund, they have to allocate a certain amount of money to initial investments, another chunk to follow-on investments in successful companies, and still a third for “problem children” i.e., the companies that still show promise, but can’t seem to keep momentum. The size of the VC fund’s staff is also a factor. There are only so many deals that one person can successfully monitor, manage and contribute to. Remember part of what you are getting with the venture capital money is the knowledge and experience of the fund principals. If your contact with the venture fund has too many pots to watch, you may not get your full measure of advice.

The net effect of all these factors is that venture funds typically invest from one to five million dollars in an early round, and generally receive anywhere from 25 to 75% of the equity of the company on a fully diluted basis, that is, assuming all options, conversion rights and other equity interests are fully exercised. However, even if you maintain 51% of this magic fully diluted number, if your company does not perform, there will undoubtedly be adjustments or subsequent rounds of financing that might dilute you down to single digits.

And single digits aren’t necessarily all that bad either. If your share declines because of follow-on investment rounds at increasing prices, then the value of your seemingly small 9%, may far exceed the value of 90% of an earlier round. Just remember, it’s all about the money. I doubt Bill Gates thinks about what his percentage of Microsoft was when he first received venture capital money. All he really cares about is what it’s worth right now.

Our Virginia and North Carolina business lawyers know quite a bit about how ownership agreements and funding structures work. Use the comments below to share your observations and questions about ownership in your start-up company.

In venture capital deals, there is a highly standardized corporate structure. A venture backed company has common stock, owned by founders and employees, and preferred stock, owned by the investor VCs. There may be several series or classes of preferred stock, depending on the number of rounds of investment. Each series or class will have specific rights of priority, rate of return etc. Within the standard model, the actual deal terms can vary widely, but market conditions tend to restrict them to a fairly narrow range at any given time.

One of the key features of preferred stock is the “liquidation preference.” Liquidation preference is the amount of money per share of preferred stock. That must be paid before the common stockholders can receive any payment for their stock. This typically matters only if the company is sold, merged or liquidated.

Historically, when a venture-backed company experiences difficulty or misses certain agreed performance targets, the preferred stockholders essentially take control. At that point, they may be less interested in getting a return on their investment as they are in just getting as much of their investment back as they can. If the company ends up in a “fire sale” transaction, the preferred stockholders may assume that the common stockholders will be left with nothing after the preferred liquidation preference is paid.

A recent case in the Delaware Chancery Court (the most influential court on corporate issues) may have changed the ground rules in such situations. In that case, In Re Trados Incorprorated Shareholder Litigation, the directors of the company were found to have breached their fiduciary duty to the common stockholders by declining to initiate a “sale process” i.e. an auction, for the company. A majority of the directors had been elected by the preferred stock investors (venture capital funds). The company had experienced major setbacks and generally failed to meet the expectations of the preferred investors, but appeared to be on the rebound, and was not in danger of failure. Nonetheless, the Board approved a merger of the company in a transaction with the result that the preferred investors recovered most of their investment, some officers received bonuses, but the common holders received nothing. Common stockholders brought a class action against the board members who approved the transaction, and the court ruled in their favor.

As in any case, there were numerous factors in the court’s decision, and there is no general “rule of thumb” that can be derived, but the implications for a director’s duties are significant.

The National Venture Capital Association (“NVCA) maintains a set of legal forms regarded among VCs and their counsel as the industry standard templates for VC transactions. In the wake of Trados the Association has modified the documents to provide greater protection for directors in situations where the interests of the preferred investors and the common owners may be at odds. Anyone considering purchase of convertible preferred stock¹ in a private company, and any board member of such a company should be aware of the heightened duties to other shareholders in light of Trados, and should also make certain that their counsel is aware of their concerns and the changes to the NVCA documents. Conversely, company founders seeking investors, and other common stock holders, or holders of options on common stock (e.g. key employees), would also be well advised to understand this case and its implications for corporate structure.

[1] At the “angel round” stage, many companies are formed as limited liability companies under the law of the state where the company was formed. Although these investments often have a structure similar to that used in VC transactions, the LLC statutes and applicable case law are not identical to the Delaware laws that applied to Trados. Even so, the principles of Trados may guide courts in other states when interpreting the LLC statutes as applied to operating agreements and other investment documents of angel round companies.

Point 3.

Communicate. Let the venture capital funds know what you’re doing. Keep them informed on developments, both in your company, and in the industry segment you hope to dominate. Any time you have a significant positive development, it’s an excuse to update their perception. Even if you have had the door practically slammed in your face, you can always say “I understand why you weren’t interested in my company before now, but you really should know about this development before you make any final decisions.”

Communicating updates is especially powerful if you can relate the development back to something that you predicted, promised or planned to do. If the portfolio manager starts to get the impression that you really know what you’re talking about, their attitude may gradually change. If, for example, you foretold a major industry development, such as an alliance between two companies or the selection of a technology standard, you gain credibility.

If the development is unexpected, then dazzle your target with your nimble reaction to the opportunity it creates. If it’s negative, explain how it will hurt your competition worse than you, and that there is still plenty of upside for feisty upportunistic survivors.

But I would be remiss if I did not also advise you to avoid being a pest. Don’t tell your quarry every little thing that happens. If you have acquired a powerful new team member, with a proven track record, that’s probably worth a note or a call. Hiring your first office manager, while a crucial positive step, probably does not rise to the level of “news” in the VC universe.

In summary, be useful, be noticed and be relevant. And, while it goes without saying (but I’ll say it anyway in my next post) – be prepared!

I have added a few thoughts of my own. While the basic advice is directed to businesses making a pitch to banks, the insights are equally applicable to entrepreneurs who are sending out business plans for prospective investors, or the seller of a business who is preparing a memo for presentation to potential buyers in the M&A context. Let me know if you agree or even have additional points of your own. David Carroll

23 Tips on Presenting your Project
Vitaly Michka, Concord Capital
www. concordcapitalonline.com

1. Be very specific in all aspects. Do not add fluff! This is a red flag to a banker.

2. Make all important information available in an executive summary, and have the summary in the very beginning of the presentation. You should be able to communicate the essence of your plan in three or four pages at most.

3. Have a very basic table of contents with page numbers and follow it.

4. Say what you need and support it with facts, numbers, pictures and charts, not the other way around.

5. Try to keep history, philosophy and personal feelings out of the presentation, unless they are a center point of your business plan.

6. Include information on the management team – education, experience and special achievements and why the team is particularly well suited for the business.

7. Have the document available in pdf or Word format and all calculations in Excel format available for the bankers or buyers to work with, not on the internet. The bank wants all documents presented to them directly. This is your job. The bank will not seek out your information.

8. Make all electronic pictures or other media elements of appropriate size, so they don’t make the document bloated or cumbersome to transmit.

9. Make sure the document is smaller than 10 megabytes, so it will be possible to email. If necessary, break it into smaller pieces.

10. Video presentations – do not stream or vend over the internet – send by Express Mail on a DVD or USB jump drive in the several formats – NTSC and PAL at least; especially for international transactions. You don’t know what format the target audience may use.

11. Try to have as many references as you can for the data you provide in your presentation, in the form of footnotes or endnotes. Don’t take it for granted that just because you state a fact or opinion the reader will believe it.

12. DO NOT send data in zip files.

13. DO NOT make bankers look-up stuff up on the internet.

14. DO NOT send documents that you and your people do not fully understand.

15. DO NOT send any documents that have not been read carefully by you and the people in charge of the project.

16. DO NOT send projects with unverified numbers – triple-check all numbers and calculations; the bank will verify your numbers.

17. DO NOT save money on translation of the documents into English for international deals. Use good translators, familiar with technical and financial terms in your document. Have a native English-speaking person read the documents to make sure that the translations are correct.

18. DO NOT send any information that is assumed, everything must be based on facts: if you do not have a permit for construction – do not tell people that you have one until you have it your hands!

19. DO NOT underestimate the depth of due diligence – all information, including your resume, will be verified.

20. Remember the SWOT analysis (Strengths, Weaknesses, Opportunities and Threats) — you have to present potential problems or weaknesses or you will lose credibility.

21. DO NOT TRY TO SAVE MONEY ON THIS PRESENTATION! Well deserved projects must be presented properly.

22. Prepare your business plan as though PricewaterhouseCoopers will be doing the due diligence on your plan; because, they may very well be.

23. Have several copies of entire presentation printed and bound and be ready to send it via FedEx to the Bankers.