Seriously. I know it sounds like a pitch, but I am sincere. Of course we hope that you will hire North Carolina corporate attorneys and Virginia business lawyers from Sands Anderson, but even if you don’t, make sure that you find an attorney who has experience in these matters. I can give you several good reasons.

First, if your business is worth investing in, then you probably have your hands full – or you are excess baggage. You should either be closing your next sale, getting your next-generation prototype to work, or hiring a replacement for the engineer who left suddenly, leaving a critical project is completed. You need to delegate.

If you’re capable of getting a venture capitalist interested enough to give you a term sheet, you’re probably bright enough to learn all the ins and outs of VC financing structure. But that doesn’t mean that you should. As we discussed in Point Number 8, the VC capital structure model, while elaborate, really doesn’t change much from deal to deal. The parameters may change, e.g. the pricing, compensation levels, vesting schedules, liquidation preference factor, etc., but the essential structure of the deal follows a tried and true path. If you really want to reinvent the venture capital business model, you’ll have a lot more luck after you have successfully IPO’d your company. Until then, you will be wasting your time trying to reinvent a wheel that’s already round enough.

Another reason you should hire a good lawyer, is that no right-thinking VC will invest in the company that is not represented by competent counsel. It raises too many questions. It also puts an extra due diligence burden on the VCs and their lawyers. They need to know that everything is where it needs to be, the corporate records are up to date, patents have been filed, and all of the outstanding stock has been properly authorized and issued. In answering these questions, they get lots of comfort from having a law firm on the other side of the deal issue a legal opinion. Even if you could give such a legal opinion, it wouldn’t be worth much unless you have a legal malpractice policy of your own.

Good venture capital lawyers, with many of these transactions under their belt, are more likely to pick up on subtle cues or wrinkles in the deal. They may be able to anticipate where a venture capital firm will give way on one point, and use that to your advantage to protect you on another point. If you or your attorney haven’t done these deals before, you won’t know where the trade-offs are. You could easily give away too much to obtain something that the venture capital firm didn’t really care that much about. In other words, there’s no substitute for experience. Related to that is that a good venture capital lawyer will stay up to date on “market” deal terms. If the VC is asking too much, your lawyer should know that. If they haven’t done enough deals, they would have nothing to compare to. Depending on the state of the economy, the scarcity of capital, the state of the market for IPOs or strategic acquisitions, venture capital deal terms will change, just like the price of the stock fluctuates in the public market. The difference is that with private companies, it’s not a simple as a quoted price. Take a look again at the term sheet referred to in Point Number 8. There are many knobs to turn and switches to flip.

Finally – you will need good counsel. Issues may arise that you cannot or should not discuss with your employees. You may question why the VCs are asking for a specific term or a piece of information, and your partners or employees will not know the answer. You will want to know if the VC is being too aggressive, or if their body language suggest that you can get better terms. Here again, experience is the key. Good venture lawyers have a “sense of the deal” that develops only with time and deal flow. They can also come up with creative solutions that you would not think of. Almost every deal threatens to run aground over some issue in the process between term sheet and funding – but there is almost always a solution. In negotiating deals, as in navigating rivers – It’s good to have an experienced pilot who knows the shoals, the rocks and the currents.

If you’re serious about raising venture capital, you must be prepared to accept virtually all of these terms, if you expect to close. In the process, it’s crucial that you be honest with yourself. If you really cannot get comfortable with the standard terms, you would be better off bootstrapping your company. Otherwise, talking to VCs — let alone getting into extended negotiations with them over terms that are pretty much nonnegotiable — is a waste of your time and theirs.

So here are some of the biggies.

1. The stock you own may be “reverse vested.” What does this mean? It means that even though you issued stock to yourself when you formed your company (or LLC membership interests, as the case may be), the deal terms may require you to put substantial amounts of your equity at risk. This is the VCs way of making sure you stick around. In effect, you have to earn your equity back. The period over which you earn, the equity back may be from 3 to 5 years, and it may affect all or maybe just a portion of the equity. But you can pretty much count on subjecting a significant portion of your ownership to this mechanism.
2. The VCs will not buy common stock or its LLC membership equivalent. They will have what is known as a liquidation preference. Simply put, they get their money back before you get any of yours. When venture money is especially scarce, or IPO conditions are unfavorable, the VCs may even ask for a multiple liquidation preference. This is a way of extracting a decent return even if the company’s performance is mediocre.
3. You will sign an employment agreement that will enable the VCs to fire you if you’re not performing. There is significant flexibility in terms of compensation, perks, etc. But the bottom line is, if you’re not getting the job done, the VCs can and will replace you. The employment agreement may grant you termination benefits, which can be either generous or downright stingy. These are some of the areas where you can negotiate successfully, as long as you stay within the framework.
4. The VCs will have the right to participate in any public offering of stock. They will also have the right, under certain conditions to demand that you register their stock for sale with the Securities Exchange Commission, even in the absence of an IPO. At the same time, you may have to agree not to sell your stock in the IPO and for some time thereafter. Investors generally think it’s a bad thing to see founders cash out at the IPO. This demonstrates a certain lack of confidence in the company’s future, and of course the price of the IPO is based almost entirely on the company’s future. So even though you will look wealthy on paper the day after the IPO, you may be no more liquid than the day before.
5. VCs do not have infinite patience. They have to answer to their investors, and they expect to invest and recover their funds over period of 5 to 10 years, but the sooner the better. That is why they require redemption rights. Redemption rights allow them to turn in their stock for a return of the original capital plus all accrued dividends. This protects the VCs in case the company makes progress, but is not able to arrange an IPO or acquisition, whether due to market circumstances or less than stellar company performance. By maintaining the right to get their money back, the VCs can have greater assurance that they can close out a fund, clearing the decks for them to raise another. Bear in mind, the VC’s job depends entirely on their ability to both invest and recover capital within a reasonable timeframe. Most of their investors are institutional (insurance companies, pension funds, sovereign wealth funds, etc.) and all of them desire some degree of predictability.

These are just a few key points that often pose problems for founders. Founders tend to be self-reliant, control oriented, highly confident (sometimes to a fault) and utterly convinced that they have the right idea, and the unique ability to bring it to fruition. These same factors that make entrepreneurs successful can also get in their way in the venture capital process. As a founder, you have to realize that the VCs assume that you possess all of those attributes, otherwise they probably wouldn’t even be talking to you. But from their experience, they know that they have to control founders for their mutual benefit. The faster a company grows, the sooner it outgrows the management capabilities of the founders, requiring installation of “professional” management. The mentality of the professional managers can be quite at odds with the entrepreneurial mindset, and clashes are the rule rather than the exception, so be prepared.

For a complete overview of the terms of venture capital deals, look at the NVCA model documents. By downloading these documents, you can at least be forewarned, and forearmed before entering into negotiations. It’s no secret that these terms can be tough. But at least you can anticipate them and make your decisions accordingly.

“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.

Point 2.

Be persistent – very persistent. The venture capital business model assumes founders will face many obstacles as their businesses grow. This is one reason why the valuations they place on early-stage companies are so low compared to what the founders may think they are worth.

Experienced venture capitalists also know that they will be “in the trenches” with the management team, and will probably be asked for more money at some point, often under circumstances where the company’s continued existence is at stake. If they sense, for any reason, that the founder or the management team does not believe enough in their concept or their abilities have the courage of their convictions, they may walk away even if they like the business opportunity, or they may condition their investment on installation of the management team of their choosing.

Some venture capital investors will even admit that one of their screening tactics is continue to show interest, while dragging their feet. The goal is to see how far the fledgling company can get without outside money before giving them any of their own. In this way, the venture capital investor gets to see how they founder reacts under pressure, and also just to invest at a time when the need for money is greatest, giving them the upper hand in negotiating terms.

Ideally, a venture capitalist would like to back a founder who is more like Winston Churchill than Neville Chamberlain. Recall Churchill’s advice to the students at Harrow:

Never give in–never, never, never, never, in nothing great or small, large or petty, never give in except to convictions of honour and good sense. Never yield to force; never yield to the apparently overwhelming might of the enemy.

You can find more of Churchill’s quotations here.

Thomas Alva Edison was also noted for his persistence and recognized its role in success. Here are just a few of his pronouncements on persistence.

• Genius is one percent inspiration and ninety-nine percent perspiration.
• I haven’t failed, I’ve found 10,000 ways that don’t work.
• I was always afraid of things that worked first time. and
• Many of life’s failures are people who did not realize how close they were to success when they gave up.

Edison’s arch rival was Nikola Tesla, the inventor of AC power, the power grid and almost everything connected to it (except Edison’s light bulbs). Edison would probably have admitted that Tesla was the brighter of the two, yet Edison became wealthy and Tesla died a virtual pauper.

Compare this quote from Tesla to the ones above.

My method is different. I do not rush into actual work. When I get a new idea, I start at once building it up in my imagination, and make improvements and operate the device in my mind. When I have gone so far as to embody everything in my invention, every possible improvement I can think of, and when I see no fault anywhere, I put into concrete form the final product of my brain.

Perhaps Tesla was the embodiment of the phrase “The better is the enemy of the good.” Without minimizing his fantastic accomplishments, it’s clear why venture capitalists would have preferred Edison over Tesla.

So, as long as you don’t hear “absolutely not, never, not in a million years would we ever invest in your company” – keep trying. In fact, even if you do hear that, give it one more try! Persistence is valued over IQ, industry knowledge, and originality.

My next observation and advice will be on the importance of communication in the relationship with venture capitalists. Meanwhile, should you want to know more about venture capital funding, you cna contact any of the Virginia business lawyers at the law firm of Sands Anderson PC.

For many in the investment banking community most of the requirements of the Series 7 license do not apply directly to their work. Investment bankers doing mergers and acquisitions often complain that the Series 7 exam does not relate well to what they do day-to-day and is not a good test of what they need to know to be effective investment bankers. Beginning November 2, 2009, amendments to NASD Rules 1022 and 1032 require individuals whose activities are limited to investment banking and principals who supervise such activities to pass the new Limited Representative – Investment Banking Qualification Examination (Series 79 Exam).

The Financial Industry Regulatory Authority (FINRA) has developed this exam “to provide a more targeted assessment of the job functions performed by the individuals that fall within the registration category.” This exam seems well suited for transaction professionals in M&A boutiques, financial intermediaries, and business brokers who work on mergers, acquisitions, buyouts, refinancings, and financial restructuring as well as public investment banking.

NASD Rule 1032(i) requires an associated person to register with FINRA as a Limited Representative – Investment Banking (Investment Banking Representative) and pass a corresponding qualification examination (Series 79) if such person’s activities involve:

1. Advising on or facilitating debt or equity securities offerings through a private placement or a public offering, including but not limited to origination, underwriting, marketing, structuring, syndication, and pricing of such securities and managing the allocation and stabilization activities of such offerings, or
2. Advising on or facilitating mergers and acquisitions, tender offers, financial restructurings, asset sales, divestitures or other corporate reorganizations or business combination transactions, including but not limited to rendering a fairness, solvency or similar opinion.

The registration category does not cover individuals whose investment banking work is limited to public (municipal) finance or direct participation programs as defined in NASD Rule 1022(e)(2). Moreover, individuals whose investment banking work is limited to effecting private securities offerings as defined in NASD Rule 1032(h)(1)(A) may continue to function in such capacity by registering as a Limited Representative – Private Securities Offerings and passing the corresponding Series 82 exam.

The topics covered on the exam include: (i) collection, analysis and evaluation of data; (ii) underwriting/new financing transactions, types of offerings, registration of securities; (iii) mergers, acquisitions, tender offers and financial restructuring transactions; and (iv) general securities industry regulations.

What about those registered representatives who already have their Series 7 license? The good news is that these reps will be able to “opt in” during a six-month window and receive the qualification for the new investment banking representative license without having to take the exam and will retain their Series 7 registration. Investment bankers who hold the Series 7 registration, as well as those who have passed and are registered with a “Series 7-equivalent exam” may opt in to the Investment Banking Representative registration, provided that, as of the date they opt in, such individuals are engaged in investment banking activities covered by Rule 1032(i). Those individuals who choose to opt in will retain their Series 7 or Series 7-equivalent registered representative registration in addition to the investment banking registration. After May 3, 2009, any person who wishes to engage in the specified investment banking activities will be required to pass the Series 79 Exam or obtain a waiver.

The registration and qualification requirements for Investment Banking Representatives will become effective November 2, 2009. The six-month opt-in period will begin on that date and end May 3, 2010.

Go to http://www.finra.org/Industry/Regulation/Notices/2009/P119462 for a FINRA’s Regulatory Notice, which summarizes the new Limited Representative Investment Banker category and the Series 79 exam.