Introduction to Venture Financing

Business and Legal Considerations

Major Issues
Sources of funds & expectations of investors Business plan & process of raising capital Deal issues:
Selection of entity structure Other legal considerations Role of Intellectual Property

How Do Entrepreneurs Raise Money?

Sweat Equity (Bootleg) SBIR Friends, Family, Fools Banks Savings, 2nd Mortgage, etc. Angels Venture Capitalists

Lender (Banks) Expectations

Good Business Track Record Ability to Repay Staying Power Community impact Collateral < 100% funds

Angel Investor Expectations

Return Ego Philanthropy Involvement

VC Investor Expectations
Clear understanding of the business:

Competitive Advantage- what is the value proposition Huge Market- do you understand it. Strong Management Team Strong Marketing and Sales Plan

Some Skin in the Game Exit Strategy Obscene Return

Investor expectations: the bottom line on innovation

Indomitable perseverance in a business properly understood almost insures ultimate success
Attributed to Cyrus McCormick(1809-1884)

Business Understood
McCormick understood that the success of Americas push west required adequate supply of food. Adequate supply of food was facilitated by his invention, the patented Virginia Reaper, but made it a business by developing credit mechanisms for customers.

The Venture Capital Industry

A Typical Fund
General Partner (VC Firm) 1% of Capital 2.5% Mgmt. Fee 20% Carry

$ Expertise

Limited Partners 99% of Capital 80% Carry

$ $ $ Newco A Newco B Newco C Newco N Megaco A Bigco B Hanginginco C Loserco N

Venture Economics US Private Equity Performance Index (PEPI) Investment Horizon Performance as of 6/30/2002

Fund Type
Early/Seed VC Balanced VC Later Stage All Venture All Buyouts Mezzanine All Private Eq.

1 Yr
-35.3 -20.8 -20.5 -27.0 -11.4 -4.4 -16.5

3 Yr
36.9 27.7 11.8 26.5 -1.3 6.0 5.5

5 Yr
46.2 26.2 17.6 30.6 3.4 7.8 10.9

10 Yr 20 Yr
32.6 22.4 24.1 26.1 9.8 1.6 16.1 20.2 15.0 16.5 16.9 12.9 11.4 15.2

Source: Thomson Venture Economics/NVCA *Venture Economics Private Equity Performance Index is calculated quarterly from Venture Economics Private Equity Performan ce Database (PEPD). The PEPD tracks the performance of 1400 US venture capital and buyout funds formed since 1969. Returns are net to investors after fees and carried interest.

VC Capital Invested:
Source: Thomson Financial

What Does a VC Do?

Organizes Partnership Raises Capital Receives Management Fee Creates Deal Flow in Focus Area:

Stage of Company Size of Deal Business Area Geography

Performs Due Diligence Syndicates Deals

What Does a VC Do?

Invests, but is not just a financial intermediary: Supplements Management Team Sits on Board Arranges Exit and Liquidation Creates Wealth for:

Workers Investors Entrepreneur Society

What Does a VC Look for in an Investment Opportunity?

Management, Management, Management

Full time Committed & enthusiastic Skilled Willing to listen

Clear, Concise Executive Summary (Elevator Pitch) Written Business Plan with Financials Feasible Business Model Knowledge & understanding of Industry, Market, Competition

What Does a VC Look for in an Investment Opportunity?

Proprietary Intellectual Property Realistic Time Frame/Milestones Revenues Via Business Model Clean Balance Sheet Uses of Funding VC Exit Strategy

Raising Money is as Much of a Strategy as the Business Is

Raising money is a process

Prepare Sales documents- Plan & Presentation Must pursue multiple simultaneous paths to finance Start looking before you need it its a long process, network is critical Industry focus Investment phase segment Product

Identify right partners

VCs dont sign NDAs Valuation depends on selling the opportunity

Need a Formal Business Plan, but also Concise Executive Summary Complete, Realistic Financials Know the business

Key Elements for Presentations to Investors:

Barriers to Entry Competitive Analysis

Strong Management Team Scalability

Business Plan Content

Executive Summary Company Description Product/Services Description Industry Overview Market Analysis Competitors/Customer Marketing and Sales Plans Development Operations Management/Personnel Financial Summary Financials Offering Appendices

Key area- Competitive Analysis

Clearly understood value proposition Knowledge of industry Realistic analysis of potential market Ability to protect intellectual property/patents Customer references

Key area- Strong Management Team

Experience

Entrepreneurial Industry Board of Directors Board of Advisors

Advisors

Professional service providers

Lawyers Accountants Consultants

Key area- Exit Strategy

Venture companies are not lifestyle companies Know your exit before you enter Exits change with the marketplace Advisors and board are critical Company structure can help or hinder No exit strategy = no venture money

Legal issues & Investment Capital

Securities act of 1933 exempts offerings of private securities from registration (no more than 500 shareholders) Regulation D Rule 501 defines accredited investors and excludes these investors from the count Rule 504 & 505 also exempt small offerings (less than $1m & $5m)

Legal issues & Investment Capital

Even if exempt from registration:
Disclosure is still necessary Cant advertise the offering Must document solicitations

Firms prepare the Private Placement Memorandum

PPM
Mission/objective Capitalization & shareholders Company & Management (mini Bus plan) Financial Legal Exhibits

Legal issues & Investment Capital

VCs will want all of the following issues resolved before investing. Angels, depending on sophistication, may want some or all of these issues resolved before investing. What isnt resolved will be resolved using proceeds of the financing round. The more that is resolved ahead of time, the greater the proceeds available from the deal. (The lawyers and accountants get you now or they get you later, all we know for certain is that eventually they do get you).

Selecting a Business Entity

Sole Proprietorship General Partnership Limited Partnership Limited Liability Company Subchapter S Corporation Subchapter C Corporation

Factors to Consider
Start-up Economics (NOLs) Projected Growth Exit Strategy Limited Liability Employee Incentives Tax Issues

PROS

Limited Liability Company

CONS

Flexible structure Can have different classes of stock, different rights & allocations Owners can be persons, corporations or other LLCs Conversion to corporation easy Familiar structure for foreign investors (GmbH, SARL) Partnership tax treatment Can convert to C Corporation without adverse tax affects

Body of law not well developed No stock to use for options Not attractive structure for institutional investors Many states require 2 members (not DE or NY) Death of member may affect continuity All income may be subject to selfemployment tax

Subchapter S Corporation
PROS
Security of corporate structure Well defined law on corporations Death of shareholder does not affect continuity of company Qualified tax exempt entities can be shareholders Can have corporations and LLCs as subsidiaries Partnership tax treatment Only salary (not profits) subject to self-employment tax

CONS
Can have only 75 shareholders Can have only 1 class of stock No foreign investors Only for qualified small business corporations Not suitable for institutional investors Limited employee benefits to large shareholders Conversion to LLC requires liquidation and adverse tax effects Issues on conversion to C corporation Limited flexibility on allocations of income, leases, credits and deductions

Subchapter C Corporations
PROS
Limited liability for shareholders Maximum flexibility on classes of shares, liquidation preferences, voting rights Preferred investment choice for institutional investors Suitable for initial public offering Stocks options available No limit on number or type of shareholders Well-defined law on corporations Most favorable structure for employee benefit plans

CONS
More formalities - Board meetings, shareholder meetings, voting issues, etc. Double taxation on dividends (but rate reduced to 15%) Limits on how much of earnings can be retained in closely held companies Limits on level of salary to avoid dividends of closely held companies No pass through of net operating losses to personal return

Additional Start-Up Considerations

Selecting a Name
Secretary of State clearance Web site clearance Trademark clearance

Additional Start-Up Considerations

Partnering Issues (should be settled up-front)
Management roles Ownership Buy/Sell rights Death, Termination, bankruptcy Put and Call rights Valuation (Book value, EBITDA, appraisal)

Additional Start-Up Considerations

Promises to Initial Investors
Anti-dilution rights Percentage ownership promises Options

Additional Start-Up Considerations

Employment/Consulting Agreements
Term, Compensation, Non-Compete Assignment of Intellectual

Intellectual Property Strategy

Additional Start-Up Considerations

Professional Management (know your limitations) Attracting Board Members- not Grandma!
Industry Contacts Professional Managers D&O Insurance

Advisory Board

Intellectual Property May Well Be Your Companys Most Valuable Asset

I.
II.

Identify and Understand What Types of IP Exist

MAKE SURE YOU OWN IT! Investors will insist the entity own the IP rights!

I. Identify And Understand What Types Of IP Exist

If you are purchasing assets for your business, understand what you are buying and make efforts to acquire clean title.
Which of the following types of intellectual property are you acquiring? A. Trademarks and service marks? A company name? A product name? Copyrights? Manuals accompanying instrumentation? Computer programs protected by copyright? Web page design?

B.

I. Identify And Understand What Types Of IP Exists

C. Trade Secrets? Know-how associated with a developed technology that you are acquiring? D. Patents? Granted patents? Applications pending? International filings? E. Do the due diligence associated with each IP asset. Is the title conveyed by the seller clear? (e.g., have inventor assignments been recorded for patents?) Is the trademark registered? Foreign registrations? If you are acquiring any IP via a license, understand the scope of the licensed field. Exclusive or nonexclusive?

I. Identify And Understand What Types Of IP Exists F. Does the seller have any knowledge of infringement claims by a third party (i.e., does the IP you are acquiring enjoy freedom to operate?) G. If you are acquiring patents, are there government interests?

II Make Sure You Own It

Insure that you are creating a clean ownership record for your patents

Assign the patents to the business Insure that all inventors execute assignments Record all assignments at the USPTO

Use employee agreements for all employees. Use confidentiality agreements.

Use consulting agreements- Work for Hire.