Partners and Investors
At some time during the life of your business, you may need capital to start the company, continue the enterprise, or make it grow. This capital can come from a variety of sources, such as:
The purpose of this article is to assist you in deciding how to go about selling an equity interest in your business to investors and raise the capital you seek. This workbook is intended to be only a general discussion of this very complex topic; it is not a substitute for, and is not intended as, legal or financial advice. Any company contemplating a securities offering must obtain the advice of competent professionals.
This workbook discusses the essential issues that you may confront when you decide to bring in outside investors. Although most of the discussion centers around presenting a corporation to investors, the same issues challenge businesses organized as limited partnerships or limited liability companies.
This module covers:
I. Initial Considerations
Not all businesses - or business owners, for that matter - are attractive to or appropriate for outside equity investment. There are several important issues you must consider before bringing in third parties. For example, if you are not comfortable being second guessed when making pivotal decisions, having contractual limitations on decisions such as whether to incur debt or extend credit, and answering to your company's board of directors, outside investment will be a no-win situation for you.
Because some entrepreneurs are not suited to investors, there are numerous instances of long-term relationships have soured, families have been divided, and former friends have become bitter enemies. You must be honest with yourself at the outset. There are other appropriate funding sources available.
Strategic planning is also an important element to consider at the outset. Without a business plan, neither the business owner nor the investor knows where the business is going, how to value the business, or how to determine success, so be prepared to write an in-depth business plan that will be closely scrutinized.
For help in determining if taking on outside investors is right for you and your business, see Growing With Partners and Investors.
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II. Preparing for the Challenge
Before approaching anyone about investing in your business, you'll need to go through certain exercises and prepare certain documents that are "ready for inspection" by an outsider. The term "ready for inspection" means that you, with your accountant and attorney, have drafted, tested, challenged and redrafted a strategic business plan containing financial projections supported by reasonable assumptions, spelled out in detail. This business plan should be as perfect as humanly possible. It must be custom-designed for your business. A "cookie-cutter," one-size-fits-all, off-the-shelf model just will not do.
"Strategic planning" means just that: The business plan should show where you intend your business to go and how you intend to get there. Although preparing a business plan is a useful exercise for any business, it is a key element in any presentation to outside investors or other funding sources. The business plan should also contain a realistic picture of the status of the business, ambitious but attainable goals for the future, and an outline of the steps necessary to reach those goals. It should describe the markets the company is targeting, the realistic percentage of the market the company expects to capture, the costs of providing the company's product or service, the price at which the products or services can be sold, and the gross revenues and net profits the company expects to earn. The plan needs to show an intimate knowledge of your current and potential competitors, including their products, their strengths and their weaknesses. Please note that you must tailor the business plan to your own circumstances. Your professional advisors can assist you in that process.
There is nothing more annoying to a potential investor than to waste his or her time reading a business plan with many typographical errors. Beyond this obvious example, there are a number of things to double check before you distribute the business plan.
Use the following checklist to assist you:
During the development of your business plan, you may uncover weaknesses within your company that need to be addressed. Perhaps the management team is somewhat inexperienced, or perhaps the financial statements show a history of unpredictable results, or maybe it is unclear what the company's vision is. No matter what issues are uncovered, the time to correct them is now before you make a presentation to prospective investors: Add the appropriate team members, get your finances in order, and ensure you're giving off the appropriate impression. Some of these corrective actions may take longer than you'd hoped for, and in some cases, it may be necessary to delay approaching investors until you've had time to complete them.
Once the initial business plan is ready, you should allow your most skeptical advisors to review it and to find the holes in the plan. Ask them to look for unclear objectives and the unspoken assumptions. At this point, every statement of fact, every assumption of the projections and every calculation must be subjected to rigorous inspection, because once you present the plan to investors, it is too late to catch any mistakes. With many investors, you will have only one opportunity to state your case. If you fail because of a careless error or an unclear idea, you have lost that opportunity with that investor for good. Only a fraction of the good business ideas presented to investors are funded. Your goal must be to make it past the first round of scrutiny and get as far as the in-depth review.
Ask yourself the following questions to determine whether you are prepared to approach investors.
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III. Stalking Investors - Different Species and Different Diets
Finding investors is like hunting wild game: You need to learn where your preferred prey lives, what it consumes, and what attracts or repels it. Most importantly, you need to know what to use for bait! All hunting metaphors aside, this discussion assumes that you will prepare all the necessary legal documents to offer securities properly to investors.
If your company is a start-up with limited or no assets or track record, investors will invest on the strength of their prior business or personal relationship with you. Although you must provide these investors with the full complement of information, they will look to you to make sure that their investment is safe. More than any other investors, they are investing in you. These persons are not investment professionals. Who are these "personal" investors? They can be:
On the positive side, these investors will not be relying on the business's record (or lack of one) to make their investment decision - they are counting on their experience with you. Although you should approach every investor in a business-like manner, the basis of the relationship will determine the manner in which you approach your investors. Simply put, you can invite family and friends into the deal in a less formal way than former employers, customers or other business acquaintances. Business relationships are extremely useful, since not only will a businessperson have a better appreciation of what you are trying to accomplish, but in light of their personal stake in your business, they may be able to recommend your business to others and be able to offer you practical advice.
In the minus column, personal investors, as stockholders, can be difficult to manage since they can sometimes believe that their personal relationship gives them rights not enjoyed by all stockholders. They may want you to guarantee their investment in some way. They may expect inside information on the company's progress. They may expect preferential rights if the company is sold or goes public. They may expect you to drop whatever you are doing when they call or they may stop by unexpectedly. The only way to handle these expectations is to nip them in the bud. As with all investors, choose them carefully.
In my experience, the worst investor in any deal was a distant relative of a business owner who initially begged to be a part of the business. This person pleaded to have the minimum investment requirement waived, then proceeded to badger the business owner, complain to other family members, and demand the investment back. The company offered a full return of the money invested, plus interest, which the investor declined in writing.
Unfortunately, this company fell on hard times, and the investor filed complaints with the securities authorities of the state, the consumer protection office and the Securities and Exchange Commission. Luckily, the company preserved all of its correspondence with the investor, so all of the complaints were dismissed. However, this investment cost the company far more than the money invested by the small investor.
It is typically difficult to raise significant capital from one's family, friends and business acquaintances; therefore, when a company needs to expand or acquire a business, professional investors are vital. As a result, many business owners look to high net worth individuals who invest in speculative companies to bring their company to the next level. These "angel" investors are often successful businesspeople who have retired from active management of an entrepreneurial company they founded who want to make money and regain some of the excitement of a start-up business without necessarily being involved in its management.
Angel investors typically are willing to invest early in the life of a business, but they want to see significant investment of time, effort and financial resources by the entrepreneur. These types of investors usually keep their investments limited to specific areas of business in which they have some expertise. Angel investors often want significant control over how money is spent, a say in the company's choice of attorney and accountant, and at least one seat on the company's board of directors.
The route to angel investors is often through personal contacts in the business world, including attorneys, accountants and other investors. Many cities have groups of entrepreneurs that sponsor presentations by companies seeking investors. These meetings are a good source of contacts. As with the business plan, meticulous attention to detail is key, since these investors have numerous investment options and use these presentations to weed out the vast majority of possible investments.
Venture capital investment has changed since the term was first coined. Initially, venture capital was regarded as early stage investment in start-up companies. As businesses and technology became more complex, and more established companies looked to raise venture capital funds, venture capital has evolved into a middle-stage financing option for companies that intend to go public or be acquired in a three- to five-year period. The term "venture capital" usually refers to investment funds managed by investment professionals specializing in evaluating growth companies in specific industries. Some large corporations also have venture capital investment arms. Venture capital firms solicit funds from investors with the object of investing these funds in emerging companies and benefit from their growth.
A number of directories list venture capital firms and are available at your public library. Most venture capital firms concentrate their investments in specific industries, which are noted in the directories. Because venture capital firms are listed in public directories, they tend to get substantially more financing proposals than they could possibly fund. Thus, venture capital funds tend to drive very hard bargains when it comes to financing. As a rule, venture capital firms demand (and get) substantial financial and management control. Venture capital firms generally look for 50 percent per year returns, with a definite exit strategy.
Some popular online VC directories include:
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IV. Information Required and Protecting Confidential Information
Now that you have staked out your prey, what do you use for bait? In other words, what information should you use to entice your prospective investor?
Earlier, we discussed writing a business plan. When soliciting funding from banks or venture capital funds and, to a lesser extent, angel investors the business plan is the essential document. We have also addressed the importance of accuracy and testing the information. If done well, the business plan will give an investor or lender a very good idea of your business concept, how you expect to profit, your proposed or current pricing structure, costs of materials and production, profit margins and overhead. Although this information is vital to allow an institution or sophisticated investor to evaluate your business, it would also be extremely valuable to any current or possible competitors. For this reason, you need to protect this information from unauthorized use, disclosure or reproduction.
As much as the product or service you sell, information is a valuable commodity. If you have done it right, you have spent substantial time, effort and legal and accounting fees drafting, revising and polishing your business plan. Before you release this information to anyone not already under an obligation to keep the information confidential, you must ask them to sign a confidentiality agreement, which requires them to keep the business plan and any other information you give them confidential. Such an agreement is designed to give you the ability to prevent unauthorized use of the information, or at least give you grounds for a lawsuit should that occur. Just as important, consistently requiring all persons who receive confidential information to sign confidentiality agreements proves your intention to keep the information confidential. A legal professional can assist you in developing an airtight confidentiality agreement.
In addition to a confidentiality agreement, but not in lieu of one, the most effective way to prevent unauthorized use of confidential information is to be very selective in the people to whom you give the information. You should distribute your business plan in numbered copies on a need-to-know basis. If a funding source declines to invest, you should request that the business plan and any supporting documents be returned.
If you are seeking equity financing (i.e., selling part ownership of the business in the form of stock) or debt financing from more than one source, your company is making an offering of securities, and compliance with the state and federal securities laws is required. (See Section IX: Securities Law Disclosure and Filing Requirements).
Depending on the type of investor you solicit, you may be required to prepare additional documents that contain disclosure required by law. You may also be required to file notices with federal and state securities authorities. Many of the requirements are highly technical and are beyond the scope of this discussion. You should consult a competent professional before making any offering of securities.
Approaching individual investors, as opposed to institutions for debt financing, requires compliance with state and federal securities laws. This is required whether you are seeking debt or equity financing. The types of disclosures required under federal and state law are determined by the types of persons you solicit and the amount you are seeking to raise. In its Small Business Initiatives, the SEC adopted rules to simplify the capital raising process and make it easier for small businesses to raise a limited amount of funds. As noted above, the technical requirements of federal and state law are beyond the scope of this discussion. However, note that the main requirements are full and fair disclosure of all material facts regarding the issuer and the risks of the investment, along with specified financial information.
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V. The Presentation
Assume your business plan has attracted the interest of an angel investor or venture capitalist, who now requests a meeting. How do you prepare yourself to distill a 75-page business plan into a 20-minute presentation? The answer is, you will have to omit extraneous details and present only the most essential points. They include:
Avoid the tendency to give a verbal version of your business plan. While it's important to touch on the key areas in your plan as listed above, your mission during this meeting is to give the investor a dynamic insight into your commitment to the business and the skills of your management team. It is also a time to highlight your business's growth potential, and the means by which you will accomplish your goals.
Experts agree that investors make their decisions based largely on personal factors namely whether they like and believe in your team so you'll want to establish trust right from the outset. Try to gain rapport immediately by maintaining a confident, friendly demeanor, normal eye contact, and good posture and body language. To convey a knowledgeable image, you'll want to avoid awkward silences or fidgeting caused by your inability to answer questions; if you can't provide an answer on the spot, tell the investor confidently you'll get back to him or her as soon as you return to your office. He will likely appreciate your honesty rather than your trying to make up an answer to appease him.
You should attend the meeting with the top three people who will play a key role in the business: the CEO, the VP of marketing and sales, and the VP of business development. Be sure these individuals are presented in the best possible light, emphasizing their relevant experience and education. Although each person may not have a chance to add to the presentation, it is important that they are present to answer any questions that may arise concerning their areas of responsibility. Please note: Not all investors will insist that you have a management team in place. If they believe strongly enough in your idea, they may provide an investment with the stipulation that they will appoint some key team members to run the business.
Many people liken the investor-business owner relationship to a marriage it is that serious and that personal. So resist the temptation during your presentation to make things sound better than they actually are or to hide embarrassing facts. The investor will eventually uncover any such untruths anyway when he or she conducts due diligence, and at that point, even minor fibs can break the deal. Most VCs agree that learning about negative issues up front will not deter them from making an investment if a company presents a good return on investment and if the management team has learned from their mistakes.
During your presentation, you must also give your potential investor a means to evaluate your success, including measurable goals and timetables, and a clear plan for how your company will repay his or her investment, with appropriate returns given the risk. Investors will want to know exactly how you plan to accomplish your objectives and, as a result, exactly what return they can expect on their money.
Finally, you will want to make sure your presentation has pizzazz so it stands apart from the hundreds of others that the investor likely sees in a year. Consider using various technical elements that will give it a polished, cutting-edge feeling. You can turn any standard presentation into a multimedia show for investors for less money than you might expect.
Checklist: Common Mistakes to Avoid in your Presentation
At this point, you will understand the importance of avoiding mistakes and having a third party review the plan for gaps and inconsistencies. It is possible to be quite embarrassed at meetings such as this if you have not done a superlative job with the business plan, the presentation and rehearsal.
Keep in mind that, as in any marriage, both parties must feel that the relationship is a good match. So if you don't hit it off with your potential investor or if you feel that your business philosophies do not match, you can and should continue to shop around until you find the right person.
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VI. Valuation Issues
One of the most difficult questions a business owner must ask is, "What is the value of my business to investors?" This is especially problematic in the case of a start-up business with no assets and no history of revenues, since there is no track record by which to value the business. One method, and by no means the only method, is to use the company's financial projections and base the valuation on the present value of the projected earnings, multiplied by the average market multiple for similar public companies, with a substantial discount because the business is not public. Another method is to base value on the value of existing companies in the same line of business. As a third option, the company can use the present value of the company's projected cash flow.
As should be apparent, there is no recognized standard of value. Because of this, it is important not to have the value appear arbitrary. You should state the basis for the valuation and be ready to defend it.
Once you have settled upon a reasonable value for your company, the rest of the math is easy. If the company were valued at $2,500,000, $500,000 would equal 20 percent of the company. That is where the bargaining begins.
For an expanded discussion on this topic, see Valuing a Business.
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VII. Negotiating the Deal
The terms of the deal are based on the relative strengths of the parties. To the extent that your company needs the investment urgently, you are at a disadvantage in dealing with investors. To the extent that you can say no to an investor, your company has leverage. Companies, especially startups, are in a better position dealing with personal investors rather than angel investors or venture capital firms. Generally, friendly investors will allow the company to set the terms, then they will either take it or leave it.
At the other extreme, venture capital firms generally drive extremely hard bargains when making investments. These firms do their own valuation analysis, which usually comes in less than that of the company. They may also require voting control, and set severe limitations on the company's ability to spend money, go into debt, or make other major management decisions. Many firms make their investments in stages, with greater equity going to the investor if the company does not achieve certain goals. Investments may be structured as a preferred stock, convertible at a formula into common stock, giving the investor greater control of the company if financial goals are not met. These formulae can be very complex. As a rule of thumb, most venture capital firms require a 50 percent return per year on the initial amount invested. These firms also often require liquidity within a definite period.
Somewhere in the middle lies the angel investors. They also drive a hard bargain when making investments, but their expectations and investment requirements can be idiosyncratic. Many want the right to nominate persons to the board of directors, or pick persons to fill certain positions, such as CFO or outside accountants or attorneys. Angel investors are usually less explicit as to their bottom-line requirements, which may vary from deal to deal. They usually want to be more involved in decision making, often taking on an advisory role. However, it is difficult to generalize.
No matter what type of investor you're dealing with, you can expect some intense negotiations, which are best handled by an attorney who can protect your best interests in the process.
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VIII. Legal Rights of Investors and Management's Responsibilities
The law of the jurisdiction in which the business is incorporated governs stockholder rights, and specific rights vary somewhat by state. Rights of equity owners in limited partnerships and limited liability companies also vary by state and are affected by the governing documents of the entity. In general, stockholders have the right to call an annual meeting if the board of the company fails to do so within a certain period. Stockholders have rights, determined by the company's formation documents, to vote for members of the board of directors and to vote on certain fundamental changes in the corporation, such as mergers, dissolution and the like. Founders have several mechanisms available to limit these rights before bringing in outside investors. Under certain circumstances, governed by state law, stockholders may also request a look at the company's books and records, and may request a list of stockholders.
More importantly, management has the responsibility to act as trustees for the investors' funds and must use such funds for the purposes disclosed to stockholders. Management must run the company for the good of all stockholders and not in a way to benefit particular stockholders (such as the founders). Management may not enrich themselves at the expense of investors, nor may management take business from the company for their own benefit. For example, suppose X Company manufactures bicycles, and Y Corp. proposes to buy them for a certain price. An officer or director of X Company may not go directly to Y Corp. and offer to sell the same bicycles for a cheaper price. If management misuses funds or otherwise violates its fiduciary duty to stockholders, stockholders may have a right to bring a lawsuit in their own names or on behalf of the corporation against management. These rights vary by state and are limited by recent federal law on stockholder suits brought under federal securities laws.
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IX. Securities Law Disclosure and Filing Requirements
As noted above, the company has the obligation to give prospective investors all material information regarding the company, its management, its proposed business and its uses for investors' funds, along with historical financial information. In addition, the company may not commit fraud by intentionally misstating information or omitting facts necessary to understand the investment. Federal securities laws as well as state securities and antifraud laws impose this requirement. Note that the disclosure required by the securities laws is different from the material in the business plan. The placement memorandum normally follows a prescribed format and places great emphasis on the risks of the investment. The technical requirements imposed by federal and state law are beyond the scope of this workbook.
Federal and state law provide several different exemptions, and the scope of required disclosure and filing requirements vary based on the amount sought to be raised, the financial status and sophistication of the investors, the states in which the investment is to be sold, and the methods used to sell the proposed investment. Federal and state laws may impose filing requirements before any offers or after sales are made. Laws and regulations may limit use of certain information, such as financial projections. In addition, securities laws are in constant flux due to amendments, administrative actions and case law interpretations. Please consult competent professionals before offering securities to any investors.
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James Arkebauer, "The McGraw-Hill Guide to Writing a High-Impact Business Plan," (McGraw-Hill, 1998)
Pratt & Bokser, "Pratt's Guide to Venture Capital Sources: 1998," (1998)
Patrick J. Coveny, "Business Angels: Securing Start-Up Finance," (John Wiley & Sons, 1998)
William Stolie, "Start-Up Finance: An Entrepreneur's Guide to Financing a New or Growing Business," (Career Press, 1997)
ACE-Net, the Angel Capital Electronic Network
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