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Funding For Early Stage Companies

Summary of the Symposium: Understanding the Full Funding Spectrum

October 26, 2012 – McLean, VA

I attended a panel discussion sponsored by Capital One Bank and The Community Business Partnership (cbponline.org) on the topic of Funding for Small Businesses. On the panel were representatives from standard banking, venture capitalists, angel investors and Virginia state-sponsored investing, non-traditional lenders from the non-profit and micro-lending communities, SBA lenders, and crowd funding experts.

Here are some of the highlights from the panelists:

• Crowd funding 

Crowd funding has been as much a marketing tool as a source of funding. But as a funding source it currently has two components:

– Pre-market sales in which customers pay now for future release of a product

– Gifts

With the JOBS Act, there is supposed to be a new component that theoretically would overshadow the first two:

– True “equity investors”

The JOBS Act accomplishes the last approach by changing the definition of “qualified investor” so that more individuals would become potential investor. However, many questions remain because regulators are not finished crafting the rules behind this funding source. [Note: Some say that the SEC, who is charged with crafting regulations, are in effecting gutting the intentions of Congress by attaching requirements that would negate all the positive effects of the legislation. Stayed tuned to see if the Executive branch of government will once again succeed in thwarting the intentions of the Legislative branch.]

Even without the uncertainty over regulations, crowd funding will pose challenges to companies who might require later rounds of financing. Later-stage investors will be wary to enter the picture if there are already too many early stage investors, and especially if the rights of those early stage investors preclude the effective control tat later stage investors need.

Conclusion: Tread gingerly into this area of funding.

• Standard bank investing

Banks do not want equity and they do not want to own your collateral. They want you to succeed in paying off your loan through positive cash flow. Here are some of the situations that generate an automatic decline of a loan application:

– The owner is not willing to invest in his own business

– No standard accounting practices

– The owner hasn’t taken the time to establish a relationship with the banker

– There is clearly no thought behind the application. In particular the application doesn’t show how will the money be used or how the company will generate enough revenue to repay the loan while paying the owner.

• Venture Capitalists

These are the late stage equity investors, the ones who look for the IPO or sale to a very large company for a lot of money.

There are many venture capital firms with different emphases, geographical preferences, sector preferences, and preferences on the stage or size that the target company is in. Companies who plan to approach VCs should do their own due-diligence on the potential investment company to make sure there is a fit.

Venture capitalists fund only about 0.1% of all the deals they receive. Grotech Ventures, represented by Steven Fredrick, says his firm prefers that initial correspondence be in the form of a 15-page Power Point presentation of the applicant’s company instead of a lengthy business plan (which they will request if they are interested). And you should approach VCs through someone they know and trust. Blind solicitations are almost never successful.

They’re in business to takes some risks, but they take as many precautions as possible to minimize those risks. You need to know the following:

– Their mission is to create value and make money for their investors.

– At least a $1 billion market, which the company thinks will reach at as much as 10% penetration

– They don’t like to see large number of early stage investors, so angels should form an LLC and use that as their investment vehicle if they intend to sell to VCs.

– What is important is transparency. No deal is perfect. They will find deficiencies, so you should be upfront about all hidden risks and problems.

– They must invest in C-Corporations, so plan to convert from LLC or S-Corp before coming to them.

– They use standard terms and boilerplate (some of which can be downloaded from NVCA.org). Only a few of those terms may be negotiated (importantly: valuation and dilution terms), but they always retain the right to completely replace the company’s management.

This last point is not a threat, it’s just business. Any owner who brings on equity investors must consider that the company goes from being “My Company” to “Our Company.” If the founder/owner of a company does not have the skills necessary to take his company to higher levels, he will be replaced. Owners who, for personal reasons, want to maintain control of a smaller company rather than retain a piece of a much larger one should not court VCs.

• Angel Investors

Typically invest $25k – $100k in return for equity, and they come in at an earlier stage than VCs. However their goals tend to be aligned with VCs because they typically sell their interests when the VCs arrive. Angels typically don’t have time to run a company, and they usually take a minority position, which means they rely on the owner and his management to grow the company to a point where the angel’s investment will pay off. Expect angels to fund good management.

• A non-profit lender: Virginia Community Capital

This organization in Virginia originates loans to underserved markets including main street businesses, turn-around and startup situations. It does NOT fund technology. Their sources of funds are patient and often look for companies that satisfy a “social interest.” Although Virginia is one of the few states that recognizes the B-Corp organizational status, VCC is not a B-Corp; however it is B-Certified.

•General advice to position your company for early-stage financing

The panel offered the following suggestions if you are interested in seeking early stage capital:

– Put some of your own skin in the game—bootstrap your company as far as you can.

– Make sure you assess your company’s future in a global economy.

– Demonstrate that you know you customer and how much they will pay.

– Think through you business model—have a PLAN.

– Don’t quit your day job until your business can pay you without an infusion of capital—investors want you to be paid from your business.

– Teams of people succeed far more often than solos.

– Investors typically pass on a deal if the team has major holes in marketing or accounting or management in general.

– Be able to educate your investors—that is, be thoroughly knowledgeable on your markets and the financials.

– Spend more time on the financial projections than on the narrative.

– Have regular meetings with your banker, who will help you organize your company to present well.

– Know what key metrics each investor you approach uses and address those metrics.

– It will always be very hard to obtain funding for certain businesses:

› Service companies that scale linearly with people or that are susceptible to having their people leave and compete;

› Industries with historically low multiples (the ratio of company value to company revenues).

 

Hopefully you are now armed with a little more information about how to position a startup for outside funding.

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