The Specific Issues Entrepreneurs Typically Face

You may find some subtle but highly significant issues negotiated. Much attention needs to be paid to the details. Some examples:

Cosale provision. This is a provision by which investors can ten­der their shares of their stock before an initial public offering. It protects the first-round investors but can cause conflicts with investors in later rounds and can inhibit an entrepreneur's ability to cash out.

Ratchet antidilution protection. This enables the lead investors to get free additional common stock if subsequent shares are ever sold at a price lower than originally paid. This protection can create a "dog-in-the-manger syndrome," whereby first-round investors can prevent the company from raising additional necessary funds during a period of adversity for the company. While nice from the investor's perspective, it ignores the reality that in distress situations, the last money calls the shots on price and deal structure.

Washout financing. This is a strategy of last resort, which wipes out all previously issued stock when existing preferred shareholders will not commit additional funds, thus diluting everyone.

Forced buyout. Under this provision, if management does not find a buyer or cannot take the company public by a certain date, then the investors can proceed to find a buyer at terms they agree upon.

Demand registration rights. Here, investors can demand at least one IPO in three to five years. In reality, such clauses are hard to invoke since the market for new public stock issues, rather than the terms of an agreement, ultimately governs the timing of such events.

Piggyback registration rights. These grant to the investors (and to the entrepreneur, if he or she insists) rights to sell stock at the IPO. Since the underwriters usually make this decision, the clause normally is not enforceable.

• Key-person insurance. This requires the company to obtain life insurance on key people. The named beneficiary of the insurance can be either the company or the preferred shareholders.

Sand Traps

Strategic Circumference

Each fund-raising strategy sets in motion some actions and commit­ments by management that will eventually scribe a strategic circumfer­ence around the company in terms of its current and future financing choices. These future choices will permit varying degrees of freedom as a result of the previous actions. Those who fail to think through the consequences of a fund-raising strategy and the effect on their degrees of freedom fall into this trap.

It is impossible to avoid strategic circumference completely. And while in some cases scribing a strategic circumference is clearly inten­tional, others may be unintended and, unfortunately, unexpected. For example, a company that plans to remain private or plans to maintain a 1.5 to 1.0 debt-to-equity ratio has intentionally created a strategic circumference.

Legal Circumference

Many people have an aversion to becoming involved in legal or account­ing minutiae. They believe that since they pay sizeable professional fees, their advisors should and will pay attention to the details.

Legal documentation spells out the terms, conditions, responsibili­ties, and rights of the parties to a transaction. Since different sources have different ways of structuring deals, and since these legal and con­tractual details come at the end of the fund-raising process, an entre­preneur may arrive at a point of no return, facing some very onerous conditions and covenants that are not only very difficult to live with, but also create tight limitations and constraints—legal circumference— on future choices that are potentially disastrous. Entrepreneurs cannot rely on attorneys and advisors to protect them in this vital matter.

To avoid this trap, entrepreneurs need to have a fundamental pre­cept: "The devil is in the details." It is imprudent for an entrepreneur not to carefully read final documents and very risky to use a lawyer who is not experienced and competent. It also is helpful to keep a few options alive and to conserve cash. This also can keep the other side of the table more conciliatory and flexible.

Attraction to Status and Size

It seems there is a cultural attraction to higher status and larger size, even when it comes to raising capital. Simply targeting the largest or the best-known or most-prestigious firms is a trap entrepreneurs often fall into. These firms are often most visible because of their size and investing activity and because they have been around a long time. Yet because the venture capital industry has become more heterogeneous, as well as for other reasons, such firms may not be a good fit.

It is best to avoid this trap by focusing your efforts toward financial backers, whether debt or equity, who have intimate knowledge and first­hand experience with the technology, marketplace, and networks of expertise in the competitive arena. Focus on those firms with relevant know-how that would characterize a good match.

Unknown Territory

Venturing into unknown territory is another problem. Entrepreneurs need to know the terrain in sufficient detail, particularly the require­ments and alternatives of various equity sources. If they do not, they may make critical strategic blunders and waste time.

An illustration of a fund-raising strategy that was ill conceived and, effectively, a lottery—rather than a well-thought-out and focused search—is a company in the fiber optics industry called Opti-Com.* Opti-Com was a spin-off as a start-up from a well-known public com­pany in the industry. The management team was entirely credible but members were not considered superstars. The business plan suggested the company could achieve the magical $50 million in sales in five years, which the entrepreneurs were told by an outside advisor was the minimum size that venture capital investors would consider. The plan proposed to raise $750,000 for about 10 percent of the common stock of the company. Realistically, since the firm was a custom supplier for special applications, rather than a provider of a new technology with a significant proprietary advantage, a sales estimate of $10 million to $15 million in five years would have been more plausible. The same advisor urged that their business plan be submitted to sixteen blue-ribbon mainstream venture capital firms in the Boston area. Four months later they had received sixteen rejections. The entrepreneurs then were told to "go see the same quality of venture capital firms in New York." A year later, the founders were nearly out of money and had been unsuccessful in their search for capital. When redirected away from mainstream venture capitalists to a more suitable source, a small fund specifically created in Massachusetts—to provide risk cap­ital for emerging firms that might not be robust enough to attract con­ventional venture capital but would be a welcome addition to the economic renewal of the state—the fit was right. Opti-Com raised the necessary capital, but at a valuation much more in line with the mar­ket for start-up deals.

Opportunity Cost

The lure of money often leads to a most common pitfall—the oppor­tunity cost trap. After all, an entrepreneur's optimism persuades him or her that with good people and products (or services), there has to be a lot of money out there with "our name on it." In the process, entre­preneurs tend to grossly underestimate the real costs of getting the cash in the bank. Further, entrepreneurs also misjudge the time, effort, and creative energy required. Indeed, the degree of effort fund-raising requires is perhaps the least appreciated aspect in obtaining capital. In both these cases, there are opportunity costs in expending these resources in a particular direction when the clock is ticking and the cal­endar pages are turning.

There are opportunity costs, too, in existing emerging companies. In terms of human capital, it is common for top management to devote as much as half its time trying to raise a major amount of outside capkal. Again, this requires a tremendous amount of emotional and phys­ical energy as well, of which there is a finite amount to devote to the daily operating demands of the enterprise. The effect on near-term per­formance is invariably negative. In addition, if expectations of a suc­cessful fund-raising effort are followed by a failure to raise the money, morale can deteriorate and key people can be lost.

Significant opportunity costs are also incurred in forgone business and market opportunities that could have been pursued.

Underestimation of Other Costs

Entrepreneurs tend to underestimate the out-of-pocket costs associated with both raising the money and living with it. Consider the incremental costs a firm must pay after it becomes a public company. The Securi­ties and Exchange Commission requires regular audited financial state­ments and various reports, there are outside directors' fees and liability insurance premiums, legal fees are associated with more extensive reporting requirements, and so on. These can add up quickly, often to $100,000 or more annually.

Another "cost" that can be easily overlooked is of the disclosure that may be necessary to convince a financial backer to part with his or her money. An entrepreneur may have to reveal much more about the com­pany and his other personal finances than he or she ever imagined. Thus, company weaknesses, ownership and compensation arrange­ments, personal and corporate financial statements, marketing plans and competitive strategies, and so forth may need to be revealed to people whom the entrepreneur does not really know and trust, and with whom he or she may eventually not do business. In addition, the ability to con­trol access to that information is lost.

Greed

The entrepreneur—especially one who is out of cash, or nearly so— may find any investment money irresistible. One of the most exhilarat­ing experiences for an entrepreneur is the prospect of raising that first major slug of outside capital, or obtaining that substantial bank line needed for expansion. But desperation may lead to taking the wrong kind of investment from the wrong kind of investor. If the fundamen­tals of the company are sound, however, then there is money out there, and it always pays to find the right source.

Being Too Anxious

Usually, after months of hard work finding the right source and nego­tiating the deal, another trap awaits the hungry but unwary entrepre­neur, and all too often the temptation is overwhelming. In this pitfall, entrepreneurs want to believe the deal is done with a handshake (or per­haps with an accompanying letter of intent or an executed term sheet), and they terminate discussions with others prematurely.

Take-the-Money-and-Run Myopia

A final snare in raising money for a company is a take-the-money-and-run myopia that invariably prevents an entrepreneur from evaluating one of the most critical longer-term issues—to what extent can the investor add value to the company beyond the money? It is a rash entre­preneur who takes the money even though he or she is unsure whether the prospective financial partner has the relevant experience and know-how in the market and industry area, the contacts the entrepreneur needs but currently lacks, or the savvy and the reputation that adds value in the relationship with the investor.

As has been said before, the successful growth of a company can be critically impacted by the interaction of the management team and the financial partners. If an effective relationship can be established, the value-added synergy can be a powerful stimulant for success. Many founders overlook the high value-added contributions that some investors are accustomed to making and erroneously opt for a "better deal."

Conclusion

Understanding how the capital markets determine valuation is the key aspect of raising money to grow your venture. When calculating the value of a firm, suppliers of capital must determine the probability that a company will achieve the growth goals to which they aspire. That is the heart of the risk return scenario. But remember, this is rarely a "fair fight." Small business owners only infrequently raise equity capital, while investors do so every day. The latter prefer staging their com­mitments, thereby managing their risk and preserving their options. Numerous potential conflicts exist between users and suppliers of cap­ital, and these require appreciation and managing. The economic con­sequences can be worth millions to founders. Successful deals are characterized by careful thought and sensitive balance among a range of important issues.

Deal structure can make or break an otherwise sound venture, and the devil is always in the details. The entrepreneur encounters numer­ous strategic, legal, and other "sand traps" during the fund-raising cycle and needs awareness and skill in coping with them.

While deal making is ultimately a combination of art and science, it is possible to describe some of the characteristics of deals that have proven successful over time:

They are simple.

They are robust (they do not fall apart when there are minor deviations from projections).

They are organic (they are not immutable).

They take into account the incentives of each party to the deal under a variety of circumstances.

They provide mechanisms for communications and interpretation.

They are based primarily on trust rather than on legalese.

They are not patently unfair.

They do not make it too difficult to raise additional capital.

They match the needs of the user of capital with the needs of the supplier.

They reveal information about each party (e.g., their faith in their abilities to deliver on the promises).

They allow for the arrival of new information before financing is required.

They do not preserve discontinuities (e.g., boundary conditions that will evoke dysfunctional behavior on the part of the agents of principals).

They take into account the fact that it takes time to raise money.

Notes

1. William A. Sahlman's "Note on Financial Contracting: Deals," HBS Note 9-288-014, Harvard Business School, 1987, p. 1, and "AMethod for Valuing High-Risk, Long-Term Investment: The Venture Capital Method," Note 9-288-006, Harvard Business School, 1987, have sig­nificantly influenced educators, entrepreneurs, and equity investors thinking about deal making.

2. HBS Note 9-288-014, pp. 35-36.

3. HBS Note 9-288-006, p. 56.

4. Ibid., pp. 58-59.

5. Ibid., p. 24.

6. ventureone.com/ii/2Q03FinancingRelease.xls.

7. Jeffry A. Timmons, "Deals and Deal Structuring" lecture, Babson College, Oct. 2002.

8. Bob Thomas, Walt Disney: An American Original (New York: Simon and Schuster, 1976), p. 276.

9. Herb Cohen, You Can Negotiate Anything (New York: Bantam Books, 1982), p. 15.

10. Ibid., p. 16.

11. Roger Fisher and William Ury, Getting to Yes (New York: Penguin Books, 1991), p. xvii.

12. See, for example, H. M. Hoffman and J. Blakey, "You Can Nego­tiate with Venture Capitalists," Harvard Business Review, March-April 1987, pp. 16-24.

13. Fisher and Ury, Getting to Yes, p. xviii.

14. Paul B. Brown and Michael S. Hopkins, "How to Negotiate Prac­tically Anything," Inc., Feb. 1989, p. 35.

15. Jeffry A. Timmons, "Deals and Deal Structuring" lecture, Babson College, Oct. 2002.

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