Issue No.07 - July (2012 vol.45)
Published by the IEEE Computer Society
Brian M. Gaff , Edwards Wildman Palmer LLP
Richard N. Kimball , Edwards Wildman Palmer LLP
Jill M. Hanson , Edwards Wildman Palmer LLP
DOI Bookmark: http://doi.ieeecomputersociety.org/10.1109/MC.2012.240
The seventh in a series of articles providing basic information on legal issues facing people and businesses that operate in computing-related markets explores ways to raise capital. An audio podcast is available at http://youtu.be/3lYpjoONWn8. It provides basic information on legal issues facing people and businesses that operate in computing-related markets that explores ways to raise capital.
Like all start-up companies, new companies in computing-related markets need to raise capital. That can be a daunting prospect, especially for those entrepreneurs new to the capital raising environment. In this month's installment in this series of articles, we focus on where to find capital, how to get it, and the pitfalls to avoid.
Be sure to check the IEEE Computer Society's website for the podcast that accompanies this article ( www.computer.org/portal/web/computingnowcomputing-and-the-law).
Sources of Capital
If you recently started a new company, you may be asking yourself how you're going to go about finding capital to get this company going. Obviously, you can use your own funds, but if you're like most entrepreneurs, that's not the most viable option.
Luckily, there are many other sources of capital available to start-ups, such as angel investors, venture capitalists, friends and family, government programs, incubator programs, peer-to-peer lending, and venture lending. The type of funding you seek will vary depending on how much you're raising, whether the deal is equity or debt, what kind of rights the investors will be given, and the company's valuation.
When considering raising capital, most people immediately think of angel investors and venture capitalists. Angel investors will either invest alone or with a prearranged group of other angel investors, while venture capital firms will invest by way of one or more of their fund entities.
Venture capitalists will expect preferred stock. Angel investors will be more willing to accept common stock or convertible promissory notes. Preferred stock is more beneficial to the investor as it provides dividends, liquidation preferences, and anti-dilution protection to the extent there are future rounds of financing with other investors where equity is sold at a lower price.
Another common way to raise early-stage capital is through your friends and family. While many start-ups do this, not all do it right. Any money that a friend or family member gives to the company must be properly documented—failure to do so could come back to haunt the company when a future investor does diligence on the company. The last thing you want is to put your friends or family in a precarious position or spend a lot of money on lawyers cleaning up problems down the road. This is a good reason to get lawyers involved from the beginning, regardless of the type of funding you obtain.
If seeking funding from friends and family isn't an option, there are also incubator programs. These programs are designed to give start-ups support for the successful development of the company through an array of business resources. Many programs are run through successful companies or universities. Your lawyers, accountants, bankers, and financing intermediaries should be good sources for leads about incubator programs.
A less recognized source of capital is government funding. Several government programs are available to start-up companies around the world. Typically, these programs are tailored to certain industries or the company's size, but they're well worth the time it will take to prepare an application.
Governments aren't looking for equity as the're more interested in the company following the rules of the award to benefit the government. In the US, a good resource for government funding is www.sba.gov; in the UK, it's www.businesslink.gov.uk.
As commercial banks aren't in the habit of lending money to start-ups, peer-to-peer lending, a new funding resource, has begun to surface around the globe. This new form of lending is facilitated through websites devoted to matching investors with individuals or companies looking for capital. The interest rates are typically higher than with commercial banks, and the length of the loan is typically shorter; however, peer-to-peer lending is still a viable option for companies that need a quick influx of capital.
A more established practice is venture lending. Usually, the venture capital firm will accept the company's equipment or other assets as collateral for the loan. Again, the interest rates will be a bit higher than a more established company would receive from a commercial bank, but this option allows a start-up company to get capital quickly.
When approaching investors, you need to give some thought to how involved you want them to be and how much control you're willing to give up.
Angel investors tend be somewhat hands off compared to venture capital firms, which prefer to behave more like a partner. VC firms typically will seek a seat on the board of directors in addition to taking stock in the company.
Securing investments from friends and family tends to be more complicated. Often, an entrepreneur receives money from friends or family members only to have them interject their opinion on how the company should be run. While this type of capital raising shouldn't be discouraged, it's necessary to approach it with kid gloves.
Finally, it shouldn't come as a surprise that money awarded from government programs will come with rules for what you can and can't do with the money.
A common pitfall of start-ups is failing to spend just as much time networking to meet potential sources of capital as on developing the company itself. It's a struggle for all entrepreneurs, but it must be done.
When pitching to investors, there are a few things to consider that will help increase your chances of securing capital. First, make sure that your business plan has been accurately and succinctly converted into a pitch presentation. The milestones that you discuss inside the company need to be clearly laid out in your presentation. Nothing turns off an investor more than a founder's inability to communicate a vision of where the company is going over the next several years.
Make sure you've clarified how much money you'll need and why. A common mistake is asking for less money than is needed because you have based your economic model on best-case scenarios rather than worst-case. That being said, don't overask so that you can't justify why you need the money and where it would go. Investors will work with you to find a number that works for both of you, so try to balance being realistic with making sure you cover your expenses until the next milestone.
Once you've found an investor, you'll need to negotiate and agree on a term sheet. This document specifies the material terms and conditions under which an investor is willing to make an investment. It typically consists of three sections: funding, corporate governance, and liquidation.
Funding will discuss the investment amount, the agreed-on valuation, antidilution provisions, and the ownership claims the investor receives in exchange for the investment. Corporate governance will address things such as the number of seats to be received on the board of directors. Liquidation will define certain rights such as the exit strategy, redemption rights, drag-along rights, and tag-along rights.
Some terms such as antidilution are considered standard, while others, such as the liquidation provisions, are heavily negotiated.
Navigating the term sheet negotiation process can be difficult for a new entrepreneur. Your best bet is to involve an experienced lawyer to help you protect your interests.
No matter what source of capital you pursue, raising it can be difficult.
The most important thing to remember when raising capital is that no matter how much you need the money, you shouldn't take it from any source if your gut tells you it isn't a good fit. While some investors will be more hands-off than others, they're all your partners, and you will have to answer to them. They need to agree with how you envision the company evolving.
While walking away from a term sheet might seem foolish, seasoned entrepreneurs will tell you that doing the deal and regretting it is worse than walking away.
Brian M. Gaff is a senior member of IEEE and a partner at the Edwards Wildman Palmer LLP law firm. Contact him at firstname.lastname@example.org.
Richard N. Kimball is a partner at Edwards Wildman Palmer. Contact him at email@example.com.
Jill M. Hanson is an associate at Edwards Wildman Palmer. Contact her at firstname.lastname@example.org.