Getting Funded

This is a puzzling dilemma for many entrepreneurs looking to finance their start-up in today’s economic environment. TCN recently hosted an expert lunch with sponsor Silicon Valley Bank around this topic, covering the basics of venture debt financing. Brad Holt, a Relationship Manager at SVB, was the featured speaker and provided the following insights:

What is Venture Debt? Venture Debt is also known as early-stage term debt in a start-up. Venture debt is generally utilized by companies that are venture backed, and want to prolong their equity and enhance their valuation. To put this into perspective, Brad placed venture debt slightly above angel investments and slightly beneath venture capital in regards to the size of investment on what he calls “The Money Food Chain.” In regards to cost of capital on The Money Food Chain, venture debt is classified quite a bit below venture capital and angel investments. Based on this, venture debt provides a lower investment but also yields a lower cost.

When determining whether or not to back a company, SVB has a credit model that varies slightly from the traditional credit repayment model, which looks at cash-flow and hard assets as sources of repayment. SVB primarily looks at cash-flow from future equity as a primary source of repayment. Their job is to judge the probability that investors will provide additional equity sufficient enough to support the business as well as repay the loan. Should this fail, SVB looks next at enterprise value, rather than more the more traditional kinds of collateral. Their job is to determine the probability that the value of the business, including the customer base, licenses, intellectual property and other assets is sufficient enough to repay the loan should future financing fall through. Brad also highlighted other types of loans, including working capital lending, in which cash-flow and collateral is examined only within the working capital cycle, looking strictly at accounts receivable. When utilizing this method, SVB is taking less venture risk, but rather taking performance or business risk.

So how does an entrepreneur benefit from taking debt, rather than taking on additional equity? When an entrepreneur decides to forego equity and pursue debt financing, they not only receive the benefits of debt financing, such as a fixed cost and creditworthiness with vendors and suppliers, but also it allows them to maintain control of their companies as opposed to venture capital and other forms of equity financing which can be dilutive and result in less control of the business.

Directors and Officers Insurance may not seem like a topic that you have to worry about, but after hearing some statistics you may think twice. The Capital Network (TCN) recently hosted a lunch with sponsor Mason & Mason Assurance Group, featuring two key speakers.

Jordan Hershman, a partner at Bingham McCutchen offered some crucial statistics as to how important D&O Insurance can be. For example, 31% of private companies do not obtain D&O Insurance because they think their D&O risk is low or none, when in reality, 40% of companies with 250+ employees have faced a D&O lawsuit. Because D&O Insurance involves a lot of lengthy litigation that varies from state to state, Jordan made sure to emphasize the critical factors in Indemnification under Massachusetts law.

• In MA, indemnification will not be provided to any person who is found not to have acted “in good faith in the reasonable belief that his action was in the best interest of the company” (MA Indemnification Law); meaning that any person found to have acted in a way that was harmful to the company or beneficial to themselves will not be provided with indemnification
• D&O’s are liable if they are found to lack requisite care of the company; i.e. due to negligence and failure to keep up to date with company information to make the most optimal decisions for the firm
• Shareholders of a firm do not only have a responsibility to act in the best interest of the firm, but also have a duty to each other. The majority shareholders owe fiduciary duty to the minority shareholders.

Not only do directors and officers face risks, venture capitalists invested in a company can easily face similar risks. A company is not required to provide indemnification; therefore, as a director or officer you want as much indemnification as you can get.

Offering a deeper dive into the specifics of D&O policies was Steve Schoenberger, an account executive at Mason & Mason Assurance Group. Some key pointers on selecting a D&O Insurance policy are below:

• When choosing a firm, be sure to check their D&O insurance policy. Policy’s should have past, present, and future coverage during your time with the company. Policies also expire after 1 year, so be sure the policy is up to date.
• When looking for a policy, look for one with as few and as narrow exclusions as possible. Some exclusions to watch for: fraud & intentional act exclusions, IP exclusions, and products, liability, bodily injury, and pollution exclusions. Also, beware of exclusions that prevent protection against disputes between two people in the same company.
• When looking at exclusions, terms should say “exclusions for” versus “exclusions arising from or attributing to” because the latter is vaguer and can leave you open to a variety of risks.
• Be sure to be familiar with the policy’s reporting procedure at all times. Don’t risk reporting a claim too late or to the wrong person because the policy may not cover an incorrectly reported claim.

While D&O Insurance can seem daunting, it is well worth the effort to know your firm’s policy in the event that it ever needs to come into use. Being well prepared for problems that may arise is your best method of protection as a director or officer.

They say taking venture capital is like getting married. That’s true with all of the possibility for amazing success and radical failure that it implies. So how do you avoid staring deeply into a partner’s eyes (that once, maybe not so long ago, held so much affection and promise) and seeing disappointment? Or worse, seeing the desire for you to move out? Well, like any good relationship, it all begins with a few critical things: Passion, Leverage, Dating and a Good Lawyer.

Passion –When looking at a sea (okay, maybe a pond) of potential investors, you definitely want to start with the ones who are as passionate about your venture as you are. Early stage investors should show you some love on your first date. If they don’t get you, you shouldn’t want them. Just like dating, you can’t logic your way into someone’s heart. While you can definitely act in ways to eliminate the passion, there is very little you can do to convince someone who is “just not that into you.” So find a date with an investor who cares about your sector, or who loves your customers, or who loves your technology, or who at least loves you. If you don’t share the passion, it will be hard to weather the storms that are likely to come.

Leverage – Let’s face it – everyone would rather be chased by prospective suitors than to have to do all of the chasing. If you have identifiable customers with significant business pain, a killer solution, a fantastic value proposition, a proven business model, a large and growing market, a defensible competitive advantage and are led by an experienced team, then you WILL have investors coming to you. The stronger your venture, the more you can select marquee VC firms and have better opportunity to keep valuations high, and draconian performance milestones low. You will be able to resist deal terms that may leave you vulnerable to firing, or which may be painful to your Angels who backed you from the get-go. In Seinfeld-Language, who’s got more “Hand” will tell you a lot about how your potential relationship is likely to play out. So just like before dating, get a haircut, buy some nice clothes, think about your profile, and above all, create a valuable business that is in high demand — because being one of the pretty ventures definitely has its advantages.

Dating - You should definitely date. Even if you are very young startup – go date. If you are desperate and marry your first investor suitor, you won’t know much about your new partner – and you won’t know how they compare to other possible investor mates. If you wait too long until you are in financial distress, you will wind up in the disempowering world of the arranged marriage (also known as the recapitalization) – not something likely to turn out well.

So, date! Find out if your potential investors have good reputations around town. Ask around – just like you would of your friends about prospective life partners, fellow entrepreneurs, lawyers and angels will have useful information about the reputation of your potential venture mate. Do they support their investments? Are they financially strong? Are they in fact smart money providing you leverage and reach into your customers or strategic partners? Will they step up for follow on investments? Do they work with and help grow Founders, or do they have a pattern of bouncing the founders at the first opportunity? Do they value the risks taken by your Angels? Does your venture fit into their long term portfolio strategy or are you just the soup-de-jour? By spending time comparing possible mates, you ensure that you understand how your partner will likely act when the inevitable hard times arise. Because they will.

Lawyers – Okay, so without an excess of cynicism, I hope you will agree that things do in fact go wrong. Didn’t you ever look back and think: “but s/he seemed like such a good fit at the time – they were passionate, had a good reputation and offered a great partnership.” And because you didn’t want to scare off this once oh-so-desirable partner, the mantras were “trust me” and “we’ll work out the details later.” And then, of course, things went wrong. In fact, in business, things ALWAYS go wrong – it’s a question of how often and how bad. Like the old military parable, no business plan ever survived contact with the marketplace! So unlike in love, your lawyers are not just useful – they are a necessity. Because there is a thin line between love and corporate warfare.

Lawyers will help you understand the deal, the risks, possible solutions (the Solomonic opportunity of splitting the baby), and your obligations to your team, angels, customers, lenders etc. By the time you actually enter into the partnership you should be crystal clear on issues such as voting control, employment termination scenarios, dilution, board seats, performance milestones, strategy, compensation and when and how the company will be sold.

So while many will tell you that marriage to a VC or angle investor is a terrible thing – I think just the opposite. The relationship can be an amazing matching of capital, skills and knowledge with your venture’s opportunity, passion and team. Make sure that you spend the time and gain the leverage to find the funding partner that is right for your venture and that you flush out the details of the relationship. Because in the land of venture capital, there is no annulment.