Getting Funded

Dan Allred - Senior Relationship Manager, Silicon Valley Bank

There has been lots of talk lately about how innovation will be the means by which the economy starts growing again. We hear this from politicians, from academics, from economists, and most importantly, we hear it from the entrepreneurs and investors who are taking the inherent risks associated with the business of innovation.

However, those risks have been evolving. Traditionally, entrepreneurs have taken on a lot of technology risk in their attempts to bring new products to market, and angel and venture capital investors provided the capital needed to develop such technology. The premise was such that if entrepreneurs could solve a very hard technical problem that met a market need, then there would be lots of customers, often large enterprises, ready to buy the product made possible by the entrepreneur’s technical breakthrough. In short, the technology risk was very high, but the market risk was relatively low. In such a scenario, there were large amounts of capital needed early on in a company’s life to hire advanced engineers and to develop very complicated and often unproven technology. This dynamic set-up well for venture capitalists who had large funds to deploy and were willing to bet on high-profile, experienced technologists, scientists and entrepreneurs. The VCs knew they were taking on lots of technology risk, but they could rest assured that there was market demand for the products if these teams of entrepreneurs could pull it off.

Of late, I have seen the model shifting to a dynamic where the technology risk is relatively low but the market risks are high, just the opposite of what I describe above. Open source software, cloud infrastructure and distribution platforms such as the App Store and Facebook have changed the way that entrepreneurs are thinking about innovation, and as a result, the way they are thinking about risk. They are able to leverage established technologies and established infrastructure to build out products much quicker and much cheaper than the entrepreneurs described in the paragraph above. Also, they are leveraging the Internet as a distribution platform for reaching the masses, the proverbial long tail. They are less concerned with Fortune 500 clients and their many demands leading to long product development and long sales cycles, and more concerned with consumers and SMBs who are not likely to pay as much for any particular product but offer a hugely scalable business should the product be adopted. And product adoption is the key question. SMBs and consumers are notoriously difficult to predict, especially where innovation is concerned. Thus, technology risk is low, but market risk is high.

So, if you are an entrepreneur, and you are pursuing a start-up that you need to finance, you should ask yourself which of these is the predominant risk that you are taking on – technology risk or market risk. If you are developing proprietary technology that will be the core of your product, that will offer your business significant barriers to entry and will be protected by a strong IP defense, then you are most likely taking on a lot of technology risk, and you would be well served to find deep pocketed investors, likely VCs, that understand your business and are accustomed to longer product development cycles, complex engineering projects and partnerships with larger companies such as OEMs, joint development agreements, etc. which may help you in bringing your product to market. Chances are you will need to take on more capital (probably in the millions of dollars) early on to be able to hire the right team and to develop and protect your technology.

If however, you see a relatively short path to market that will only require a few months and a few developers and you already know how you will distribute your product (through an app store, through social media, SEO, SEM, inbound marketing, etc.), then you may be a better candidate for a seed financing (probably in the hundreds of thousands of dollars). Such investors are likely to be angels who know your market well or who like to work with early-stage companies and founders. Micro-VCs or super-angels (many of which are raising micro-VC funds) are also candidates for such a financing. These companies are likely to raise money on lower valuations as there is little value in the their IP; however, the amount raised will be much lower than in the “technology risk” scenario, so dilution to the entrepreneur will not be significantly different.

In the “market risk” scenario, it is important to understand that you are likely to need larger dollars eventually, once you prove out your concept (thereby overcoming, or at least mitigating, the market risk). At this point, you would probably want to raise a larger round (again, in the millions of dollars), perhaps from your existing investors if they have deep pockets, or from VCs or strategic partners. Keep in mind, that you would theoretically be raising this money on a higher valuation now that you have mitigated the market risk in your company and are taking on execution risk, a risk that is typically easier to handicap, account for and manage.

A final note: I know that I am speaking in generalities here, but there is a very clear trend that I am seeing in the market. Sure, there are still plenty of IP-centric companies that are undertaking huge technology risks and solving big problems, and we should be very excited about these companies as they are very important to our region and our economy as they tend to be high profile companies and larger employers. We should also embrace this newer class of companies that want to leverage technology, versus creating it, in order to reach new customers and to innovate on old business models. If they are successful in doing so, they have the potential for serious economic impact as well.

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.

Entrepreneurs who have successfully launched and grown their venture will inevitably have to start preparing for an exit. At last week’s panel on Financing Growth and Exits, The Capital Network (TCN) brought in an expert panel consisting of a successful entrepreneur, an investor, an investment banker and a lawyer to provide participants with a complete overview of the exit process. Here are some highlights of the Breakfast Roundtable on June 29:

Exit experiences become a complex but exciting process of “letting go” for entrepreneurs. Dr. Murat Kalayoglu, Founder and Chief Science Officer of HealthHonors, successfully took his idea from start-up to a successful exit in just 3.5 years. His advice was:

• Take the time to prepare the business, (as well as your mental state) for an exit.
• Leverage existing data to find new customers as well as reducing the cost of delivering incentives to customers for a speedy exit.
• A successful growth and exit can only be achieved by giving up some control and letting others help you succeed

Tim McMahon, Managing Director of Covington Associates, discussed the keys to executing a successful deal. His key points to ensure a successful exit were:

• Keep your exit strategy in mind - Company building is fundamentally about building long term monetary value
• Start raising your visibility by aggressive PR and building strong relationships with potential buyers
• Know both your tangible and intangible value drivers: revenue, profit, team, sales, expense, geography
• Articulate the story of your business and keep it consistent. What differentiates you from your competitors?
• Know your buyer universe: Market/Channel Partners, Vendors, Suppliers, Competitors, Indirect, Direct, Investors, Angels, Venture Capital, Private Equity
• Build strong relationships early and often: a successful partnership has two-way benefits at exit time
• Get organized – A successful exit takes time. Make sure your financials are in order and you have gathered the right advisors

Roger Walton, General Partner at Castille Ventures, spoke of the many paths a business can take from seed to expansion and growth, and finally to an exit. He advised:

• Any company that incurs revenues greater than $5 million and has proven its idea can grow should have begun exit preparation.
• A firm’s main motivations to acquire another company are to fulfill a strategic need, lower costs, lower risk, to increase growth or valuation potential, or to acquire a unique technology, intellectual property, or team.
• The keys to a successful growth in the eye of the investor are a large market, sustainable competitive edge, a scalable offering and business model, and a scalable team. Firms that take all of this into account should consider themselves in good standing to be acquired.

Panelist Paul Sweeney, a Corporate Partner with our sponsor Foley Hoag LLP, provided some key tips for entrepreneurs to consider when preparing for an exit. He advised:

• Founders should always remain in close contact with their lawyer and collect due diligence throughout the entire lifetime of the business.
• Don’t lose track of your equity holders: make sure your stock ledger and capitalization table are complete, correct and up-to-date
• Don’t ignore 409A problems: Granting options below fair market value can have a very ugly result
• Founders should limit unaccredited investors because unaccredited investors such as friends and family often impose a greater disclosure liability, are not as sophisticated as an accredited investor and require more disclosure.
• Pay close attention to key LOI terms, i.e., purchase price calculation, tax treatments of certain issues, identification of non-competes and employment agreements, indemnification limits
• Don’t give away “veto” rights unless absolutely necessary: Preferred Stock investors should be only non-founder player with right to block transaction
• Don’t freely grant Rights of First Refusal or Rights of First Offer

While founders, investors, lawyers, and acquirers all play a vastly different role in an exit, all are an essential part of the process. Learning what to expect from each party will help entrepreneur’s carry out the most successful exit.

A key theme mentioned by all panelists throughout the program, is the important of building strong relationships early. It is important to build relationships with customers and potential buyers early on to ensure a successful and competitive sale process later on.

When should a startup cleantech company use angel investors, venture capital, or government funding when seeking early stage funding? TCN’s recent special evening event focused on this topic, with over 100 entrepreneurs attending and a panel of speakers including Philip Guidice, the Commissioner of the Massachusetts Department of Energy Resources, David Kopans, co-founder and CFO of EnergyClimate Solutions , Dave Power, president of Power Strategy, and Bard Salmon, chairman of the board of Perillon Software.

General consensus among the panel was that that venture capital is not the best place to seek funding for clean technology. As summarized by Bard Salmon, CleanTech is the new “.com”, and most venture capitalists are looking at the industry as a new opportunity to have in their portfolio. There is a general lack of experience among venture capitalist groups regarding the cleantech industry. While there are some venture capital groups that do attempt to specialize in a specific aspect of cleantech, the panel generally seemed to advise against venture capital for early stage funding. As a general rule of thumb, Bard Salmon advises to seek venture capital only when the total money needed for the business is greater than $5 million dollars.

David Kopans suggested the following steps when considering angel funding for your firm:

• Invest as much as your own money as possible in the idea. Then turn to your parents, then college friends, then friends of friends who may be interested in your idea, and finally angel groups. Bootstrapping is essential to this strategy. By investing as much of yourself in your idea as you can in terms of time and money, you create credibility for potential investors.
• Cut your business into milestones. Outline specific value creation steps for you business, no matter how small, and decide who will fund your business at each milestone. This is especially helpful with angels who are worried about dilution of their ownership when you seek further funding. By outlining this beforehand, angel investors will know what to expect at each stage of your business.

As far as available government funding opportunities for cleantech companies, Philip Guidice, discussed that finding new energy sources is a high priority in Massachusetts as well as Washington right now. He cautions however that government funding should not be an entrepreneur’s main source when seeking funding. Working with the government will help more with credibility, testing, and market opportunities, as well as creating credibility for newly developing companies. One great resource is the Massachusetts Clean Energy Center that provides small amounts of funding to entrepreneurs by matching their current fundraising.

Any additional advice on cleantech early stage financing? Feel free to post your comments here.

About 80 entrepreneurs, early stage VCs and angel investors came to Nutter McClennen & Fish’s Seaport office last week for The Capital Network’s first Venture Fast Track Boot Camp. The theme of the interactive FastTrack was to give entrepreneurs an in-depth understanding of what it takes to raise early stage capital for a startup company.

In the audience were folks like Read McCarty, founder of Sandbox Medical (a provider of neonatal feeding solutions), Farnaz Bakhtari, Founder of TrainingPal (a SaaS based solution for the personal training and physical therapy markets), and Robin Coxe, founder of Close-Haul Communications (a developer of cellular over IP hotspots). Attendees included companies in the biotech, medical equipment, SaaS, cleantech, mobile, enterprise software, and other high growth fields.

In addition, fellow TCN Venture Coaching Graduates attended to share their success, such as Bettina Hein of Pixability and Joshua Herzig-Marx of Incentive Targeting. The group was joined by active Angels and VCs such as Jean Hammond of Launchpad and GoldenSeeds, David Beisel, of Venrock Capital, Jon Lim, of Polaris Ventures and the Polaris Dogpatch, Chris Sheehan, of Common Angels, and Elon Boms of Launch Capital.

The day started with keynote speaker Eric Paley, Managing Partner of Founder Collective, who discussed the current state of early-stage financing and the importance of leveraging the “network of trust”. Eric’s inspiring story focused on what to do when you are ready for financing, but it isn’t forthcoming. He illustrated the importance of building a strong Board and an active advisory group that were not just “window dressing.”

Some tidbits of advice gleamed from several of our sessions include:

On Creating a Business Model & Financing Plan moderated by George Simmons of Launchpad Venture Group & Yumin Choi of HLM Venture Partners:

• Lack of a consistent CEO is one of the biggest mistakes a start-up company makes. Founders should ask themselves honestly: Am I the right person to take my company from idea to exit?
• Would you rather be “rich” or be “king/queen”. Would I rather own 6% of a $100 million dollar company, or 100% of a lifestyle company?
• Fundable companies have large markets, create valuable solutions for critical customer problems, create barriers to entry for competitors, and have a well rounded “A” team.
• Most common mistake in looking at your financials? Entrepreneurs focusing only on top/bottom line. Learn to appreciate the value of gross margins, compare yours to your industry and know why your gross margin is higher/lower than others.
• Capital efficiency is critical to determining your financing needs.

On Raising Money from Friends & Families, Angels & VCs led by Jean Hammond, of Hub Angels, Launchpad Venture Group, and Golden Seeds, Carl Stjernfeldt of Castile Ventures, Joshua Herzig-Marx of Incentive Targeting, and Alex Golvsky of Nutter McClennen & Fish:

• When pitching your idea to an investor, even if the investor is not a good fit, ask if you can pitch to get advice.
• When going to friends and family for money, always write it down.
• When looking for angel group funding, find an internal champion.
• Always perform due diligence on your investor to see if they are good match — by stage, size, return profile, exit timing, interests and strategy.
• Some companies are a better fit than others for a particular type of capital. Figure out if you are a best fit with venture capital, angel capital, strategic capital, debt capital or bootstrap financing.
• Consider who an investor’s competitors are — because you may not be able to get funding from their competitors later.

On Dilution & Founder Equity Issues, led by Jeremy Halpern, of Evolution Advisors:

• Entrepreneurs should model the dilution impact of early stage investment – and understand exactly how this will affect the ultimate distribution of proceeds from a downstream sale of the company.
• The last investor is the most senior investor, which means last money in, is first money out.
• Participating preferred stock makes a deal significantly more investor friendly.
  If you pair strong valuations with strong anti-dilution measures, subsequent downround financings can radically diminish a founder’s equity value.
• Founders will typically take 100% of the dilution impact from an option pool that is adopted as part of the financing. If you are raising 12 months worth of cash, the option pool will need to cover the Company’s compensation needs for such 12 month period. This is just a fancy way of decreasing the pre-money valuation.

On Pitching the Plan led by Jeremy Halpern, of Evolution Advisors, Yumin Choi of HLM Venture Partners, and Jeffrey Arnold of Boston Harbor Angels and Mass Med Angels:

• When pitching investors, first appeal to their greed, then address their fears, then make sure they think you are a good use of their time.
• Successfully raising capital starts and stops with establishing your credibility – are you honest about the opportunity, risks and problems, and do you appropriately blend passion, humility and confidence.
• Investors invest in people because businesses don’t make things happen, people do.
• Focus on the value proposition and the market – not the technology
• If you can’t present your opportunity, solution, market, value proposition, competitive advantage, business model and team in less than 15 slides – you don’t know your business.
• Powerpoint slides are not the presentation – they are illustration – YOU are the presentation

On Angel & Venture Term Sheets and Negotiation/Valuation led by Bob Creeden, of Partners Innovation Fund, Jean Hammond,of Hub Angels, Launchpad Venture Group, and Golden Seeds, Jon Lim, of Polaris Ventures, Jeffrey Arnold of Boston Harbor Angels and Mass Med Angels, and Michelle Basil, of Nutter McClennen & Fish:

• It is important to pick your battles, not all terms are worth arguing over. Find the and focus on the key terms that are important to you.
• Understand how participation or multiple liquidation preferences change the economics of the deal
• Control over the board and the timing of selling the company is a critical issue
• Covenants and other rights of the Preferred investors can mean that even a minority investment will exercise significant control over the operation of the business
• Will you require the investors to pay-to-play – to support the company in subsequent financings or lose their preferred status and rights
• Valuations are driven by stage, leverage, the venture’s underlying competitive advantage and the ability to drive revenue
• Traditional valuation methodologies do not work for high risk, early stage companies — investors are trying to understand what their percentage of ultimate sale proceeds will be – and whether that is a good return on their investment.

Participants found the sessions very helpful, unlike any other all-day program with concrete takeaway material, a Mentor lunch session and a chance to meet with a high quality group of similar entrepreneurs. Tim Noetzel, founder of Pintley.com (an online community for the craft and micro beer industries), called it, “the most helpful and comprehensive program on early stage fundraising I ever attended.”

Let us know your thoughts on some of the above topics. We’d love to hear from you!

Investors, recruiters and entrepreneurs agree that startup success is based on three things: the team, the product/technology, and the market opportunity. But it is an often repeated truism that angels and venture capital firms invest in teams more than they invest in ideas.

The recent roundtable, “Building a Fundable Team,” provided investors’ perspectives on this dilemma, along with a discussion of other team-related topics, such as:

- What is a founder’s role on the management team?
- Is the current team complete enough for the stage of the company?
- Does the current team need someone to play an interim role to fill in a critical need?

We invited three experts to speak to the topic:

Glenn Champagne, a member of Launchpad Venture Group, with an 18+ year career in startup/early stage companies including Oracle, Business Objects, Eprise and InBoxer.

Dr. Omar Amirana, MD, a Partner at Oxford Bioscience Partners, who has helped raise over $60M in venture financing which resulted in three IPOs: EP Technologies, Cardima, and MedicaLogic/Medscape. He has held a variety of executive roles at early stage companies: CEO and co-founder, and in business development and marketing.

Sarah McIlroy, Founder & CEO, Fashion Playtes, an experienced, innovative marketing executive with 15 years experience in product management and the interactive world of gaming.

Brent Larlee, Managing Director, WaiHaka Strategies, moderated the session.

They each offered some guidelines about the way they think teams should be built to get funding:

Omar Amirana: The team is all that really matters. VC’s invest in People. Companies are People. People produce Innovation. People (and cash) fuel economies.

People have to be honest, trustworthy and rational. They have to be motivated and hungry for the opportunity. VC’s look for teams that are smart and knowledgeable with deep domain experience. This is particularly important in health care.

VC’s also look for teams that are strong but not bullying, and that have healthy checks and balances. They need to be results-oriented and responsive.

Sarah McIlroy: It’s true that a broad based skill set is a necessary component because needs change as a company grows. I truly believe the key for any early stage team member is an entrepreneurial spirit and a can-do attitude. There are lots of obstacles and it’s critical that you have a strong team ready to stand by you to build the business. It usually takes longer than we expect.

Glenn Champagne: An ideal fundable team is three to five CxOs on their 3^rd startup together after two very successful M&A/IPOs, leveraging their experience, market and product knowledge. This team, primarily the CEO, will set the corporate culture.

We look for a CEO who is a proven leader and a visionary, someone capable of selling to customers, investors, media who is in charge and a CTO who is capable of managing development as company grows. Sales and Marketing can be added later, but these functions will identify the customer, and determine the price point, then sell the product. We only look for a CFO if the company is financially complex.

We expect everyone to wear a lot of hats in the early stage, and that there will be an environment of openness to foster innovation and solve real business problems.

The key characteristics we look for in our teams are:

•Honesty
•Leadership
•Vision
•Coachable
•Accessible
•Intelligence
•Driven
•Good communication skills

To learn more, please view Glenn Champagne’s presentations here and Dr. Omar Amirana’s presentation here.

What do you think it takes to build a fundable team? Post your thoughts here.