More advice on raising money – Legal…

I wanted to write a follow-up to a previous post detailing some lessons learned as we continue our capital-raising journey. The topic of the first post was focused on identifying potential investors and how to approach them. This follow-up is focused on the “how” of what documentation is needed to raise money once friends or family say they are willing to invest. The basic advice I had been given and will pass on is to make sure you document everything in writing. This does not mean writing down an IUO on a napkin at your favorite local diner. Don’t laugh, I’ve read many stories (some of them successful) of entrepreneurs documenting investments on a napkin. I wouldn’t recommend it though. For this, you need a lawyer, specifically a lawyer who is familiar with capital markets transactions, which is a fancy term for companies raising money.

A lawyer will be able to provide you with the right kind of documentation so you can raise money one of two ways, selling stock in your company (most common) or borrowing money as a loan from investors. There are even things in between where you can borrow money from investors and offer them the right to convert their loan into stock in your company in the future. This is called a convertible security, and it’s not as complicated as you think. Nonetheless, you need a legal expert who knows this stuff to give you the right document. Most of the wording is going to be the same no matter which lawyer gives you his template. So don’t try drafting these agreements yourself.

If you decide to sell stock in your company by selling shares to investors, the documentation will involve several pieces of documentation. That’s what the lawyer is for. The trick with selling shares in your company is that you need to figure out what each share is worth. This is a frustrating exercise and involves you determining how much you think your company is worth (i.e. $250,000, $1 million, $5 million). If your start-up is in the idea-phase, meaning you don’t have any revenues, this will be difficult. Many people will argue your business is not worth anything, and you will argue that your business is worth as much as the idea is worth (billions and billions). In the end, you will have to negotiate down to something reasonable (I will put up another post that discusses valuation).

If you need to raise money quickly and don’t want to spend the $10k it will probably cost for the legal work associated with raising equity, you’re best bet is a convertible note. As discussed before, this is a much simpler document and outlines how you will be borrowing money from investors and that their investment will convert into shares later on (most of the time it’s within 12 months) when the business is further along and people are more comfortable discussing how much the company is worth when you hopefully have revenues and cash-flow. The convertible note is a complex IOU which says that when the investor gives you the money, you sign the document that says the company promises to convert the loan into shares in your company. The best part of using a convertible is that the legal costs are minimal (doesn’t require any custom work) and you don’t need to set a valuation for the company, meaning you can raise money much more quickly because there’s no negotiations taking place. As far as choosing the right law firm and where to start, check out my other posts on the topic of searching for and hiring a law firm. If you’re curious who we’re using, it’s Perkins Coie out in Menlo Park CA. Shoot me an email and I’d be happy to make the introduction.

JT

Do we need a banker? part 2

Get up to speed on the story before reading our first post on Hiring a Banker

So I met with Mr. Banker about two weeks ago at this point to discuss our capital needs and how he might be able to help us raise some money. Given I understood and spoke the banking jargon, Seth and I decided that I would manage this process until we were ready to make a decision, upon which time Seth and I would decide together on the right path to take. I had never dealt with a start-up banker/consultant before, so this was a real education. The basics for how this works is that these bankers typically work alone and help start-ups or small companies with a variety of financial advice, such as M&A (i.e. selling their company), raising money, and general business development (i.e. finding partnerships), among other internal finance processes. Some will even offer to stand-in as CFO (chief financial officer) to ensure that the financial processes are in place and that the accounting is being done properly. Mr. Banker offered his services on all these levels.

I thought this was a great idea and asked him for a draft agreement so we could share it with our lawyers and get a general sense for how the economics (i.e. payment to him) would work.He sent me the paper work a day after we met (about a week ago), and I went through it with a fine-toothed comb. In short, I didn’t like the fee structure and thought it was going to be very expensive. There were fees for everything, but Mr. Banker mentioned that most of the compensation would be for stock in our company so that he can “share in the upside.” Seth and I liked this part because if he did a good job raising money for us on a good valuation (more on that in another post), he would also benefit from our stock being worth more. However, I come from a world of finance where clients paid bankers significantly less for a private placement. Although the size of our deal would be much lower, I did not feel comfortable paying 60% more than I was used to at a big investment bank.

I sent the agreement back and forth with Mr. Banker, making edits to the language and negotiating the terms.After working on this for two weeks, I was comfortable with the agreement and thought it provided us with adequate protections and fair fees. But then again, I’m not a lawyer. To be sure, I sent the agreement to our lawyer for final review and waited a couple days for him to get back to me.So he came back to me yesterday with a ton of notes and a lot of issues with the agreement. In short, he said that it was very unfriendly to the company and thought that we should not sign this agreement under any circumstances. He believed so strongly that we not sign the agreement that he was going to draft a letter to us stating his advice so that his view was documented should we go ahead and sign it anyway. I assured him that we were absolutely going to follow his sound legal advice. I spoke with Mr. Banker and told him that we could not sign the agreement. I told him that Seth and I would need to speak about this and would get back to him with an alternative next week. So I’m pretty sure that we are not going to hire a banker at this point, but I’ll let you know how this goes…

Bottom Line: Be very careful when hiring a banker to help you raise money. Don’t sign anything before having a corporate contract lawyer review it. This could be your uncle, cousin, brother, or the lawyer you hired because you don’t have anybody in your family who would do it for free. It doesn’t matter. Remember, that your signature is binding, and signing anything without fully understand it (especially in business) could be a huge mistake. Look for other sources of money first before hiring a banker, since other sources will probably be free and a banker will charge you a big fee for what he’s doing. If you decide to hire a banker, make sure the contract is completely performance-based. This means that he gets nothing if he can’t raise money, form partnerships, etc. This creates ultimate accountability for the baker. If the banker you’re talking with doesn’t like that, don’t hire him. Remember, hiring a banker does not mean that he will have your best interest in mind. He wants to raise you money so that he gets his fee. It doesn’t matter how much of your business he needs to sell to do it. So make sure you understand how much of your business you’re giving away when you’re banker brings you interested investors wanting to put in money. Everything comes at a price…

JT

Hiring a banker…

We’re now in August, and Seth and I began talking about raising money from outside investors. We had begun conversations with potential technology vendors to outsource technology development to India or eastern Europe. It was going to cost anywhere from $150k to $250k depending on how complicated we wanted our technology to be. There was also another chunk of change for development costs associated with implementing our registered card program with a different third party vendor. This would enable us to allow consumers to register any/all existing credit/debit cards with us and get the rebates/discounts from our merchants directly on their card when they shop in brick & mortar stores. Other costs that we saw on the horizon were some key employee hires, paying us a little bit to cover rent, some travel costs, and maybe even office space if we could swing it.

So last week, we thought it was necessary to try to raise some money (about $500k), depending on whether or not we could create enough interest among investors.One of our advisers told us that it might make sense to hire an investment banker to help us raise money, since they have relationships with wealthy angel investors and VCs. I thought that wasn’t a bad idea and went out on yet another search, this time for a banker (at least just to test the waters and gain another education). Given I had come from investment banking, I was pretty familiar with the process of private placements (raising money for private companies from private investors), and found it interesting how I was not in the client’s seat on the opposite side of the table this time around. I reached out to a few of my old friends at Citigroup and found out that their private placement group would not work with anybody raising less than $25 million (obviously not us). I also got in touch with a few smaller investment banks that would not work with us unless we raised at least $15 million (again not us).

So I was advised to search for a banker/consultant with ties to the venture community who was not employed by a investment bank.Last week I put out a few calls to some of these individuals. The names came to me from a variety of sources. I once again tapped my personal network and sent out feelers to friends, colleagues, and business contacts to ask if anybody knew such a banker. One of the individuals at a technology outsource firm I had been speaking with suggested a friend of his who works with small companies. One of our advisers recommended a friend who used to work in banking and now runs his own consulting practice. A third referral was from a distant family member who had just wrapped up a round of capital for his own start-up in Boston and had a person up there he had spoken to. I reached out to all three and received two call-backs. I have a meeting with the NY-based banker next week. I’ll let you know how it goes…

JT

Selecting a law firm…

To catch up on the law firm search process, check out the initial post at Searching for a Law Firm…

So it’s been a few weeks since we started our search for a law firm. I’ve spoken with 5 firms and received a ton of useful information (and glossy promo materials). In the end, there were two big differences in the firms (1) location and (2) billing practices. The first thing I noticed was that 4 out of 5 were based in California and the remaining firm was based out of D.C. I was not that excited about working with a firm three hours behind but realized that it was not the end of the world. All the firms I spoke with were reputable and had a division that was exclusively focused on “emerging companies” (i.e. start-ups). Moreover, I thought it would be good to branch out from the east coast and begin building recognition for our business on the West coast, since those law firms have their own relationships with West coast investors and potential partners.

The second observation was that the law firms in CA offer a pretty appealing billing structure, where they are willing to defer all legal costs associated with raising money (shareholder documents, stock certificates etc.) until we raise substantial funds to cover those costs. I really liked that, but then again, who wouldn’t? For a start-up looking to conserve cash, postponing payments means available funds to grow the business. In general, I found that this was a CA thing, maybe a dot-com phenomenon that has carried over to present day. Maybe it’s just a cultural difference between CA and NY/D.C. Either way, we made our decision based on the two factors mentioned above and the simple fact that we just felt that there was more of a “fit” with the lawyer who would be handling our account at this firm.

Bottom Line: If you’re choosing a law firm for your start-up, speak to a minimum of 3 and look for a full-service firm that can do all sorts of legal work for your venture as the business grows. Make sure you pick a firm with an “emerging companies” practice because that means that they work with start-ups and will be better suited to understand your legal needs at this early stage. As important, pick a firm with a flexible payment structure and don’t worry about hiring a firm in CA. That’s probably the only place you’ll find such a firm. Also, don’t forget about personality fit. You should make sure you like the attorney you will be working with and feel comfortable that he/she will be responsive to your needs. Once you get the information you need to satisfy these key points, make a decision quickly so you can move onto growing your business…

JT

Searching for a law firm…

We have been using a law firm here in NY since we began in June that we got through a reference from our accountant. Our current attorney is a corporate lawyer who has helped us with things like incorporation and employment contracts with prospective employees. However, Seth and I agreed that we needed legal counsel that could also help us with legal documentation related to raising money, patents (IP), and general corporate law. I headed up the search last week by reaching out yet once again to my personal network and asking Seth to shoot an email to his fraternity list-serve from Cornell, which has an amazing number of lawyers/consultants/banker in its graduating ranks. We received a bunch of responses, both directly from attorneys at prospective firms and from individuals providing recommendations to certain law firms or attorneys they knew. One of my parents’ friends came up huge and recommended a firm on the east coast. Most of the firms were based out in CA, not a surprise since most start-ups are out there as well. I have calls set up with approximately 5 law firms over the next week or two and will let you know how it goes…

Bottom Line: Given I had no idea where to start, we were forced to be as resourceful as possible. My first piece of advice would be to be resourceful and use your friends and personal network to find the people/firms you need. Don’t use the internet. Personal relationships, it seems to us even at this point, are what makes the world go ’round and will probably lead to a better decision and less headaches. I’ll let you know if this our hypothesis turns out to be true…

JT