Category: Funding

Pursuing Funding – It Takes Money to Make Money

In one of my earlier post I discussed the time challenges that start-up companies face when raising investment funds. Many start-ups greatly underestimate the time commitment involved and the slow timeline that is usually associated with raising funds. A related issue is that companies pursuing investment also frequently underestimate the costs that are involved in the process. This is a situation that illustrates the truth of the second part of the Johnston corollary to Murphy’s Law – “Everything takes longer and costs more.”

As part of helping clients work through funding, early in the process I ask clients about their budget or estimated costs for obtaining equity investment. Even though I’ve worked in the startup ecosystem for nearly twenty years, I’m still surprised by the number of times the answer is “we don’t have a budget” or “we don’t expect there to be any costs.”

What type of costs should the company anticipate and at what points in the process? There are multiple steps involved when pursuing investment, but let’s focus on the phases that typically involve outside costs:

INVESTMENT STAGE OUTSIDE COSTS
1)         Preparing for investment
  • Meeting with legal counsel to develop an understanding of securities law (do this before you pitch to investors!) and to help prepare for the due diligence that investors will perform
2)         Prepare proper investor materials, consisting of, at a minimum, a business plan including financial statements and pro formas, executive summary, a pitch deck, and private placement memo or other documents that will comply with securities law.
  • Accounting costs to develop proper financial statements and pro formas
  • Marketing costs to help create the business plan, executive summary, and pitch deck, since these all marketing documents to varying degrees. It is important that these documents present the company clearly and to maximum advantage.
  • Legal costs to prepare a private placement memorandum or similar disclosure document
3)        Negotiating deal terms via a term sheet. Besides valuation and investment amount, a proper term sheet will also deal with an array of other issues, such as investor shareholder rights, liquidation preferences, investor representation on the board of directors, investor information rights, tag-along and drag-along rights, no-shop provisions, and confidentiality.
  • Legal costs to help develop and negotiate a properly detailed term sheet. This is where most of the negotiating takes place, so experienced counsel can help ensure that the company gets the best deal possible.
4)         Preparing and negotiating the definitive documents (stock purchase agreement, shareholders’ agreement, investor rights agreement, etc.)
  • Legal costs – for angel investment, to draft and then negotiate the documents, and for VC investment, to review and negotiate documents prepared by counsel to the VC fund. The “skinnier” the term sheet, finalizing the definitive documents will likely involve negotiating substantive issues and be more protracted.
5)         Closing the deal
  • Legal costs to ensure that all documents are in order and to assist in the closing process

There may be other types of costs depending on the specific situation, but presumably the above information conveys the fact that significant out-of-pocket expenses are an unavoidable part of the process. The amounts vary depending on a variety of factors, including the experience level of the management team, the amount of investment pursued, whether pursuing angel or VC investment, and the length of time it takes the parties to agree on the investment terms. It is vital for company executives to meet with their lawyers and other service providers at the outset and have detailed conversations about estimating the length of the process and a likely range of fees.

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