Funding Round Advisory

Observations from our Founder and

Managing Director

Topic: Avoiding the Six Most Common Mistakes in

Positioning for a Capital Raise.

As a serial entrepreneur, as well as an activist investor for over

forty years in over a hundred private companies, you begin to

see patterns. Patterns in the behavior in individuals, and in

groups of individuals that have the stewardship of launching

and sustaining companies, some of which lead to success, and

some of which lead to disappointing failure.

From these behaviors, the more positive outcomes can, in

retrospect, be codified into “best practices.” Nowhere is this

more apparent than in what are called “funding rounds.”

A Funding Round Advisory Consultancy seeks to avoid the

six most common mistakes that businesses make in

accessing capital markets:

1. Complicating the Capital Structure of the Company

In the majority of pre-funding advisory consultancies, the

capital structure, adopted by the founders, must be undone, or

more accurately, restructured to properly prepare the company

for a funding round. Specifically, stock grants to “advisors”

who never actually add measurable value, reverse splits to

consolidate shares into a capital structure that may eventually

qualify for family office or managed fund investments (a

significant percentage of family offices and managed funds

have by-law provisions prohibiting investment in any stock,

public or private, worth less than $10; therefore, million or

multi-million-share, fraction-of-a-penny cap tables are an

immediate impediment), execution of stock option agreements

with prospective employees who may not ultimately survive

due diligence vetting by the potential funders, or entering into

agreements that reserve assets, territories, or future intellectual

property discoveries from benefiting investors.

The list grows with the imagination of well-intentioned but

inexperienced founders. Any complication, covenant, or capital

structure that obscures transparency or complicates accounting

and distribution earnings becomes a disqualifier in the eyes of

veteran funding sources.

2. Overpromising and Underdelivering During the

Friends and Family Rounds

It is often the case that the founder’s representations to the

Friends and Family Round (FFR) about the current condition,

the valuation utilized to set the share value for the FFR round,

or the future promise of the company, as well as the likely

re-valuation and dilution during a formal funding round, create

at best ill will, and at worst compromise the company’s ability

to raise additional capital. The FFR typically comes from

non-accredited investors who believe the "story" of the

company’s founders describing a future valuation at

stratospheric valuations, which cannot and will not be

sustained in subsequent funding rounds.

3. Misunderstanding the Actual Stage of the Company

Founders, reflecting their entrepreneurial spirit, are frequently

mistaken about the actual operating condition of their company

as well as the current position fix of the company. If a company

has no closed contracts for sales, has never had a sale, and has

prospects for sales but no income, it is a pre-revenue company.

The prospects for revenue is not revenue. A purchase order

without terms for payment attached to a contracted deliverable

on a calendar date is not a bankable asset. An agreement to

purchase widgets from a sister company that has no capital is

an empty, invalid agreement. A business model based on

giving away samples in order to procure future orders cannot

book those give-away samples as “sources of future revenue.”

Booking a services agreement at an “operating loss” to the

company is not an asset; it is a liability. In flying or sailing or

business, a current, accurate position fix is absolutely necessary

to understand the resources necessary to eventually arrive at

the preferred destination.

4. Misunderstanding the Valuation Process for a

Pre-Revenue Company

Having reviewed literally hundreds of “funding decks”

prepared solely for the purpose of garnering funding, one

cannot ignore the “wish craft” associated with the

representations. Wish craft frequently will compare the

pre-revenue startup to established operating companies that

have public shares trading at a multiple of actual earnings. This

is not apples and oranges; it is more like apples and bicycles,

not a remotely close comparison. Or, assumptions are made

that the company will obtain, after entering the market, a

certain market share of a “gazillion-dollar” market. Or, the

competition that exists in the targeted vertical will give up its

market share without a fight. Or that the company will grow in

a linear fashion quarter after quarter. Or that future funding will

be available at a higher valuation. While these favorable

fantasies cloud founders' judgments, often, it is realistically not

going to happen.

The primary considerations for funders, in a funding round

particularly of a pre-revenue company, given that there are

literally thousands of investment opportunities available to

them every day that are transparent, proven, and highly liquid

are:

● Is there anything truly unique to this opportunity?

● How realistic is the “funding valuation”?

● How probable is it that I will get my capital back?

● How probable is it I can ever book a dividend or a gain

on my investment?

● Is the business model for going to market rational?

● Are the current people capable of execution?

● Is the targeted burn rate to get to break-even possible?

● What is the reserve of funds for unknown

contingencies?

● Is there any market protection (patents or trade secrets)

that affords the company time to establish a market

presence?

● Are the projections even remotely accurate to get to

viability?

● Would any current players in the market, public or

private, want to buy this company if the widget actually

works, or would well-funded competition just reverse

engineer the offering and go after the same

opportunity?

And, whatever the founders believe the company is actually

worth, it is only worth a fraction of that number, in a best-case

scenario. Truth be told, absolutely no one gets a “best-case”

scenario.

5. Negotiating with an Angel Investor or Family Office

Funding Source that Gives the Investor Control over a

Future Funding Round

Funding covenants, terms, and conditions of taking any party’s

capital matter. Covenants that require an early investor to

“approve” a future funding round’s terms and conditions are a

stranglehold on future funding. Covenants that require board of

director participation can shrink and narrow a company’s

opportunities. Anti-dilutive covenants on a “down round” are

protection for an investor but will normally force founders to

give up shares to get a deal done. Debt instruments that are not

pre-payable without a penalty, or convertible only at the option

of the lender, or prohibit the company from securing an

additional credit line without paying out the initial lender can

jeopardize a multi-million-dollar credit facility. It is not

unusual for the pre-funding advisory team to find it necessary

to re-negotiate debt instruments or previous equity sales that

attach control mechanisms designed to force the company to

abide by terms that were seemingly harmless at the time of the

original funding, but now are unworkable for the next funding

round.

6. Being Victimized by an “Investment Banker” that

Charges a Significant Upfront Fee and Never Delivers

the Promised Capital on the Promised Terms

The typical contract requires a downstroke payment of $50K to

$250K, plus an unaccountable expense slush fund, plus

reimbursement for all out-of-pocket expenses, plus a block of

non-diluting equity, plus a fee range that may vary from 3–5%

for debt and 8–10% commission on equity sold. After six

months of meetings, conference calls, and “good potential

leads on capital,” the firm comes back to the table and

proclaims that the proposed terms for equity and valuation are

not being accepted by the “market.” This is sadly the

experience of literally hundreds of companies that have lost

millions of dollars to “brokers” who promise to access the

capital markets on the company’s behalf but, in the end, deliver

only broken promises and invoices for travel expenses.

Investment bankers often refer to this experience as: “having

an investment bank job done to you, rather than for you.”

Avoiding Financial and Regulatory Landmines When

It Is Time to Negotiate for Additional Capital

Many companies grow to the point where future growth cannot

be sustained on the current capital structure of the company. At

that point, either the company ceases to grow, or grows in fits

and stops but with vulnerability to any interruption in cash

flow, or the company seeks additional capital through some

type of “funding round.”

The funding round may consist of a commercial credit line

from one or more banks, an equity or debt funding round from

a circle larger than the typical “friends and family” round

which may include “family offices,” or it may require a

third-tier or even a second-tier investment banking firm that

will commit to lead an underwriting process to raise millions of

dollars for a fee plus equity.

The Purpose

The primary objective of a funding round advisory is to prepare

the company to negotiate the very best terms on the amount of

capital needed for company growth. Getting the wrong amount

of capital on the wrong terms for less than the optimum period,

an all-too-often result, almost always penalizes the company.

The Advisory Process

A potential funding round advisory process typically requires

the input of four professionals over a three- to five-month

process:

1. A CPA with experience in building P&L projections,

balance sheet projections, cap table before and after

funding, and “burn rate” studies, who will also assure

that all tax compliance in all jurisdictions is current at

the time of the anticipated transaction, and that reports

utilized to support the anticipated funding round are

compliance-accurate.

2. A Corporate Compliance Attorney who will update

all bylaws, charters, corporate filings, directors’

agreements, advisory board agreements, employee

agreements, contracts with third parties, shareholder

agreements, debt holders’ agreements, and

intercompany agreements; additionally, the attorney

will affirm compliance with all applicable regulatory

agencies that have jurisdiction over the company’s

operations.

3. A Securities Attorney. All stocks, debentures, debt

instruments, and even lines of credit are securities.

Issuing any equity or debt instrument to a third party is

subject to state laws (in the domicile of the issuer and

the buyer) and federal laws that force compliance of

most types of “exempt offerings” and “non-exempt

offerings.” The securities attorney reviews the plan to

raise capital, the “material statements” that may be

made orally and in writing, and all documents utilized

in the solicitation and exchange of money or credit for

equity or debt, as well as maintaining compliance with

pre- and post-filings if and when required at the state or

federal level.

4. An Investment Banker Advisory Resource. A fee

based consultant with years of experience acting as an

investment banker is typically retained as a strategist to

advise the company board of directors and the C-suite

on the optimum structure of the proposed financial

transaction, and point the company in the direction of

the best candidates to assist with the proposed funding

process. The consultant is retained as an advisor and an

advocate to work with the C-suite in the negotiations

necessary to receive a funding commitment from third

parties on fair terms. He or she represents the company,

not the money source, so the advice is never conflicted.

It is a very unusual occurrence for a business to be self-funding

and be able to scale operations to build any degree of wealth,

whether a service company or a product company.

Additionally, it is normal to need more capital, for longer

periods of time, to achieve the corporate mission than

originally perceived.

Given that this is the “normal” experience, the most effective

way to navigate funding options and secure the right terms at

any stage of company development is to engage seasoned

counsel.

— From the Office of the Managing Director