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VC Funding in Bad Times: Five Steps to Better Odds

Sarah Richmond, Esq.

(This article was originally published in substantial part in Mass High Tech on March 26, 2001)

March 2001

Despite the increased difficulty of raising money in today’s market, high-tech entrepreneurs fantasize about multi-million dollar venture financings at high valuations. While nothing beats a breakthrough technology and hot management team, there are other steps a company can take to smooth the way to a successful venture round.

I. Incorporate in Delaware.

Founders strapped for cash in a new venture are often tempted to incorporate in Massachusetts where the filing fees and ongoing costs are lower than in Delaware. However, a business planning to raise a significant equity round (and hoping to be acquired by a large corporation or going public) is usually better off incorporating in Delaware. The Delaware legislature, judicial system and secretary of state have collaborated to position the state as the most favorable home in the country for corporations. As a result, venture capitalists prefer to invest in Delaware companies.

Although a VC will not reject a company just because it was incorporated in Massachusetts, it will often require the company to “reincorporate” in Delaware before putting in money. While not the end of the world, reincorporating will divert precious time, resources and management attention that could otherwise focus on building the business. Having to do a reincorporation is like getting a bad cold – it is probably the last thing you want to deal with when trying to raise your first round.

II. Choose a Corporation rather than a Limited Liability Company (LLC).

Most businesses planning to raise significant outside financing should set up as a corporation rather than a limited liability company. Accountants love LLCs for the tax benefits and structural flexibility they provide, but VCs are very wary of them. The documentation for LLCs can be extremely complex, and trying to muddle through 12 pages of dense tax language describing profit and loss allocations is enough to scare anyone away.

In the end, VCs are creatures of habit and are used to dealing with the corporate form. They are reluctant to take on the additional costs and responsibility of ensuring that their interests are adequately protected with an LLC.

III. Protect your Technology.

Although a high-tech company’s technology is often considered its “crown jewels,” many companies are not careful in protecting these valuable assets. The valuation a company gets from an investor (or an acquirer) will be adversely impacted if the company has not taken steps to safeguard and enhance the value of its technology.

What should you do to make your company’s intellectual property assets as attractive as possible to investors? At incorporation, transfer all necessary technology and inventions of the founders into the business. Conduct trademark clearance searches for all proposed product and service names, and consider whether patent protections are appropriate. All employees and consultants involved in the development of the company’s products should sign onto nondisclosure and development agreements, and the company should sign confidentiality agreements with business partners. At product launching time, have protective licensing and distribution terms in place and include proper copyright and trademark notices on products.

A company that does not take these steps will often be in the uncomfortable position of trying to close the barn door after the horse has already escaped. It’s no fun to find yourself begging a former consultant to sign an inventions agreement on the eve of the closing. When the former consultant is a disgruntled one, he can literally hold the deal hostage until the company can convince (or bribe) him to play ball. Plan ahead: these situations can be avoided.

IV. Stay Organized.

In a new venture, the founders and their employees work at break-neck speed to get the company’s technology developed and product launched. There are limited resources and the company is not focused on the niceties of staying organized. As a result, companies often keep their documents in complete disarray and do not keep their corporate minutes and stock records up to date.

This lack of organization can come back to haunt a business seeking capital. After a term sheet is signed, the VC’s attorney will send the company a “due diligence request list” that is usually the length of a short novel. The business will need to send the VC a copy of all of its contracts, leases, minutes, stock records, employee documents, financial statements, tax returns, and charter documents, and every other relevant piece of paper it can find. The company will need to organize these documents into various lists and schedules to be attached to the investment agreement. Needless to say, the business that has kept its documents up to date and organized will have a lot easier time of it than the company that has kept its documents spread out in piles on the floor.

V. Get the VCs to Read your Business Plan.

Most venture capitalists look for a standardized format in business plans, and you will need to push the required buttons to stay in the game. Pay most attention to your executive summary; VCs will skim the executive summary and decide whether to read the rest of the plan or put it down. VCs are flooded with business plans and your executive summary needs to grab them like a best-selling thriller. Also, don’t write an overly long business plan. When the VC is deciding which plan to take out of his briefcase on the train ride home, you don’t want yours to look too intimidating.

Get a personal introduction to your potential financing source when at all possible. Although an introduction to a VC won’t necessarily translate into an investment, it may mean that your business plan gets pushed to the top of the pile, which is a good start.

Of course nothing can guarantee a quick and easy financing, especially in today’s market. However, all else being equal, a company that has taken appropriate steps along the way is much more likely to successfully close a venture round than one that has not.