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Financing your early stage company

Jul 26 2010 by Bob White | (0) comments

Categories: Finance, Start-Up
Tags: entrepreneur, financing, start-up, investment, capital

Financing your early stage company

The information contained in this blog post is based on general principles of law and is intended for informational purposes only. I make no claim as to the comprehensiveness or accuracy of any of this information. None of this information should be considered as legal advice, and this blog post is not offered for the purpose of providing legal advice to any party. The information contained in this blog post represents my own personal views only, and does not necessarily represent the views of my law firm or any other lawyer in my law firm. My provision of the information in this blog post does not create an attorney/client or any other relationship between me or my law firm and the readers of this blog post or any other party. All readers of this blog post should consult their own legal counsel and other advisors before taking any actions or making any decisions based on any aspect of the information contained in this blog post. I am not certified by the Florida Bar as a “specialist” or “expert” in any area.

Financing is often the most important focus for an early stage company. This is usually not healthy, as it can distract the entrepreneur from the key strategic and tactical issues that he or she is facing, but it’s understandable since running out of money normally means game over. To help you get on top of this situation and alleviate some stress, here are several thoughts that may be helpful to early stage companies in the financing context.

An entrepreneur should first consider how much financing is required and what the company’s valuation will be. These are complicated factors with critical ramifications. Take too much money now at a low valuation and you sacrifice a percentage of equity ownership in your company. Take too little and you risk running out of money. This is further complicated by current harsh economic conditions – there is a real risk that money may not be available on acceptable terms or at all when you need it. Carefully balance your short- and long-term cash needs with your strategic and tactical plans (including all contingency plans) and the projected availability of financing for your company.

Valuation of an early stage company in an early financing round is a critical component as it will significantly affect the size of your equity interest both now and in the future. These valuations are difficult, however, as many traditional valuation metrics cannot be fully utilized with early stage companies. You need to get good professional advice in these situations. A trusted outside accountant is often a good source for early stage valuations. Remember that entrepreneurs sometimes develop unrealistic valuation expectations. One key item: Always be aware of your equity ownership in the company and how it could change based on all applicable circumstances (for example, additional financing at a low valuation, exercise of options and warrants and any anti-dilution rights granted to other investors).

Don’t ever assume that adequate financing will be available just because you’ve got a great idea or business model. In my experience, financing has never been easy to obtain for an early stage company – it’s definitely been easier than it is today, but I’ve never known it to be really easy. The other thing to remember is that even if financing is available, the terms are likely to be egregious if you wait until you’re desperate and have no bargaining power.

Financing for early stage companies normally involves a combination of loans from shareholders and other parties and various types of equity financing. Most of these companies will not qualify for bank financing at this stage. If shareholders contribute equity capital, it is critical to document the percentages of equity that they receive. It is also quite common for professional investors to require shareholders and principals to convert prior loans to equity, so be prepared for this.

The company may then do one or more rounds of “friends and family” financing, which involves funds received from family members and preexisting friendly relationships. This type of financing often seems attractive because it comes from people who you know and feel comfortable with, but it can have a very negative downside if things go wrong.

As your company progresses, you may encounter opportunities for professional financing from sources such as angel investors, venture capital firms and private equity firms. Your company may also have access to strategic financing from another industry participant or a party such as a vendor or customer. All of these may be good sources of financing, but you must be extremely cautious because of the sophisticated and professional natures of these parties. They are generally smart and dispassionate about their investments.

These financing sources will attempt to impose very strict and tough terms and conditions in their transactions, and you may not have the bargaining power to avoid this. It’s imperative that you understand what you’re getting into and what your obligations will be, as well as the consequences of not being able to comply with such terms and conditions, some of which could be extremely negative for your company and you. On the positive side, many “smart money” financing sources can add considerable value to your company beyond just their financial investment.

It is always essential that you clearly and correctly document all of the terms and conditions of any financing. Don’t ever leave any term to be construed later, and don’t depend on friendships and relationships here. People and their perceptions and situations always change (sometimes quickly and radically), especially when money is involved.

Remember that Federal and state securities laws potentially impact every financing transaction, regardless of how small and informal. You need to get proper legal advice from a qualified practitioner in this area. These laws can impose substantial penalties and liability on your company and its officers and directors individually.

The financing process can be complex, frustrating and painful, but it is a fact of life for most companies. Use the simple items contained in this blog as broad principles to guide you through the process, and use your advisors for specific advice. The end result of a successful financing transaction can be extremely rewarding and gratifying for your company.