John P. Beavers and Thomas R. Brownlee, Jr.
Partners, Bricker & Eckler LLP
March 2001

The goal of this white paper is to provide businesses with guidelines for raising capital to commence operations of their ventures. If you have developed your business plan and have protected your venture’s resources through employment and confidentiality agreements, you may want to skip to the heading “Preparing Your Presentation to Venture Capital Firms.” If you require seed financing to fund your venture’s business planning and resource protection, see “Raising Early Stage Seed Capital.” And, if you want to review some guidelines to make sure that you have adequate plans and protections, begin with “Requisite Preliminary Steps: Plan and Protect.”

Requisite Preliminary Steps: Plan and Protect

Unless you have a successful track record of starting businesses, you should complete these two requisite preliminary steps to raising any capital: plan the development of your business and protect the resources of your venture.

Planning the development of your venture’s business

A business plan has two purposes. One is to plan the development of your venture’s business so you can assess its development and make changes in an orderly fashion. The other is to describe your business, its development to date, and your plans for future development so that potential investors and other providers of capital, such as banks and lending institutions, can determine whether to provide such capital.

A business plan has several key sections including the business description, management expertise and experience, security ownership, management’s discussion and analysis of the plan of operation, financial statements and project financial information which are discussed in the paragraphs below. Securities and Exchange Commission (SEC) Regulation S-B provides helpful guidelines detailing the issues to consider for each of these sections. Regulation S-B is available on the SEC’s Internet website,

Business description. For guidelines, see item 101 of Regulation S-B. The business description typically includes a description of:

• Your products or services and the stage of their development;

• The potential clients or customers for those products or services;

• The markets of those potential clients or customers and the size of those markets, both geographically, if relevant, and financially, including potential sales;

• Your competitors and how customers or clients will distinguish your products or services from theirs; and

• The principal properties, both physical and intellectual, of your business and, to the extent relevant, their location and capacity.

Management expertise and experience. For guidelines, see item 401 of Regulation S-B. To the extent that your business plan is intended for potential investors and other providers of capital, such as banks and lending institutions, it should describe the expertise or competencies each member of the management team brings to your venture and their experience in providing those skills to similar ventures and other businesses. For most investors and other providers of capital, experience is more important than any education, degree or certification obtained, and only the most recent five years of experience are relevant. Investors and other providers of capital attach importance to the extent members of the management team are obligated to the venture pursuant to employment, confidentiality, and non-competition agreements.

Security ownership. For guidelines, see item 403 of Regulation S-B. This section should identify and describe the ownership of each owner of five percent or more of each class of equity securities as well as the ownership of management.

Management’s discussion and analysis of the plan of operation. For guidelines, see item 303 of Regulation S-B. This section should discuss both the needs for and sources of capital for the ensuing years. Needs typically discussed are product research and development, acquisition or expansion of plant and equipment, and attraction or retention of key personnel. Sources of capital should include:

• Internal sources, such as those from operations; and

• External sources, such as those from debt, including borrowing, and those from equity, including sale of securities.

Financial statements. For guidelines, see item 310 of Regulation S-B. At the very least, these should include a balance sheet for the end of the most recent fiscal year and statements of revenue and expense, cash flow, and changes in stockholders’ equity for the fiscal year then ended. If your venture has not yet completed its first fiscal year, the financial statements should include a balance sheet as of the most recent practicable date.

Projected financial information. The projected financial information should include:

• Statements of revenue and expense, cash flow, and changes in stockholders’ equity for at least the next three years with monthly detail for at least the first year; and

• A balance sheet as of the most recent practicable date and projected balance sheets for the end of each year covered by statements of revenue and expense, cash flow, and changes in stockholders’ equity.

Protecting the venture’s resources

Investors and other providers of capital will generally require that your venture’s resources are protected for the venture as a condition to their providing capital. The two most important resources are the human resources of your management team and other key personnel and the intellectual property of your business, products, and services.

Employment terms. With respect to the human resources, investors and other providers of capital typically want key members of management and other key personnel obligated to the venture through employment contracts. Two of the most important provisions of an employment contract are:

• Notice provisions, which require an employee to give advance notice (typically 30 days to six months) before resigning or quitting; and

• Discharge provisions, which authorize someone, typically the board with respect to the CEO and the CEO or the board with respect to any other officer or employee, to remove an individual from his or her authority and responsibilities as an officer and employee, with or without cause.

Often these notice and discharge provisions provide different levels of compensation through either continuation of salary and bonus or payment of separate severance benefits if there is cause for discharge or good reason for quitting.

Restrictive covenants. Other provisions, typically referred to as “restrictive covenants,” are also important to investors and other providers of capital. The most common of these covenants place restrictions on:

• Outside activities. These provisions are typically provided either in the affirmative, requiring employment “on a full-time basis,” or in the negative, prohibiting any other employment or activity that impairs the person’s ability to exercise his or her authority and to meet his or her responsibilities fully.

• Ideas developed. Usually an affirmative covenant, this provision states that any idea or invention developed by the employee for the business of the venture belongs to the venture and often includes an assignment of any such ideas, including inventions, to the venture.

• Use of confidential information. Typically a negative covenant, this provision prevents the use of business or trade secrets and other confidential information, except as authorized, in the course of the venture’s business.

• Solicitations of resources. These provisions are generally a negative covenant prohibiting the solicitation of any employee, customer or client, vender or supplier, or similar resources of your venture to cease their relations with your business.

• Competition with business. Typically a negative covenant, this provision prevents competition with the business of your venture during, and often for a period after, employment.

Third-Party nondisclosure agreements. In addition to protecting the human resources of your management team and other key personnel, your venture needs to protect its business and trade secrets and other confidential information, including technology and inventions. In addition to affirmative covenants and assignment by employees of ideas or inventions developed for the business of the venture as discussed above, third parties, including potential investors and other providers of capital, should sign a nondisclosure agreement before being given access to any such business or trade secrets and confidential information. Access to the business plan itself should require signing such a nondisclosure agreement.

Trademark, trade name, and domain name protection. Investors and other providers of capital will require your venture to protect its entity name, often including exclusive rights to an Internet domain name identifying your venture, as well as trade and service mark protection of your business’ products or services.

Raising Early Stage Seed Capital

Typically, venture capital is not available until your venture is ready to begin marketing your business’ products or services. This means you have a developed business plan, protected resources, and developed products or services to the point of commercialization.

Entrepreneurs generally have to fund development of the venture’s business plan and protection of its resources with their own funds or those of family and friends.

Only a few venture capital firms provide early stage seed capital. This capital is typically not available until your venture is ready to begin development of the products or services of your business. However, even this early stage seed capital is not available until your venture’s business plan is complete and its resources are protected.

The most common source for financing the development of products or services to the point of commercialization is “angel investors” - investors who either understand your products or services or have the utmost confidence in the management team and are willing and able to assume the risk of investing at this stage in your venture in return for whatever potential return your venture offers.

There are several ways to find angel investors. One is through advisory boards such as Business First’s Business Advisory Board Exchange, which matches businesses with potential advisors, including advisors with knowledge of the angel and venture capital communities. You may contact Business First’s Business Advisory Board Exchange by calling 614-461-4040 or by visiting its website.

Angel investors may also be found through a service, such as OhioAngels.com, that serves as a portal linking potential angels to Ohio entrepreneurs. You may contact OhioAngels by calling 614-262-5568 or visiting its website. Another source of angel investors is through small capital investment bankers, such as Hellston Capital Group (614-262-5543).

Sources of venture capital include CID Equity Partners (614-222-8185), Ohio Partners (614-621-1210), OnVentures LLC (614-224-4878), NCT Ventures LLC (614-659-8629), and Stonehenge Partners, Inc. (614-217-1111). Groups that facilitate entrepreneurs presenting their plans before potential capital sources include Columbus Venture Network (614-225-6060) and Innovest (216-229-9445).

A Caution about Securities Laws

Although your venture’s initial resources will probably be limited, you must comply with federal and state securities laws when issuing securities, including either equity, such as stock, or debt, such as notes or debentures. If your venture fails to comply with these securities laws, purchasers of your venture’s securities will have a rescission right that can force your venture to refund the entire purchase price of the securities. In addition, your venture, as well as you and persons who control your venture, may also be subject to civil and criminal liability. Although exemptions are available to avoid the costly registration provisions of federal and state securities laws, any offering of securities must be carefully designed from the beginning to take into account both past sales and possible future offerings. Accordingly, any venture should consult with competent legal counsel before any offering or any sale of securities.

Preparing Your Presentation to Venture Capital Firms

Your presentation to any venture capital firm should focus on those matters that venture capital firms consider important in deciding whether to make an investment. Most venture capital firms are willing to assume a technology risk. Therefore, your presentation should not be a technical treatise regarding the technology underlying your product and the steps in completing your product development.

Most venture capital firms are less willing to assume an unknown market risk. Most venture capital firms are looking for businesses that offer rapid revenue growth, such as a growth of $100 million over a period of ten years or less. Accordingly, they want your presentation to focus on the size of the market, the potential customers and competitors, and the competitive advantage of your venture in its intended business.

Venture capital firms are investing as much in the human resources of your venture as they are in its technology and ideas. Your presentation should demonstrate that you have in place the protections discussed above under “Protecting the venture’s resources.”

Finally, most venture capital firms are looking for a liquidity event (commonly known as the “exit strategy”) returning their investment within three to five years. Such liquidity events include the sale of the business or an initial public offering of the equity of the business. Therefore, you should design your presentation to show a substantial return to the venture capital within this period.

Selecting Venture Capital Firms for Your Presentation

Begin with some basic research over the Internet or through directors like Pratt’s Guide to Venture Capital Sources or the Directory of the Western Association of Venture Capitalists. Ask for suggestions from other entrepreneurs who have successfully raised venture capital and bankers, lawyers and accountants who work with emerging businesses. Because venture capital firms have become industry and even product oriented in order to reduce technology and marketing risks, look for venture capital firms that have extended capital in your industry or for similar products. Because venture capital firms often limit their investments to businesses within a few hours drive or direct air flight of the venture capital firm’s principal office, look also for venture capital firms that have such geographical proximity.

After you have made a list of potential venture capital firms, interview several. Look for someone to introduce you to those on your list. A referral will often have the effect of a third-party validation of your legitimacy. Also, a referral who personally knows representatives of a venture capital firm can help get and give feedback to you.

When you interview, you are looking for more than just money. First, because the venture capital firm will be your partner for a period of at least three or more years, you are looking for personal chemistry between you and the venture capital firm. Second, you are looking for contacts. Ideally, your venture capital partner will have access to those resources and skills to which you do not.

How Much Should You Raise

Today, venture capital generally or frequently comes in tranches, each for a particular phase of the development of your venture’s business. The earliest phase is completing product development to the point of productivity for market. Each phase should have a well-defined milestone. More is better than less because you need to make sure that you can fund your venture not only through unexpected delays, but also until you can complete the next round of financing.

An important limit on what you can raise is the valuation of your business. Most venture capital firms are looking for a tenfold or greater return in five or fewer years. They generally estimate future value based upon a multiple of earnings, usually between 10 and 20 times, and then discount that future value using their desired rate of return to a present value of your business. Finally, most venture capital firms want their resulting investment to give them control of 50 to 60 percent of your venture on a fully diluted basis, taking into account employee equity plans.

Finally, conduct research on what valuations venture capital firms are giving to other ventures at the same development stage and in the same general market area as your venture.

What Structure to Expect in Venture Capital Financing

Venture capital financing is typically structured as a form of preferred stock. The selling price of the preferred stock is generally at a substantial premium over relative prices paid by you and other founders for your shares. There are several purposes for the preferred stock. Unlike debt, preferred stock entitles the venture capital firm to capital gains treatment, at least for federal income tax purposes, of any appreciation in value if your venture is a success. The preferred stock is designed to give a liquidation preference if your venture is less than an ongoing success. The preferred stock has a minimum dividend providing a return on investment as a milestone for measuring the performance of management, and failure to pay those dividends or achieve those or other milestones typically results in increasing the voting power of the preferred stock so that they can replace your venture’s board of directors or other management.

The typical preferred stock will have terms similar to the following:

• Liquidation Preference. Upon liquidation of your venture, the holders of preferred stock have the right to receive a fixed dollar amount before any assets can be distributed to the holders of common stock. Typically, the liquidation preference is the purchase price plus accrued but unpaid dividends. A “participating” preferred stock also participates with the common stock in the distribution of any assets left after payment of the liquidation preference. The right to receive the liquidation preference is generally triggered not only by a dissolution, but also by any merger into or acquisition by another company.

• Dividend Preference. Venture capital preferred stock usually has one of two types of dividend preference. The more common type is the “mandatory, cumulative” dividend which is similar to interest on debt. It accrues at fixed dates, typically annually or not more frequently than quarterly, and cumulates until paid. The second type is the “when, as and if declared, noncumulative” dividend that, in essence, limits your venture from declaring any dividend on common stock until a specified dividend is paid on the preferred stock.

• Redemption Provision. The redemption provision may be either a call or a put redemption, or both. A call redemption allows your venture to “call” for repurchase of the preferred stock, requiring the holders to sell, usually at a price equal to its liquidation preference plus a redemption premium. A call redemption generally co-exists with a conversion right, entitling the holders of the preferred stock to either be bought out or to convert to common stock. A put redemption allows the holders of the preferred stock to “put” the preferred stock, requiring your venture to repurchase it, typically at a multiple of the investment made in the stock. A put redemption is normally exercisable only if dividends are not paid or other milestones are not achieved. Redemption provisions are less popular in recent years among venture capital firms because in order to fall within a safe harbor to avoid adverse consequences of possible imputed income, the redemption premiums must be limited to 0.25 percent per year.

• Conversion Rights. Generally, the preferred stock is convertible into common stock any time at the holder’s option. The conversion right specifies the ratio for the number of shares of common stock into which each share of preferred stock may be converted. In addition, conversion may be automatic upon public offerings of a certain magnitude of your venture’s common stock. Sometimes conversion rights are subject to a “pay to play” provision that dilutes the conversion right if the holder does not participate in subsequent funding rounds. With such provisions, the conversion ratio is reduced by the reciprocal of the amount that the holder would have invested if the holder had made a pro rata share of subsequent funding rounds divided by the amount actually invested by the holder.

• Antidilution Protection. Preferred stock is typically protected against both “share” dilution and “price” dilution. Share dilution provisions protect the preferred stock against dilution from stock splits, stock dividends, and similar events increasing the outstanding number of shares without the venture receiving additional capital. Price dilution provisions protect against dilution from sales of stock at lower prices. A common antidilution provision is a “weighted average” adjustment of the conversion price or ratio. The weighted average is a formula that takes into account both the number of shares and the capital received of all shares issued over a period of time. An alternative antidilution provision is a “ratchet” that drops the conversion price to the lowest price at which stock was sold over a period of time regardless of the number of shares sold. A problem with the ratchet antidilution is that it protects investors who decline to participate in lower-priced offerings.

• Voting Rights. Venture capital preferred stock usually entitles holders to a number of votes at any time determined “as if converted” into common stock at such time on any matter submitted to vote of stockholders. In addition, the preferred stock often entitles the holders as a class to elect a certain number of directors to your venture’s board or other governing body, with holders of the common stock electing the remainder. In addition, the preferred stock also entitles the holder to a class vote on certain major corporate events, such as mergers and acquisitions and the issuance of any securities on par or preferred to that class of preferred stock.

• Registration Rights. In addition to the foregoing preferences, venture capital firms require participation in liquidity events available to others, including a right to demand certain events of liquidity so that they can receive a “cash out” of their investment not later than any other investor. See the discussion of “co-sale” rights under “Other Restrictions on Management and Founders.” The most common provisions are “piggy-back” and “demand” registration rights. Piggy-back registration rights entitle holders to participate on either an equal or secondary basis in any public offering of securities undertaken by the venture or other security-holders. Piggy-back rights are on an equal basis if the holder can sell a pro rata number of shares with each other holder and on a secondary basis if the holders’ number of shares can be eliminated or reduced for marketing or other reasons, as determined by the lead underwriter or investment banker for the offering. Demand registration rights entitle the holders to demand that your venture register their shares for a public offering underwritten by an investment banker chosen by the holders. Typically, your venture pays the related expenses of any such offering other than the underwriting discount or fee which is absorbed pro rata by each seller.

Other Restrictions on Management and Founders

Venture capital financing generally imposes affirmative covenants requiring your venture to provide holders with ongoing financial information, limit compensation of management, and allow access to books and other records. Venture capital financing also imposes negative covenants prohibiting your venture from taking certain actions, such as transferring assets or incurring certain expenses or liabilities, without holders’ consent. Your management must carefully evaluate these covenants to ensure that they will not unduly interfere with your board’s ability to manage the company.

Venture capital financing imposes a “right of first refusal” on further stock issuances by your venture. These provisions typically give holders the right to buy their proportionate share of any new equity offerings prior to a public offering.

And, as discussed above, venture capital financing generally requires that management and founders give holders a “co-sale” right to participate in any liquidity event proposed by management or founders with respect to their holdings. The purpose of these co-sale rights is to prevent management and founders from “cashing out” without giving holders the same opportunity to participate.

Subsequent Rounds

As discussed above, venture capital financing typically comes in tranches. If the business of your venture is successful with the first round financing, the price received by your venture in the second round will be one and a half to three times the price received in the first round. Businesses are typically valued for second round financings at a multiple of one-times revenues or, if greater, a multiple of 10- to 15-times earnings.

If the business of your venture is not successful with the first round financing, you are likely precluded from subsequent tranches without a change in management or a substantial dilution of management and founders.

Conclusion

Venture capital is a common way of financing the development of your business until it has sufficient operations to support a public offering or attract another form of liquidity event. Planning and protecting are requisite initial steps. Careful preparation of your due diligence for potential venture capital firms is necessary. Understanding the possible structure and restrictions imposed by venture capital financing will reduce any surprises. As a result, your venture and the venture capital firm may achieve a partnership that profits everyone.