Most emerging businesses, particularly in the technology sector, require a substantial amount of capital to fund basic development work on a proposed product. Once basic development work is complete, additional capital is needed to test the product in market conditions and adapt its functionality to developing customer needs, before the emerging business can commence regular business operations. Often a patent application needs to be prepared and filed. The capital that is used for these purposes is typically referred to as "seed capital."
Raising seed capital is one of the most difficult obstacles for an emerging business to overcome. Only the most risk-tolerant investors are willing to invest in an unproven technology or product, for which there may not yet be a viable market. In addition, the reward for a successful investment at this stage is very uncertain. At the seed capital stage, an exit strategy for investors is almost always a very remote conjecture. Investors in these types of offerings are often very difficult to find; they are commonly referred to as "angels" for the good fortune involved in finding them.
Managers of an emerging business seeking seed capital can be encouraged by developments in the lowest segment of the capital markets. Although still far from being organized, the market for "angel" capital has developed rapidly over the last decade or so. According to the Center for Venture Research at the University of New Hampshire, angel investments totaled $26.0 billion in over 57,000 companies in 2007, an increase of 1.8% over 2006. The number of active angel investors during 2007 was 258,200 individuals. Sophisticated angel investors often are willing to provide seed capital, together with management and financial advice, to emerging businesses on relatively favorable terms. Although the rise of angel investing was associated with the general technology and Internet booms of the 1990s, angel investors are likely to remain a permanent part of the capital markets even after the ongoing downturn.
Sources of Seed Capital
Sources of seed capital are endlessly varied and often difficult to identify. Managers who are fortunate enough to have means of their own may fund some or all of their seed capital requirements with personal resources. Although self-funding has obvious advantages due to its flexibility, it can also have disadvantages. Later-stage investors will often consider the identity of existing investors and the quality of independent board members in assessing an investment, and self-funding can give an emerging business an ingrown character. For most managers of emerging businesses which have the potential to grow significantly, personal funds can only provide a small portion of the necessary seed capital.
Many managers are able to tap well-heeled friends and family for seed capital. With personal connections, the manager of an emerging business can often arrange an investment on relatively accommodating and patient terms. Managers with a track record in a particular industry also will often have connections with other industry insiders who are prepared to trust the manager with seed capital. Although such industry insiders often are reluctant to give investment terms the same soft touch as friends and family, their participation may be extremely valuable for the practical advice and credibility that they bring to the business.
Angel and VC Resources in New England
Geographic areas associated with technology and other entrepreneurial communities have seen the rise of semiprofessional angel groups. In Northern New England, the Route 128 and 495 corridors have high-profile groups of angels, some of which revolve around universities. A number of other areas in Northern New England have also seen the development of angel groups, for example the Nashua Breakfast Club, the Portsmouth "eCoast" group and the Mt. Washington Valley First Run group. While the approach and the philosophies of these groups vary, they have frequently served as the source of good ideas and patient seed capital.
There are numerous resources available for those looking to obtain VC or angel investment capital in New Hampshire. The state's two major universities - Dartmouth College and the University of New Hampshire - have resources on their respective campuses. Go to www.den.dartmouth.edu (Dartmouth Entrepreneurial Network) or wsbe.unh.edu/cvr (University of New Hampshire Center for Venture Research) for more information.
It hardly needs to be said that a startup business should almost always accept seed capital where it can find it. Perhaps the only exceptions to this rule are where the prospective investor does not meet the legal standards for participating in a private offering, either because he or she does not meet the test for "accredited investor" status under the securities laws or otherwise lacks the sophistication to understand and bear the risk of an investment, or where the prospective investor is part of the shady underworld of the investment community. The legal standards for participation in a private offering of securities are discussed under "Legal Considerations" later in this chapter. Whether a prospective investor is legitimate may be somewhat more difficult to determine, but shady investors follow certain modus operandi which sophisticated counsel can often recognize.
For example, an emerging business is sometimes approached by a firm claiming to be in the investment banking or venture capital (VC) business that is, in reality, a finder. Some of these firms may initially give the impression that they have the ability to provide the necessary capital themselves, but in reality only intend to act as agents to find other sources of capital. Some of these firms can, in fact, place an offering; others offer assurances that are never realized. They will often ask for up-front fees, which are explained as retention fees, fees for the preparation of offering materials, unaccountable expenses or some other item for which it would be difficult to hold them accountable. Managers of an emerging business should ask tough questions about the structure of the fees charged, the identity of the actual investors, the firm's track record with private offerings and the firm's licensure as a broker-dealer under the laws of the states in which it operates. Any unfavorable responses should put the emerging business on guard as to the firm's bona fides.
Involving finders in a seed capital round presents some special problems for an emerging business. Sometimes it appears that using a finder is one of the few ways of gaining access to interested investors. However, even legitimate finders with a favorable track record carry a risk for the emerging business. The problem stems from the fact that finders carry out a function that is not adequately addressed by existing securities laws. Under existing securities regulations and interpretations, if a finder receives "transaction-related compensation," i.e. a commission which is contingent on a successful sale of securities, he or she is required to register with the SEC as a broker-dealer under the Securities Exchange Act of 1934 (Exchange Act) and obtain licensure as a broker-dealer in the states in which he or she operates. Since broker-dealer registration and licensure present a substantial compliance and reporting burden for the large brokerage houses, a small finder cannot practically comply with these requirements, and most finders do not attempt to do so.
For an emerging business, the danger is that an investment arranged by a finder will not perform as expected and that the investors will sue both the finder and the emerging business to rescind the investment. Usually, the investor's claim is that he or she was not properly apprised of a risk that was borne out, or was not able to understand and assess that risk. Although the finder is primarily liable to the investors in such a case, the emerging business may also face liability as a "control person" of the finder. Before involving a finder in a seed capital round, the manager of an emerging business should consult with counsel, who will be able to assess the regulatory status of the finder and advise the manager on risks and alternatives.
Angel Investor Search Process
The manager of an emerging business seeking seed capital will usually find that it takes an active search process that spans several months to locate the right sources of capital. Although it obviously makes sense to follow up on expressions of interest from angel investors, the manager should take care not to curtail a wider search upon receiving preliminary expressions of interest from a particular investor or group of investors. Experience has shown that the "yield" of actual investors compared with the number of persons expressing an initial interest in an investment, is relatively low, for various reasons.
The process of lining-up angel investors can be very unpredictable, as befits an activity as complex and idiosyncratic as early-stage investing. A wise manager of an emerging business will constantly seek alternative sources of capital, to cover the situation where prospective investors back out, and to provide the appearance and/or reality of competition among investors.
Some prospective angel investors will express interest in an investment without a clear picture of their investment goals and methods. A tentative decision to invest is often divorced from a decision on the investment instrument and the terms that the investor is willing to accept. However, both angel investors and the emerging business in which an investment is proposed are well-advised to always consider an investment in the context of particular terms. Although the quality of a management team and the viability of a business plan are obviously crucial factors, it is nevertheless important for the angel investors and the company to develop a long-range plan for a particular investment, such as whether the most likely exit scenario is a recapitalization, a sale or an IPO.
Often it will be necessary for an emerging business to take seed capital from several different investors. Most angel investors pay great attention to the need to diversify their investments, given the high level of risk that they are taking in emerging businesses. It may also prove beneficial to an emerging business to take investments from different investors, since multiple investors tend to diversify the business' contacts in the capital and product markets. Of course, the greater the number of investors, the more cumbersome it may prove to be dealing with them. In the event that a charter amendment must be approved or a contractual consent must be secured from investors after the investment has closed, a large number of investors can delay a significant future transaction such as raising additional capital. In many cases, the emerging business will find a happy medium between a diversified, yet cohesive group of investors, based on industry characteristics and personal dynamics.
Choice of Entity
With the rise in popularity of the limited liability company form of entity (LLC), many founders of emerging businesses have been led to consider whether their entity should be formed as an LLC. As is common knowledge, LLCs are treated for most tax purposes as partnerships, in that the income and loss generated by the company are attributed and taxed directly to the investors rather than being taxed to both the entity and through it, the individual investors in a corporation. While it is certainly advantageous if profits are taxed once instead of twice, many other considerations bear on the issue of entity choice for an emerging business. For example, the emerging business may not be projected to show income for several years. Thus, the owners will not enjoy the advantage of a single tax on profits during this period. Of course, it may also be advantageous for owners to use losses generated by the emerging business, i.e. if they have other income that they believe they can shelter with the losses. But if the entity is projected to show losses, then investors may feel uncomfortable if they suspect that the business may be managed in part to suit the tax planning needs of the managers. When considering the use of an LLC, managers and investors should carefully review and assess profit and loss projections against the tax consequences to them and the other constituents of the company.
In considering the use of an LLC, an emerging business should also take into account the added complexity and expense associated with that form of entity. The flexibility for which LLCs are famous also means that the LLC agreement is often lengthy, complex and difficult to understand. A manager who uses this form of entity should budget additional accountants' and lawyers' fees to draft and administer the agreement, to avoid potentially surprising negative tax consequences. For example, accounting for the members' capital accounts in the LLC on a periodic basis requires significant effort and expense. Employee equity plans are also much more complex to design and administer with LLCs than with a traditional corporate entity. Although many of the characteristics, for example, of an option plan may be replicated with a specially designed LLC membership interest, it is essentially a different interest from a corporate stock option.
An emerging business typically locates the source of seed capital before determining the terms of the investment instrument. Many investment terms will be driven by the particular characteristics of the emerging business and the investor, such as the timing of funding, the composition of the board of directors and the exit horizon for the investment. Given the significant expense associated with preparing investment agreements, it makes sense to at least informally discuss investment terms before asking counsel to draft documents.
From the perspective of the emerging business, common stock is the ideal investment instrument for seed capital. By its nature, common stock provides plenty of room in the business' capital structure for priority equity instruments like preferred stock and subordinated debt to be issued in later rounds. Common stock also corresponds with the risk/return profile that many angel investors face. It obviously carries the highest risk of any equity instrument, but it also provides a high return in the event the emerging business ends up a runaway success. Common stock is often sold to investors of the friends and family variety.
Industry insiders and other shrewd angel investors will often agree to take a junior preferred stock. These types of angel investors adopt some of the objectives and methods of VC investors, with whom they often deal themselves. A junior preferred stock will often carry a nominal dividend rate and have priority over common stock in the payment of dividends and liquidating distributions. However, this type of preferred stock will often allow the company to issue additional preferred stock with distribution rights that are senior to the junior preferred stock. In order to compensate the investor for the degree of risk assumed, an investor in preferred stock will typically also ask for some way of participating in the return to common stockholders, in the event that the emerging business is a success. This participation right may take the form of a warrant to purchase common stock at a discount to fair market value, a common stock conversion feature, or a "double-dip" feature allowing the preferred stock to receive, upon a sale of the company, its liquidation preference plus a portion of the liquidating distributions to which the common stock is entitled.
Angel investors sometimes propose to invest through a debt security, e.g. a "bridge note" or a short-term or demand note. Sometimes this debt is explicitly made convertible into the next set of equity securities to be issued by the emerging business, and sometimes an understanding along those lines is implicit. Both the emerging business and the angel investors contemplating such an arrangement should be wary of the possibility that the debt is effectively a bridge to nowhere. If the expected equity financing does not materialize, then the debt to the angel investors likely cannot be serviced or repaid, and the resulting legal insolvency of the emerging business will complicate its efforts to grow its business. This is a situation which is in nobody's interests.
An emerging business which is taking debt financing from angel investors should also recognize that the debt is characterized as a security for regulatory purposes. Thus, disclosure, private placement and filing considerations will apply to the financing. Numerous court cases have found that such non-commercial-grade debt is as much a security as common stock and subject to all of the same conditions and restrictions under federal and state securities laws.
The expected term of the security that is issued by the emerging business represents one of the most important terms of the investment. Friends and family may be prepared to extend capital for an indefinite period, trusting the emerging business to liquidate the investment as and when feasible. However, sophisticated angel investors will often insist on some explicit exit mechanism for the investment, in much the same way that VC investors do. They will look at a realistic time period in which the emerging business' product will either prove to be a success or failure (for example five to seven years). They will then provide for some additional period for VC investors to exercise their exit mechanism. At the end of the investment period, they will have the right to either cause their stock to be redeemed by the emerging business or cause the emerging business to be sold and the sale proceeds paid to the investors. Whether or not such a right could ever be enforced in a court of law is usually beside the point; the existence of such a right usually gives an investor enough leverage to effectively precipitate a sale or liquidation of the company.
Ambitious founders of a startup business should carefully consider the capital structure of their business even before it is formed, taking into account the needs of potential VC investors at a later stage in the business' growth. For this reason, it is often advisable to authorize in the organizational documents some form of preferred instrument, with specific terms to be determined by the board as circumstances dictate. This type of instrument is often known as "blank check preferred" for the authority that the board is given to set its terms. Authorizing such an instrument at inception will avoid or minimize practical and investor-relations problems caused by later having to solicit votes on a charter amendment from a disparate shareholder group. It is also important to recognize that potential VC investors will generally view debt negatively, particularly to prior angel investors, on the business's balance sheet. Since debt represents a claim to the business's assets which ranks prior to preferred stock, VCs will often insist that it be converted into equity or deeply subordinated as a condition to any new investment.
When planning the capital structure of a corporation formed under Delaware law, special caution is warranted. The Delaware corporate statute contains a complex and quirky formula for determining the annual franchise tax which Delaware chartered corporations must pay. In order to avoid an inadvertently large tax calculation, it is wise to involve an experienced lawyer in designing the corporate capital structure.
While circumstances will dictate how much room for negotiation the emerging business has over the terms of a seed capital investment, counsel can recommend legal and structural protections to existing owners and point out the benefits and disadvantages of various terms proposed by new investors. Although an emerging business typically has very limited ability to engage in power negotiations with new investors, an effective tool in those negotiations may be an insightful analysis of the results that flow from a particular set of investment terms. For example, a set of investment terms that provides management with little incentive to maximize shareholder return under a realistic exit scenario, can give management a powerful argument in favor of a modification to those terms. By pointing out realistic problems with a set of terms, sophisticated counsel can provide considerable benefits.
Management and Ownership Arrangements
One of the most important issues faced by management of an emerging business seeking seed capital is how much management and voting control should be ceded to investors. Angel investors will, appropriately enough, ask for a substantial percentage of the emerging business' voting common stock or common stock equivalents. These discussions will usually center on some notional value that the parties assign to the business at that point in time. That is, the angel investors may be interested in owning, for example, 20 percent of the emerging business for an investment of $1 million, thereby implying a post-money value for the company of $5 million. However, it is vital for both parties to consider what the overall ownership might be several years in the future, assuming that substantial additional capital will need to be raised, as is usually the case. Even a very optimistic company and its investors must plan around the probability that additional capital will need to be raised before the emerging business crosses the magical break-even threshold in its operations. The key question is not whether, but at what price, new capital will be raised.
A disciplined approach to these ownership and management issues will suggest that management must have a majority or a large minority ownership position in the emerging business after a seed capital round. Without a large stake in the emerging business, the managers may feel (and act) like indentured servants to the other shareholders. But with a substantial stake, the managers will be properly incented to create value in the business. Also, sufficient room should be left in the capital structure to give subsequent VC or other investors a large minority interest in the business. In practice, these factors will suggest that angel investors should be given an ownership stake in the range of 10 to 25 percent of the expected future capital structure.
Angel investors will often ask for a board seat from which to monitor their investment. They may also ask for specific "blocking" rights, i.e. the right to approve or disapprove of major corporate decisions such as changing the essential business plan, issuing additional stock, merging with another business, declaring a dividend or share redemption or liquidating the business. Often it will be difficult for an emerging business to refuse a request by an investor for these rights. However, management of the emerging business should make sure that the company will be in a position to quickly make decisions regarding raising new capital when future circumstances require it. Enlightened angel investors should be persuaded that it is not in their interests to delay or hinder certain necessary initiatives.
Although angel investors typically are the first to raise the issue, the owners of an emerging business raising seed capital should carefully consider the range of options open to them regarding governance and ownership provisions. Many of these issues go directly to the heart of the emerging business' capital structure and who stands to reap the rewards of a successful business. Many businesspeople do not sufficiently understand the danger that, when these arrangements are poorly thought through, they can give rise to a crippling deadlock or other dysfunction among the owners of an emerging business. Experienced counsel can help the managers of an emerging business evaluate the appropriate shareholder agreement provisions.
The following is a brief description of some of the more common types of governance and ownership arrangements which appear in shareholder agreements of emerging businesses:
In addition to the challenges that an emerging business faces in finding willing investors, federal and state securities laws impose restrictions on how a private offering of securities may be conducted and who may participate in such an offering. In essence, the federal Securities Act of 1933 (Securities Act) and analogous state laws require any offering of securities to be registered with the Securities and Exchange Commission (SEC), unless the offering meets the requirements for one of several exemptions from those registration requirements. In practice, it is necessary for an emerging business to offer its securities under one of the exemptions from registration, because of the expense and trouble involved in conducting a registration. The most popular and arguably the most useful exemption is the safe-harbor exemption for private offerings that meet the requirements of Rule 506 of Regulation D under the Securities Act. In layman's terms, Rule 506 limits issuers to offering securities to carefully targeted "accredited investors" and other sophisticated investors, who are fully informed of all material information about the investment and who agree to take "restricted securities" in the issuer.
The first technical requirement of Regulation D is that the issuer must refrain from making a "general solicitation." This means that the issuer must limit its solicitation to individual investors or small groups of investors who the issuer reasonably believes to be sophisticated in evaluating privately placed securities. Mass-mailings, newspaper ads, television or radio spots and public seminars clearly violate this requirement and should be avoided under all circumstances. Internet listings will be considered a general solicitation unless the site which lists the investment opportunity incorporates certain procedures to query the investors' status and ensure that only qualified investors can access offering materials. A general posting on a Web site without access restrictions is considered a general solicitation.
Another technical requirement of Regulation D requires the offering to be made only to "accredited investors" or other sophisticated investors who have the knowledge and experience to understand the merits and risks of the investment. We strongly suggest that issuers limit their seed capital offerings to persons who fall within the "accredited investor" definition, since this classification gives the issuer substantially greater leeway in the preparation of disclosure materials. An investor will be considered an "accredited investor" if, among other alternative criteria, the investor has an annual income of $200,000 individually, or $300,000 together with a spouse; if the investor has a net worth of $1 million; or if the investor is an entity with $5 million in assets.
If the offering is limited to accredited investors, disclosure need not follow any particular format, although it should be sufficient to inform investors of all material facts about the investment. This disclosure is usually embodied in a private placement memorandum or other written materials.
The contents of such a document will vary with the circumstances, and the dynamics of the document are beyond the scope of this book. It suffices to say that experienced securities counsel should prepare and/or edit such a document. If the document does not properly describe all material risks, then the investor will have the legal right to rescind the investment and receive his or her money back-obviously, a catastrophic situation for most any emerging business. In such situations, liability can also be imposed on officers, directors and other "control persons" for misstatements or omissions of material information.
If the offering includes any non-accredited investors, then the non-accredited investors must receive a private placement memorandum which contains a long list of specific disclosure items and financial statements and is in general much more fulsome than an accredited-only document. Under the relevant caselaw, the disclosure should be comparable to what would be provided in a public offering prospectus. This type of disclosure is much more time consuming and expensive to prepare than disclosure for an offering to accredited investors only, and is ill-suited to a seed capital round.
If the emerging business has used an unlicensed finder in the process of conducting the offering, then disgruntled investors may similarly have the right to rescind the investment or seek to hold liable any "control persons" if the business has no available assets.
The Role of Counsel
Counsel typically plays a critical role in structuring and closing an offering of seed capital. If counsel is consulted early in the process, he or she can advise the manager of an emerging business about what its capital structure should look like, the type of investor that is most likely to be interested in participating in the offering, what type of investment instrument is most appropriate for the offering, how to structure negotiations with investors most efficiently and advantageously, how to make sure that the offering meets all of the requirements of the relevant legal exemptions and how to make appropriate disclosures to the investors. With the right planning, an offering of seed capital can help an emerging business move beyond the initial hurdles that it faces, to reach a point where it is a candidate for professional VC investors.
This chapter excerpted from the book, Raising Capital for the Emerging Business (Third Edition-2010). For access to the book in its entirety, please go to the following: http://www.sheehan.com/publications/books.aspx
Michael J. Drooff. Esq., Shareholder, firstname.lastname@example.org
Michael represents small and medium-sized private companies in venture capital financings and syndicated private placements. He also represents large public companies in public offerings and securities reporting and compliance work. In addition, Michael has an active mergers and acquisitions practice representing closely-held and public companies in asset purchases and sales, stock purchases and sales, cash and stock mergers and tender offers. He has played a significant role in numerous offerings of debt and equity securities by corporate issuers and offerings of debt securities by municipal issuers.
Sheehan Phinney Bass + Green PA
Sheehan Phinney is a full-service regional law firm providing a broad range of sophisticated legal services to clients in traditional and emerging areas of law. Our diverse client base includes local and regional businesses, institutions and municipalities, as well as national and international businesses with interests in the northeast.
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 In the First Edition of this book, the authors noted the establishment of several promising electronic matching services for angel investments which operate through the Internet. Unfortunately, these matching services have not lived up to the high expectations that they initially generated. Due to the risks involved in angel investing, it remains a highly personal process, in which lead investors need to have high levels of trust in managers, and co-investors need to have high levels of trust in lead investors. These factors tend to be incompatible with Internet matching services.
 Several provisions of federal and state securities laws impose liability on "control persons" to the same extent as the person primarily liable. Under those provisions, "control" is a very broad concept and is not by any means limited to majority owners, but rather, any person who has any practical influence over another. It is quite possible that an emerging business could be found to be a control person in relation to a finder.
 In a typical sale scenario, the debt and preferred stock holders have first claim on the sale proceeds, following which the common stockholders share pro rata among themselves in the remaining proceeds. If the sale price is high, then the common stockholders may have a large amount to share among themselves. Of course, if the sale price is low, then the common stockholders may be entitled to receive little or nothing, after the debt and preferred stock holders receive their preference amounts.
 Holders of a senior preferred stock, by definition, are paid before holders of a junior preferred stock.
 As Preliminary Note 1. to Regulation D makes clear, "The following rules relate to transactions exempt from the registration requirements of section 5 of the Securities Act of 1933 (the "Act"). Such transactions are not exempt from the antifraud, civil liability, or other provisions of the federal securities laws. Issuers are reminded of their obligation to provide such further material information, if any, as may be necessary to make the information required under this regulation, in light of the circumstances under which it is furnished, not misleading."
Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances. For legal advice, please consult your personal lawyer or other appropriate professional. Reprinted with permission from Sheehan Phinney Bass + Green PA.