The Three “Be’s” for Inventors and Entrepreneurs Seeking Investors

“People don’t hand over money for good ideas. They invest in businesses that can make them more money than other uses of those funds.” “If you don’t look serious about your business, why should someone else be serious about his/her money?”

Bryan Emerson (Managing Principal of Starlight Capital) offers the following three pieces of advice for entrepreneurs hoping to commercialize their inventions: Be prepared, be patient, and be flexible.

Be Prepared (be Realistic) Although family and friends may support inventors because they trust and respect them, “that is too much to expect from anyone else.” Serious consideration by other investors requires four items: 1) a working, tested prototype (preferably with paying customers), 2) a succinct executive summary (2-4 pages), 3) a full business plan which demonstrates knowledge of the costs, profit margins, sales pipeline, competition, 4) an investment-oriented PowerPoint presentation. Technical people who do not regard themselves as skillful business writers familiar with what the investment community wants to hear should hire someone to convey the commercial logic of the invention. Emerson observed that a common misconception by inventors is that investors are interested in a product per se. This is not true. Inventors who spend a whole meeting with investors talking about the widget miss the opportunity to talk with investor about what THEY care about: scalable, profitable or potentially profitable companies, preferably with multiple revenue streams that aren’t all vulnerable to the same market fluctuations. Emerson recommends that entrepreneurs find a mentor who has successfully commercialized an invention, preferably in their niche. Why make costly mistakes when a mentor can warn you in advance?

Be Patient (and Proactive) “Launching a business, seeking investors, and finding customers all take longer and cost more than one might expect. Take a long term view and use that time well,” says Emerson. Work at getting visibility in the finance and investment community. Listen to how other companies present their value proposition to the finance community. Listen to the questions that financiers ask so you won't look like a “deer in the headlights” when you get the same, logical questions. Although investors may be cautious now, they may be more interested in a year, especially if they have gotten to know you and your business in the interim. Also, set technical and commercial milestones and achieve them. Build a prototype, test it, write expert commentaries, etc. Follow up with people you have met to let them know what you have accomplished since last time you spoke. Some people may suggest goals because they are serious about your business enhancements; others may set goals to get rid of you. Learn to tell the difference by ascertaining whether they have really invested in this space or are just talkers.

Be Flexible about financing Ask a financial professional familiar with start-ups about all financing opportunities. Should you locate in an adjacent county since government grants and loans vary by district? How much money do you seek to raise? Consider angel groups for less than $1 million and investment bankers for more. Should you consider receivables financing? Companies with assets and cash flow have more financing options than those without, including both debt and equity-based loans and loans based on factoring inventory or receivables. Vendors, customers, and partners are also funding source options. Inventors and other entrepreneurs have many resources available to them, including time, documents, public information and professionals. Explore them and use the ones that make sense to ensure that your worthy invention becomes a viable business rather than a tax write off.

How Much Does it Cost to Raise Money?

What is the cost of private equity today? The answer depends on the target amount, preparation, and creative money raising strategies.

The fund raising market tends to divide itself into three categories: businesses seeking less than $1mm, $1mm – 10mm and over $10mm. Investment bankers usually won’t touch deals for companies raising less than $1mm, according to Stephen Brewer, President of Brewer Capital in Houston. “To raise amounts over $1mm, a FINRA licensed investment banker typically charges a 10% success fee and a 2-3% unaccountable allowance (expenses to raise the money). Fees decline for raising larger amounts – 8% for raising $2-5 mm and 4-6% to raise more than $5 million, with the same 2-3% unaccountable allowance.”

Kyle Holland, principal of First Avantus Securities in Austin and shareholder of Wired Angel.com, Inc. of Houston sees tougher deal terms now. “It is brutal out there trying to raise funds. Investors were burned and are very conservative now. On the other hand, some fund-raising companies really need money, so it is a seller’s market. I’m working with some guys who are factoring, doing credit lines, paying 25% on their money. Some deals are really creative with differing percentages of cash and warrants, with floating percentages of free trading stock depending on the amount raised. For example, to raise up to $2mm, I am seeing deals for 13% cash with 7% warrants. If $3mm is raised, the terms shift to 11% cash with 5% in free trading stock.”

Because it is so hard to attract investment, Karl Maier, principal of Houston Biz Starter, sees small businesses “raising money the old fashioned way – bank loans based on inventory and receivables,” or increased commitment to making sales and retaining customers. “Entrepreneurs have to spend money on professionals to raise money, just as they need to spend money on marketing to gain customers.” Neither expenditure guarantees success – it needs to be a smart “spend” either way. The biggest mistake Mr. Maier sees in companies trying to raise money is lack of objectivity in their valuation and business opportunity. He recommends that they pay to get an independent assessment of their proposal before they go before savvy investors.

The costs of raising money include many expenses other than those of the fund-raising sources themselves. To position themselves for private equity, companies need supporting materials. They can create them in-house or hire professionals to do so. The higher the stakes, the more impressive these items need to be. Documents include executive summaries, longer business plans, private placement memoranda (PPMs), and contracts. Other items include PowerPoint presentations, websites, marketing collateral and press releases. Businesses also incur costs for networking and traveling to give presentations to potential investors.

Prices for these services vary broadly, depending on several factors. The most controllable cost is how prepared a company is to engage investors’ attention. Has it done what attorney Chuck Powell, partner at Haynes and Boone LLP in Houston, refers to as “blocking and tackling” early in the life of the company? For example, does it have clear documentation of IP ownership and shareholder stakes (two areas of frequent conflict)? Has it already written a professional quality business plan with a short executive summary? Can marketing materials and PowerPoint presentations geared to customers be tweaked for potential investors? If so, the company can save tens of thousands of dollars in service fees.

Companies less well prepared must budget accordingly for time or money. An investor-oriented business plan generated from scratch or from piles of papers can cost a five-figure sum. If the executives of a company want to write it themselves, they should calculate the value of their time. Arturo Romero, President of Mejores Compras in Houston (and a client company of Houston Technology Center), put it this way: “The real cost in the search for capital has been the cost of my executive team’s time and effort. The late nights and long days producing the business plan and preparing for presentations will pay off, but it took away from the business and from our families. It is hard to put a value on that.” Other companies calculated the time for creating in-house an acceptable executive summary at ten hours and for an effective investor-oriented PowerPoint presentation at twenty-four hours.

For legal fees, a “rule of thumb” is that companies should budget 1% of the amount to be raised, so a company seeking $5mm should budget $50,000. These fees cover documentation of transaction terms, IP ownership, due diligence, disclosure, employer/founder arrangements, employee options, and closing. Of course, this amount can rise or fall depending on numerous factors, many of which are within the company’s control.

Three things can save a company thousands of dollars in legal fees,” advises Powell. “First, sophisticated, first-rate financial people on the management team” can clear a lot of the landmines that other businesses miss, such as market conditions, the success of similar deals, unrealistic financial projections, and the effect of future investment rounds on early investors and management. Second, companies would do well to address the tough stuff and reach agreement before they bring in the lawyers. The more often people change their minds or change the terms once an attorney is engaged, the more the hours rack up. “One deal that should have cost $50,000 ran $100,000 because the terms kept changing. The investor had requested long form non-compete and non-disclosure terms for all employees, each of whom engaged his/her own attorney. In addition, the VC wanted other rights that had not previously been discussed.” Third, companies should come to lawyers with a fully negotiated, non-binding term sheet in hand. “Negotiating a deal through the documents really raises fees, compared to a thirty minute conference call between the parties and their attorneys.”

The common mistakes of companies seeking private equity are overestimation of their appeal to investors and underestimation of the time it takes to do what needs to be done. By being prudent and practical, they can save both time and money.

Do Due Diligence on Your Company Before Someone Else Does

Savvy proprietors of businesses who have been waiting for the right time to sell, merge, or attract investors, are doing due diligence on their own companies before approaching anyone else. No manager wants to look like a deer in the headlights when a potential investor asks about an employee with a criminal record, a publicly registered customer complaint, or late property tax payment. Company leaders need to anticipate the records suitors will request, both from the company and from public sources, like the Internet, the bank, and licensing agencies. Prepared companies scrutinize themselves, as others with checkbooks invariably will, enabling management to approach suitors with a realistic valuation and a knowledgeable evaluation of the company’s strengths and vulnerabilities. In addition, the process can save firms tens of thousands of dollars on professional service fees.

Internal records: A functional due diligence file will contain about fifteen sections. A company with few employees and assets can expect to organize about 50 documents, some of which will need to be updated quarterly or annually. Many companies already have many of these items in separate files, such as “Employees,” “Sales,” “Taxes,” and “Legal.” Pulling them together for a purchasing or investing audience serves two useful purposes: it encourages internal management to review their records with the eyes of interested outsiders and it reveals gaps that may not be obvious when records are segregated. The files should encompass records of the company’s:

- Organization and Good Standing

- Capitalization and Stockholders

- Authorization of Acquisitions and the Transactions

- Financial Statements

- Tax Matters

- Employees Records, Benefit Plans, Salaries, Labor Disputes

- Material Contracts and Commitments

- Licenses

- Insurance

- Litigation, corporate and personal

- Patents and Trademarks

- Real Properties owned and leased

- Inventory

- Books and Records

- Operating Plans Some information will strike a potential investor differently than a potential merger partner, while other information will be equally important to both groups. Knowing the interests of each will enable the principals of a company to assemble records that matter to that target group. For example: Corporate structure: Is the firm a corporation or a partnership? In what state? The answer has implications that make your company more or less attractive to your target audience than competing firms. Ask your attorney.

Stockholders: What do the bylaws say about the rights of major/minor stockholders? Who are they? How many are there? Is management invested? Stockholders, like staff, can be perceived as either an asset or a liability to a deal. Do the shareholders bring value beyond money or do they have a history of litigiousness?

Potential buyers will demonstrate particular interests. One might care about owner expense add-backs or owner assets; another may be concerned about related party transactions. Others will have strong wishes for management to leave or to stay. A company can’t anticipate everything, but its records will be scrutinized for “deal breakers,” omissions, and evasions. Anticipate logical questions Practice your answers to them.

Management: Be prepared for tough questions. Have background checks, performance reviews, and updated resumes handy. Explain attrition. Know which managers wish to remain with the company after a deal is struck and who wishes to leave. Are non-compete documents in order? Do any have relevant outside businesses? Check LinkedIn, Facebook, SEC.gov, secretary of state corporation websites and other sources. What will your suitors see?

Material contracts and commitments: Have customer lists, letters of credit, installment plan purchases, and current and pending contracts filed in an organized fashion. If there are any insider contracts, be sure to show those, too. Are there any performance guarantees? Are any deals imperiled by a change in management? What about agreements with dealers and distributors?

Cash flow: How well does the company manage seasonal or other fluctuations in its costs and cash? Your accountant can help you design cash flow projections to show likely future scenarios. Such analysis may reveal financing options for you, too, such as factoring receivables during short term shortfalls.

Licenses: Technology companies often base their valuations on their intellectual property, so records can quickly inflate or deflate suitor interest. Patents “to be filed” or “pending” are a lot less attractive than patents awarded or defended. Equally important is who owns the technology. Is it clearly the company or could it be an employee – one who remains or a disgruntled one who has left? Was it developed in conjunction with another firm or university? The answers can substantially raise or lower the valuation. Professional service firms should have current records of all licenses, compliance forms, and proof of professional good standing.

Insurance: Physical assets can be strengths or liabilities, too. If the company owns buildings or land, have records of ecological due diligence. A building with a demonstrated lack of mold or property with no history of chemical storage or oil spills is worth a lot more than one without such a pedigree. How is inventory insured in case of flooding the day the contract is signed? Does the company have key man insurance? What about Errors and Omissions? Such evidence assures suitors that they are unlikely to suffer buyer’s remorse, and therefore, can move a deal along faster than a company that leaves such questions unanswered.

Public records: In addition to organizing records for outsider scrutiny, a company’s strategy should include a survey of its electronic presence. It is very easy to check up on other companies, so each firm should do a regular Internet search of its company name and staff. For example, hcad.org indicates whether Harris County based companies (and home owners) have paid their taxes for the year, how much they are, and the appraised value of the property. Licensing agencies, like the FINRA, have websites (as do such professional associations as realtors, lawyers, doctors, nurses, engineers) which the public can search for the names of broker-dealers (or other professionals) in good standing. A company’s own website can be very revealing. Is it current? Clear? If you contact the business through its website, does someone actually get back to you? A search on www.google.com or another search engine for the company or management team names can reveal useful information – positive or negative. For example a Google search I performed on potential clients revealed: (1) a businessman who has gotten a Cease and Desist Order from California for a business he was now trying to register in Maryland (2) a CEO who lied about his education background (he made up a university) in his SEC filings and (3) a company seeking investment that hadn’t paid its property taxes for the year.

Surely none of these is the first professional impression one wants to make on the World Wide Web. Some records can be purged by corrective action; others can be buried by generating appropriate news items, like press releases, speeches, and article bylines. In general, if your company seeks the trust, respect, and money of other people, make sure that your financial and administrative records are clean and orderly. Many other companies are knocking on the same doors you are, and they have done so.