Back in 2013 I wrote a series of blogs about preparing for and then structuring a private placement or venture deal. In today’s world where public markets are more difficult to access for smaller companies, it is a topic worth revisiting. There are three primary aspects to the private placement or venture capital arena. The first is getting dressed for the ball – i.e., preparing a company to be viewed and assessed by investors including the due diligence process; the second is determining valuation or deciding to avoid a determination through convertible instruments; and the third is structuring and documenting the deal itself.
In this two-part blog series I will discuss each of these aspects. This first part addresses pre-deal considerations including valuation considerations. Part two will address structuring and documenting the deal.
Although structuring a private placement and negotiating with a venture capital group are very different, the underlying mechanics of investments are universal. In a venture capital deal the VC firm generally has all the money and therefore all the power. In addition, the objectives of the VC fund itself often drive the investment structure. However, if a pre-packaged private placement is presented to the investment community as a company might present itself to a VC firm, the offering will generally be perceived more favorably. Also, and importantly, an understanding of the basic components of financial instruments will increase the efficiency of securities counsel and greatly add to the comfort level of all parties involved.
Pre-Deal Considerations
Before a company can package a private placement offerings or effectively negotiate with a venture or angel investor, it has to have its proverbial house in order. I always advise my clients that will, at any point in their life cycle, seek either private or public capital to maintain proper corporate books and financial records and respect their corporate structure and governance. It is important to hold regular meetings of the board of directors, officers or committees and to draft and sign minutes of meetings. Likewise, it is important to keep systems in place to make sure upper management is informed of events effecting their jurisdiction. In other words, even private companies must have internal controls and procedures including internal controls over financial reporting. All of this takes extra effort, but at the end of the day the business will be more efficient and problems will identify themselves before they become too costly or unmanageable.
Importantly, the company should have a well-done PowerPoint deck which will form the first impression for the investor. Over the years I have found that the deck can take the place of a full business plan but only if it contains clear statements of the business strategy, management bios, and a relatively complete picture of resources needed including people, equipment, intellectual property and associated monetary needs. In addition, the company’s executives should have an oral presentation prepared and practiced. This oral presentation is sometimes referred to as an elevator pitch. Venture capital and angel investors will often start with the elevator pitch and PowerPoint presentation before deciding whether they are interested enough to conduct further due diligence.
Financial Matters
Prior to speaking with investors, a company should ensure that their financial records are up to date, including ensuring that all tax returns have been filed. In addition, the company should have a clear understanding of the amount of funds it needs from investors and the intended use of proceeds. An internal analysis should be completed for extraneous expenses and out-of-date financial reporting systems.
If the company has not done so, financial projections should be prepared illustrating key milestones and clearly stating underlying assumptions. Projections can form the basis of particular investment deal terms such as the vesting of management equity, management compensation out of use of proceeds, and conditions to the release of deferred investment commitments, and as such should be conservative and realistically achievable considering all factors, including the execution and operating experience of management.
Legal Matters
Many start-up entities choose an LLC structure; however, investors, especially VC and institutional investors, will generally not invest in an LLC. Despite the tax ramifications, a “C” corporation remains the favored entity for investors. Delaware also remains the favored state for incorporation. Where an LLC is being converted into a C corporation, a company must conduct a careful tax analysis including any tax ramifications to the equity owners, and the impact on an existing net operating loss (“NOL”).
A company must make sure its corporate books and records are up to date and properly maintained, which includes, as mentioned above, keeping proper board and minute meetings. The state of incorporation should be checked to make sure that the corporation is in good standing and all publicly available information is accurate and up to date. Handshake and verbal contracts or amendments should be memorialized in writing.
Likewise, the stock issuance and registrar of the company should be complete and up to date, accounting for any options, warrants, or other convertible securities. Pre-emptive and other extraordinary shareholder rights should be examined for necessity; if they are not necessary, get rid of them. Employee stock options and rights should be well documented, subject to vesting, and terminate upon the termination of employment.
Every prior security issuance should be examined for compliance with state and federal securities laws, and where there is non-compliance, corrective measure should be taken – including, where necessary, a rescission offering.
Intellectual property rights, if any, should be carefully reviewed and protections put in place. Patents and trademarks can greatly enhance the value of an entity, especially where they form a barrier to entry against competitors. Generally, VCs will refuse to invest in a company if the founders insist on retaining ownership of the principal intellectual property that the company needs for its business. Where applicable, it should be certain that employees and independent contractors have executed non-disclosure agreements, work-for-hire, and intellectual property assignment agreements in favor of the company. In addition to analyzing existing protections and patentable rights, an analysis should be completed to ensure that a company is not violating the intellectual property rights of a third party. An intellectual property analysis is similar to a chain of title search. All potential claims by or against the company should be reviewed and addressed.
Litigation or matters that could result in litigation should be reviewed and analyzed for potential material adverse effects on the company. All general regulatory matters should be reviewed, including whether the company is properly licensed to conduct its business in each jurisdiction that it conducts business and is abiding by all foreign laws and regulations and cross-border laws and regulations including treaties.
Valuation
Determining a valuation is instrumental to answering the overriding questions of what percentage of a company is being sold and at what price. For business entities with operating history, revenue, profit margins and the like, valuation is determined by mathematical calculations and established mathematically-based matrixes. For a development stage or start-up venture, the necessary elements to complete a mathematical analysis simply do not exist. Where a company’s valuation is not easily ascertainable such as in very early or development stage entities, the company may choose to avoid the valuation question and instead sell a convertible security that will convert at a discount to some future valuation metric.
In the case of a pre-packaged private placement offering for a development stage or start-up venture, valuation is management’s arbitrary guess, a best estimate. In the case of a negotiated investment with a venture capital or angel investor, valuation is a negotiated guess or best estimate. Either way, estimated valuation must be supported by in-depth due diligence, market studies, competitive analysis, and management ability.
In determining valuation, a company must consider both pre- and post-money valuation – that is, what is the business worth prior to an investment and what will it be worth after the private placement taking into consideration the use of proceeds from the private investment. The company will want the investment to be finalized at the higher post-money valuation, and the investor will want it at the lower pre-money valuation.
Establishing valuation for a development stage or start-up entity ultimately comes down to an investor’s perception of risk vs. reward. Risk is easy to determine, if $xx are invested, that $xx dollars can be lost. Reward, on the other hand, is an elusive prospect based on the potential success of a business. In the case of an investment by a venture capital or angel investor, such investor will conduct an in-depth due diligence and review of the business and determine the valuation they are willing to invest at, as a result of their findings. I advise clients preparing a private placement offering memorandum to conduct that same due diligence review and present the results to potential investors, in the form of a private placement memorandum and business plan that supports the offering price and percentage.
In setting value, an analysis (due diligence) should be conducted on a minimum of the following: market data; competition; pricing and distribution strategies; assets and liabilities; hidden liabilities; inflated assets; technology risks; product development plans; legal structure; legal documentation; corporate formation documents and records; and management, including backgrounds on paper, and face-to-face assessments.
Whether preparing a private placement memorandum or negotiating with a venture investor, it will be the issuer (company seeking the money) that will propose a valuation which may or may not be in sync with the valuation proposed by the investor. It is important that this proposed valuation be grounded in reality and supported by research, or investors will not take the company seriously and will not believe in management’s ability.
Areas of Consideration in Determining Valuation
The following areas should be researched and considered in determining a pre-money, development stage or start-up valuation. The below list is in no particular order.
- Investment comps: have other investors, either private or public, recently funded similar companies and if so, on what terms and conditions and at what valuation;
- Market Data: who what is your product market; what is the size of the market; how many new players enter the market on a yearly basis and what is their success rate;
- Competition: who are the major competitors; what is their valuation; how do you differ from these competitors;
- Uniqueness of product or technology: how is your product or technology unique; can it easily be duplicated; patent, trademark and other intellectual property protections;
- Pricing and Distribution Strategies: what are the major impediments to your successful entry into the marketplace; what is your plan for successful entry into the marketplace; have you considered order fulfillment including transportation costs; connections to end users for your product or service; what are profit margins and will the margins increase as the business grows and scales;
- Capital investments to date: what capital investments have been made to the company to date, including both financial and services; remember that you must believe and invest in your entity before others will;
- Assets and liabilities: what does the balance sheet look like; are there hidden liabilities; any off-balance sheet arrangements; how are assets valued; are any assets either over- or undervalued; is there clear title to all assets;
- Technology Risks: what technologies do you rely upon; what is the state of evolvement of those technologies; can you keep up;
- Product Development Plans: do you have a model and samples; have they been tested; have you established manufacturing channels; exclusive contracts with manufacturers; what is your overall plan to bring your product to market and subsequently become a competitor in the industry;
- Legal Structure: type of entity – LLC, C Corp, partnership…; legal structure of current outstanding equity – just common equity or common and preferred and if preferred, what rights are associated therewith (redemption rights; liquidation preferences; dividends; voting rights…);
- Legal documentation: not only whether corporate records are in order, but are all contracts and arrangements properly documented;
- Future financing needs: Will significant future financing be necessary to achieve the business plan; what is the risk of a future down round (note that a down round is a future financing at a lower valuation resulting in dilution to the current investors);
- Exit strategies: is the company planning on going public; is it or will it be a good buyout candidate; is the offering structured to include payback via either a debt instrument or dividend distribution;
- Management: this is perhaps the most important consideration for the investment community; does the management team have a proven history of success; prior business experience in this and other industries; work ethic; general management skills; organizational skills; presentation skills; research skills; coachability; ability to attract others with strong credentials who believe in the business and are willing to work to make the business a success; does management present well in meetings and face-to-face discussions;
- Flexibility: how flexible is management in structuring the deal and considering outside advice;
- Developmental milestones: has the company achieved is developmental milestones to date.
The Author
The Author
Laura Anthony, Esq.
Founding Partner
Anthony L.G., PLLC
A Corporate Law Firm
LAnthony@AnthonyPLLC.com
Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker-dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions, securities token offerings and initial coin offerings, Regulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers; applications to and compliance with the corporate governance requirements of securities exchanges including Nasdaq and NYSE American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALG legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the small-cap and middle market’s top source for industry news, and the producer and host of LawCast.com, Corporate Finance in Focus. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
Ms. Anthony is a member of various professional organizations including the Crowdfunding Professional Association (CfPA), Palm Beach County Bar Association, the Florida Bar Association, the American Bar Association and the ABA committees on Federal Securities Regulations and Private Equity and Venture Capital. She is a supporter of several community charities including sitting on the board of directors of the American Red Cross for Palm Beach and Martin Counties, and providing financial support to the Susan Komen Foundation, Opportunity, Inc., New Hope Charities, the Society of the Four Arts, the Norton Museum of Art, Palm Beach County Zoo Society, the Kravis Center for the Performing Arts and several others. She is also a financial and hands-on supporter of Palm Beach Day Academy, one of Palm Beach’s oldest and most respected educational institutions. She currently resides in Palm Beach with her husband and daughter.
Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.
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