Some startups want to tout big fundraising numbers. Resist that urge. Focus on a smart valuation and return focus to the product... - Jordan L. Walbesser

What’s the single biggest fundraising mistake a startup entrepreneur can make, and how do they go about fixing it? That’s the question we put recently to our contributors, leading experts in these matters, for the latest JD Supra Perspective in our Startups series. Here’s what we heard back:

1. Not Taking the Time to Understand the Nature and Structural Limitations of Prospective Investors

From Adrian Rich, attorney at law firm Dorsey & Whitney: “This mistake manifests itself in several different ways. For financial investors, it is really important to know if your investors expect to be active participants or passive investors, or somewhere in the middle. Missed expectations in either direction can make for difficult relationships. It is also important to know whether your financial investors are at the beginning of their investment horizon with a lot of dry-powder, or towards the end of their fund life, because this can have a fundamental difference in their views regarding future rounds of financing and/or timing to exit. For strategic investors, it is important to appreciate the impact that the possibility of future competition and/or current commercial relationships may have on the strategic investor’s role as an investor. For example, information rights that are commonly provided to financial investors may give too much insight to a strategic investor that is also a startup’s customer or potential competitor/acquirer.

It is also very important to always consider the effect that a strategic investment may have on a startup’s ability to establish a vibrant auction market when it seeks to be acquired.

Although many strategic investors are moving away from rights of first refusal, it is really important to carefully review voting rights associated with an investment to make sure that the strategic is not able to veto fundamental transactions that a startup may seek to do – principal among them being the next financing and/or an exit by acquisition. While it is always inadvisable to allow any investor to hold such a veto, when strategic investors hold the veto it can have a significant negative impact on the company’s ability to continue its operations or sell to the highest bidder. On more than one occasion I have seen it lead to valuations – and stockholders – that were depressed. These issues are difficult to fix once investments have been accepted. The best advice is to avoid these situations in the first place or put in place contractual provisions that mitigate the risks.”

2. Raising Money from Disparate, Unconnected Sources In a Class of Securities Then Controlled by This New Money

From Pierce Atwood attorney Jack Steele: “A scenario might be that the start-up has boot-strapped for a while, but now needs outside capital to reach the next level. Fearing a loss of control, it doesn’t want to take venture capital or other professional money, so it hires a placement agent to round up some doctors and dentists to invest in a new class of preferred stock. The problem can arise down the road when the start-up now needs to amend the terms of that preferred stock or otherwise take action requiring the consent of that new class of preferred stock, and it can be very difficult to locate and corral these preferred investors. The placement agent, if still in existence, may be able to assist (likely for a fee), but obtaining the required consent from these disparate investors may be impossible, thereby putting the start-up in the position where it is unable to take the remedial action necessary for the company.

Ways to avoid this? The surest path is to avoid having the new investment made in a class of securities subject to control by these outsiders.

In that is not possible, look to have a “lead” investor or group of investors, and maintain a dialogue with them on a periodic basis regarding the fortunes of the business. If possible, ensure that individual investors truly understand that the fortunes of the business may go down or sideways (as well as up). In this way, should it be necessary to recapitalize the company, the start-up has a point of contact and hopefully a sympathetic ear. If hiring a placement agent, try to use someone with some longevity in the business, as it may be able to help in lining up the required consents from the investors, who in many cases will be established clients of the placement agent (you might also check whether the placement agent is a registered broker-dealer, but that’s a different issue). I suspect we’ll see a variant of this issue start to emerge with start-ups engaging in fundraising through equity crowdfunding from people they don’t know.”

3. Fundraising Too Soon

From Jordan L. Walbesser, an attorney in the Intellectual Property & Technology Practice Group at Hodgson Russ LLP: “Technology startups are especially susceptible to the siren song of fundraising. Fundraising steals focus away from the startup’s core value—its product. And, in fast-paced industries, falling behind on product development is lethal. So, how can a snared startup fix this common mistake? Remember three fundamental principles:

• First, pitch to the right investors. Large institutional investors can be fickle. Don’t waste time courting a large investor for a small round. Concentrate on landing a right-sized lead investor. The rest will fall into place.
• Second, delegate fundraising efforts where possible. Your startup’s founder is passionate about the product—not about pitching to investors. Utilize that passion. Enlist a passionate communicator to compliment the product. After all, a top-notch product brings investors to the table.
• Third, close the round quickly. Some startups want to tout big fundraising numbers. Resist that urge. Focus on a smart valuation and return focus to the product. Make the money last, modest as it may be. A strong funding-to-growth efficiency sets up a better fundraising round in the future—when you really need it.

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Additional updates in this Startups series:

- 7 Intellectual Property Mistakes Startup Entrepreneurs Often Make

- How and Why Your Team Is Everything (And Other Essentials for Startup Success...)

- What Startup Entrepreneurs Need to Know About Crowdfunding Before They Raise Money

- Entrepreneurs: 7 Pitfalls to Avoid When Hiring a Lawyer (by Josh Beser)
 

[image source: crowdsourcingweek]