The 2009 second quarter MoneyTree™ Report from PricewaterhouseCoopers (PwC) and the National Venture Capital Association (NVCA) came out earlier this week. As expected, the news was generally not good, but there were some rays of hope. Total amount invested nationwide was up some (15%) over last quarter but the number of deals was flat compared to the anemic numbers from the first quarter. In comparing last quarter to the 2008 second quarter figure, the number of deals was down by more than 40%.

Life Science Sector Leading the Way

By sector, life sciences faired the best. The report defines life sciences as biotechnology and medical device. According to PwC, investments in life science companies accounted for the highest percentage of total venture capital investments since the inception of the report. While the figures are not staggering, life science investments are proving to have slow but continuing exits for investors while exits for other industry have mostly stalled. With the increasing number of drugs coming off patent for large, cash rich pharma in the next few years, acquisitions of biotech companies are anticipated to increase. Many drug development companies (and investors) plan to take advantage of this as part of their exit strategy and long-term capitalization plan.

Also in the report, there was an increase in the combined size and number of seed and early stage investments, which coupled with the increasing interest in life sciences, bodes well for the Midwest if the trend continues.

Midwest Figures

In the breakdown of the regional data, the national trends generally hold true here in the Midwest. It is important to remember though that here in the Midwest, the numbers can fluctuate considerably from quarter to quarter because the deal volume is lower. So, an unanticipated quarterly spike of a given statistic (e.g., deal volume, industry investment, deal size, IPOs) in either direction is likely to be an anomaly rather than a material change in the trend line. As an aside, for purposes of the report, Minnesota, Wisconsin, Iowa, North Dakota, South Dakota, and Nebraska make up the “North Central,” while Illinois, Missouri, Indiana, Kentucky, Ohio, Michigan, and western Pennsylvania make up the “Midwest.”

When companies start up, often the first place they look for seed financing is from friends and family. As frequently as they occur, there is very little available on the details of what consists of a “good” friends and family financing. In this post, we will go through some of the considerations for your next friends and family round of financing.

Friends and family financings are frequently the first financing from outsiders of the company. Increasingly though with tough financial times, companies are relying more heavily and for longer periods of time on friends and family support to get them through the early times. So, let us get into some of the details.

Type of Securities to Issue

Almost invariably, when the company is a corporation, the company issues common stock in the friends and family round. For limited liability companies (LLCs), the security issued in the friends and family round is whatever the common stock comparable security is for the LLC—sometimes it is referred to as Class A Units or sometimes it is just a percentage interest or just “units” (if the LLC has only one class of securities). As LLC capital structures are most often a matter of contract per the company’s operating or LLC agreement and the laws vary from state-to-state, there is no single standard name for the type of security.

As later posts will echo, one important point to keep in my mind in terms of deciding on the type of security to issue is the importance of keeping the capital structure simple. In this case, with a friends and family round, it is typically best to issue common stock (or the LLC comparable). While one sees convertible notes, a “stripped down preferred,” or a certain level of warrant coverage, I recommend keeping the capitalization structure as simple as possible, for as long as possible.

Pricing

High Risk and High Price?

Pricing is often a difficult topic for a friends and family round. In my experience, it is often the round least likely where one is to see negotiation on price. It is not uncommon, however, for the friends and family round to be overpriced. How do I know that? Few would argue that of all the rounds of outside investment that companies go through, the friends and family round is likely where there is the most risk (technical and commercial) and there is likely the fewest tangible and intangible assets. I’ve seen some statistics indicate that over 90% of tech startups end unsuccessfully. Yet, it is (1) very common to see seven (or in some cases, eight) figure pre-money valuations for not much more than a skeleton of a management team, a business plan, and a patent application, license right, prototype, or vaporware, and (2) not uncommon to see either a flat round or better terms offered in the first VC or angel deal following the friends and family financing. It is not that entrepreneurs are trying to take advantage of their friends and family. But rather, it is likely because they are overly optimistic concerning their prospects; they are entrepreneurs after all, and a good sense of optimism is essential to success.

Impact of Price on Subsequent Rounds

When pricing a friends and family round, it is also important to consider the impact of the price in the context of the long term capitalization strategy. I talk about the long term strategy in my earlier post, Capitalization Strategy: Begin with the End in Mind. As mentioned in the previous paragraph, a common problem that some entrepreneurs face is having too high of a price in the friends and family round (or subsequent angel round for that matter). How can too high of a price be a problem for a company? After all, a higher price means less stock is issued and therefore less dilution. The reason it can be a problem goes back to your long term plan. Often, a high price in an early round yields problems in later rounds in terms of existing investor expectations. If you understand the likely pricing expectations of later round investors, those expectations should be incorporated in earlier round pricing. Promising companies can sometimes get too aggressive on pricing in early rounds and often stall, not because of their technology or lack of success in their commercialization efforts, but rather because they cannot find financing sources that meet their existing investor expectations. So, after a considerable delay in not getting a timely financing, companies are forced to consider either (a) “down round” pricing to get the amount of financing they need from subsequent round investors or (b) accepting less investment (most likely from existing investors) and prolonging the current share pricing as they hobble along and exist on less than ideal amounts of financing. Also, by accepting down round pricing, it can not only affect morale of existing investors but also employees as well in terms of the perception of the direction and speed of the company’s momentum.

Effect of Price on Stock Options

On a related note to employees, one other thing to keep in mind is the impact of your friends and family round pricing on your stock option pricing (or other equity-based incentive), especially if you issue common stock in the friends and family round. The price at which you sell your securities will likely affect significantly your stock option exercise price or the amount that has to be taken into income by employees and contractors if stock or other equity-based securities are issued to them. This is especially true as the ability to issue discounted stock options is no longer the option (pardon the pun) it once was in light of tax code section 409A. This is one area where offering convertible notes (or preferred stock) to friends and family yields a benefit over common stock.

Accredited Investor Status

As a general rule, it is best to limit your friends and family offering to accredited investors only. Many companies want to enable their friends and family who are not well off to “get into the action” early. Ignoring the issue of whether friends and family who are not accredited can bear the risk associated with an investment in a start-up, by including friends and family who are not accredited in an offering can drive up your legal costs to do the transaction and increase the risks of legal problems associated with the entire offering. If you are considering including investors who are not accredited in your offering, have a discussion with your attorney first before announcing the offering. Doing so will help to ensure that you make an informed decision without the pressures of the implications of backing down from an earlier announcement to your friends and family.

Amount of Funding

The amount of financing should be driven by, you guessed it, your long term capitalization plan. Conventional wisdom is that you should raise sufficient money to comfortably get you to the next significant milestone that increases your valuation. However, there are some companies that believe that they should get as much money as they can, as soon as they can. The problem with this latter approach is that, assuming your subsequent round financing is an up-round, you will suffer more dilution by getting the money earlier than what you would otherwise experience by waiting and then selling the securities later at a higher price. Also, some people believe that companies can become less efficient, less “hungry,” and lose their sense of urgency with significant amounts in the bank. On the flip side, a benefit of raising more in an early round is that less time is spent on subsequent fundraising. In addition, as those who adopted this approach a year ago will say, they are not now seeking financing in what is a very difficult time to raise money.

Importance of the Friends and Family Round

While typically not the biggest round of financing to say the least, the friends and family financing is essential for most high growth companies. It is important to do the financing right and not fall into one of the easy traps that create problems later in the company’s life cycle. If there’s interest, I can elaborate on some other traps and pitfalls in a later post.

“Begin with the End in Mind”: what a simple, yet profound concept. It is one of the habits of Stephen Covey’s 7 Habits of Highly Effective People. It is so simple, but too often overlooked.

When entrepreneurs start companies they often have vivid visions of success. Through the business planning process, entrepreneurs often develop and work through the various issues that need to be addressed in order to obtain the commercial success for which they are looking. But, what is the desired end state or exit? Or, is death the only exit? Seriously though, is the exit, sale of the company within 5 or 10 years? Is it working with and growing the company until retirement, with younger management or the next family generation buying out the company? Is it an intellectual property holding company collecting royalties from various licensees? Is it the sale of stock after a public offering? Too often, entrepreneurs dedicate only two or three sentences in the business plan to the intended exit, using almost boilerplate language. Of course, only time will tell how things will end up, but having a vision for a desired outcome will help drive decisions and planning, making your desired outcome more likely to come to fruition.

Backwards Planning Process

With the desired end in mind, the business planning process and capitalization strategy development can truly begin. It is what is referred to as the backwards planning process. Many people do this instinctively as part of their normal planning. Identify what assuredly has to happen in order to get you in position to meet your desired end state. Think of these “have to happen” items as interim objectives. It may be a certain level of sales or EBITDA, successful completion of a lead drug phase II clinical trial, a successful public offering, etc. Then, identify what conditions, tasks, and shorter-term objectives it will take to meet those interim objectives. Continue to repeat that process until you are back in time to the present day.

Capitalization Strategy

When looking at your capitalization strategy, it is a very similar process. In fact, it should go hand in hand with business planning. You also need to consider though the needs, expectations, and desires of your sources of capital—meaning your prospective investors, bankers, government agencies, customers, etc. Figure out what it will likely take in order for you to get the sources and amount of capital you need to reach your desired end state. When looking at equity capital, think through valuation issues, dilution, capitalization structure, liquidation preferences, etc. Again though, start with the end in mind and work back through time, through each anticipated round of investment, each grant and grant phase, etc. It will help you develop a coherent strategy and identify what needs to be done to get you where you want to be.

Understanding Investor Needs

I’ll go through more on investor needs, expectations, and desires in later posts, but for present purposes I will touch on two very basic ones to illustrate some of the considerations to include in developing your capitalization strategy: the amounts of money that different types of investors invest as well as when in a company’s life cycle those investors invest.

Here are a couple of charts to consider. The first one shows the ranges of investment amount by investor type. The chart contains generalizations. Of course, sometimes investments are outside of these ranges for unique deals or situations or current market conditions. For instance, this year we are in relatively tight markets so both the number of deals and the amount of investments by group are generally down.

Investor Amount by Investor Type

This next chart shows the stage of company development that investors generally invest at. As with the amount of investment, one see deals outside of these ranges based on unique opportunities or situations or the general market conditions. Also, there are variations by industry. For example, in therapeutics, the categories on the y-axis would be different: they would likely include positive preclinical animal data, filing a new drug application, commencing the clinical trial, completing phase I of the trial, etc.

Investor Interest by Company Stage of Development

The point to take from all this is that developing a coherent capitalization strategy is a deliberate process. It should take into account the entire time between today and the day you meet you desired end state, not just where your next grant or equity financing is going to come from. Have a long term strategy will actually help guide you through many decisions and assessments of opportunities that you will likely encounter.

It comes to no surprise to most people that virtually all early stage technology-based companies are in need of more money.  Even after companies raise money, they are often looking quickly for where the next grant or round of financing is going to come from.  High growth companies that are more established often weigh how much cash should be allocated to marketing and sales versus research and development and augmenting their product pipeline. 

Below is a list of some of the traditional sources of capital for high growth companies.  Most companies use at least two of these methods at any given time and it is not uncommon for companies to use all of them at some point in their life cycle.

Equity Capital

This includes investor money from friends, family members, wealthy acquaintances, venture capitalists, hedge and pension funds, and the public at large.  While not viewed this way by many, in most cases, it is the most expensive form of capital for successful companies.

Federal and State Grants and Loans

Probably the cheapest form of capital is federal and state grants.  For small technology companies, SBIR and STTR grants are often their main sources of capital.  Even for early stage tech companies that rely on investor money, they often supplement investor money with grant funds.  For later stage companies, government grants and loans often amount to only a small portion (or no portion) of their incoming capital.

Debt and Equipment Leasing

With the exception of convertible debt, debt obligations issued to insiders, and certain government-sponsored debt, significant debt financing is typically reserved for large companies that are cash-flow positive or that have a significant asset base

Strategic Alliances or Partnership Arrangements

Entering into a strategic alliance or other form of partnering arrangement is a common way for a number of companies to raise capital during the development stage, especially those that are in the pharmaceutical or other high development cost industries.  In exchange for some form of exclusivity or option for exclusivity, these arrangements frequently have a large up-front payment or the costs of development, testing and clinical trials are borne by the larger company.  Most often, continued payments are conditioned upon meeting pre-defined milestones.  Sometimes, these arrangements entail the larger company adopting a technology or platform (at reduced or no cost or in exchange for equity of the smaller company) in an effort to make the technology or platform an industry standard.

We’re going to spend a lot of time on this blog addressing financing issues.  Over the next several posts, we’ll go over some of the details on each of the areas, emphasizing current strategies that companies are using as well as current market terms in light of the tight capital markets.  We’ll also conduct some interviews with industry players and seasoned entrepreneurs to get their perspective and advice.