Due Diligence and Corporate Clean Up in Private Offerings

Due diligence and corporate clean up are important steps in the private offering process and putting together a private placement memorandum. This post elaborates on these steps.

As outlined in the Overview of the Private Offering Process, when raising equity capital, one of the first things a company should do is prepare a business plan. Good business plans typically include a long-term capitalization strategy. The business plan often forms the centerpiece of the private placement memorandum (PPM), the disclosure document that is typically circulated to investors. When putting together a PPM, the goal is to create both a complete synopsis of the company’s current situation and an accurate summary of the company’s plans for the future.

With a good business plan in hand, people preparing the PPM often turn to “due diligence” and corporate “clean up.” As it relates to private offerings, due diligence is the investigation that ensures that the company-related information and summaries included in the PPM are accurate and complete.

It is not uncommon that during the due diligence process, issues are uncovered that either should have been addressed earlier but weren’t or that need to be completed or addressed prior to the company issuing securities to outside investors. Remedying those items is often referred to as corporate clean up.

The Due Diligence Process

While the due diligence process conducted by venture capital firms is often more detailed than that conducted by angel investors, one should expect at least a base level of due diligence from both groups. Virtually all venture capital firms and most angel investor groups have a formal due diligence process in which they request in writing certain information and access to particular documentation. Here’s a sample put together for angel groups. According to a study sponsored by the Kauffman Foundation in 2007, the median duration of actual due diligence work conducted by angel investors in their large sample was roughly 20 hours per investment. Interestingly, the same study found that the those angel investor groups who spent more than the 20 hours had a 5.9x return on their investment, while those who spent less than the median 20 hours had only a 1.1x return. Regardless of the actual duration of the diligence conducted by groups you may work with, the point that is imperative to get your “house in order” before opening the company up to outside scrutiny.

As part of your disclosures in the PPM, it is essential to accurately summarize all “material” facts concerning the company. A fact is material if a reasonable investor would consider it important in determining whether to purchase the securities that the company is selling. In other words, you need to include all relevant facts that an investor might consider important in making his or her investment decision.

The due diligence process for an individual company should be designed to capture those material facts. The areas that are subject to the due diligence investigation vary from company to company, but often include the following:

Organizational documents (e.g., charter documents)
Cap Table and Shareholder and option/warrant holder lists
Copies of agreements that affect equity holders (e.g., shareholder agreements, voting agreements, investor rights agreements)
Financial statements
Summaries of litigation or threatened litigation
Governmental licenses and filings (including patent applications)
Biographical summaries of officers and directors
Material contracts
Any conflict of interest transactions or arrangements involving the company and its current owners (including their affiliates)

The PPM should include summaries and descriptions of not only the items listed above and the business plan, but also anything else that may be material to a prospective investor’s investment decision.

Government agencies (such as the NASD) have frequently commented that there can be no definitive list of items to be described in the disclosure documents. For example, a company that is seeking funding to support clinical trials should likely also include a summary of additional funding that the company will need after the current financing in order to get the drug or product through all phases of the clinical trials. A software company that is reliant on the adoption of certain third party technologies probably should include details about that technology. In essence, every company is different and each due diligence process must be customized based on the nature of the offering and peculiarities of the company and the industry in which it operates.

Conducting corporate clean-up

Early-stage companies typically spend much of their financial and human resources on product or technology development and attracting and retaining talent. Whether it is because of lack of time, money, or experience, companies often fail to keep up with many tasks that may prove to be important to the success of the company.

What usually occurs is that during the due diligence process, areas that need clean up are revealed. If you think your company is good shape, consider these questions:

Have your key employees signed appropriate nondisclosure, assignment of inventions, and noncompete agreements?
Have you granted stock options or issued restricted stock to your key employees (perhaps as previously promised or alluded to) and if so, have you complied with the tax code section 409A requirements on valuations?
Are your shareholder and director meeting minutes up to date and in compliance with statutory and organizational document requirements?
Have all previous stock issuances and significant agreements been properly authorized in the board meeting minutes?
Have you filed applicable patent applications (or at least provisional patent applications)?
Do you have any agreements or arrangements with others that should be reduced to writing?

These and other matters need to be remedied or addressed before the private offering.

The other form of corporate clean-up prepares the company for its planned structure following the financing. For example, a company’s articles of incorporation and bylaws may need to be amended to reflect changes from the company being owned and run by a small group of founders to one in which there will be a significant number of outside investors. This is especially true if you plan to offer a type of security in the private offering that has not been previously authorized (such as a new series of preferred stock).

Also, sometimes a company will try to complete certain transactions or enter into agreements with one or more “household-name” companies in order to validate the company’s product or technology prior to the offering.

Conducting a thorough due diligence and corporate clean up are essential when offering securities. Doing both creates the foundation for a solid PPM: one that both provides a prospective investor with an accurate picture of the company and limits the liability exposure of the company and its officers and directors.

Preparing for the Investor Presentation

This post covers a number of best practices for presenting to investors, whether they be angel, venture capital, or strategic investors.

Several companies we are working with are currently preparing for investor presentations. This post covers a number of best practices for presenting to investors, whether they be angel, venture capital, or strategic investors.

Identify your Objectives for the Investor Presentation

Many companies try to accomplish too much with their initial investor presentation. Rarely do term sheets get prepared after the first presentation, let alone checks, unless it is a modest sum of money from an angel investor who is already inclined to invest. So what is a good objective for an initial investor presentation? In most cases, a good objective is merely to get to the next stage of the investor’s evaluation process. In some situations, the next stage could be a second presentation to a broader audience or a different group within a strategic investor’s organization. In other cases, it could be to start a formal due diligence process. Try to identify the prospective investor’s evaluation process prior to the initial meeting to help shape your objective for the presentation.

Know your Investor Audience

As is true for most presentations, your investor presentation should be tailored to your audience. Prior to the meeting, try to identify who from the investor’s organization will be present during the meeting. If it is going to be primarily business/finance people (as opposed to technical/scientific), you can expect the questions and discussions to center around their areas of focus and expertise. Also, see if you can identify who in the room is the ultimate decision maker, gate keeper, or influencer who can enable you to get to the next stage in the evaluation process. Adjust your presentation accordingly.

Adhere to the Investor’s Rules and Be Respectful of your Audience’s Time

Sometimes, investor groups or forums have particular rules about presentations. They can limit companies, for example, to a certain number of slides, certain types of slides, or a specified presentation duration. Adhere to their rules. If you have a one-hour meeting with a VC or strategic investor, don’t bring a 50-minute slide deck to the meeting (more on this in a bit). Unless going over the agreed upon time slot is driven by investor questions or two-way discussions, don’t be guilty of holding the investor audience hostage by continuing on with a presentation that seems to never end; a long presentation won’t make your case for investment more compelling.

Presentation Format and Investor Slide Deck Composition

Assuming you have identified your objectives for the presentation, you know your audience and the restrictions you are under for the presentation, what should the presentation look like? Usually, the presentation is given by one or two members of the management team (e.g., the CEO and CSO/CTO or CFO). The appropriate number of slides of an initial one-hour meeting is somewhere between 15 and 25 and should take no longer than fifteen to twenty minutes to present, without interruption. And yes, I know it’s not easy to do and I know it can be a time consuming process to get the presentation that short and succinct. If the investor is interested, you will have no problem taking the entire hour. If the investor is not interested, well, everyone can spend the balance of the hour answering emails.

The breakdown of the slides typically works something like this:

Speaker introduction and the investment that you are looking for (1 Slide)
Company introduction and “elevator pitch” (1-2 Slide)
Identify market(s) and current market problems/opportunities (2-3 Slides)
Company solutions and product(s) to address market opportunities (2-6 Slides)
Current development status of solution/product line (1-2 Slides)
Competition (1-3 Slides)
Marketing and distribution/regulatory approval process (1-3 Slides)
Revenue model(s) and financial history and projections (1-3 Slides)
Use of funds (1 Slide)
Management team (1-2 Slides)
Anticipated Exit and Timing (1 Slide)
Recap the 2-3 main points and state the investor “call to action” (1 Slide)

Of course, there can be variations to this format. For example, a presentation to a potential strategic investor technical team should include less on market opportunities and more on product and technology.

Many times, the initial presentation is the first opportunity that an investor has to evaluate you, which for most early stage angel and VC investors is more important than your product or technology. Presumably, if a prospective investor has read your executive summary/business plan and wants a presentation, you’ve passed the initial screen and the investor is already at least somewhat interested in your company. So, it’s important to remember that you are not only selling them your product/technology, but also you and your management team.

Backup Slides for Investor Questions and Areas of Focus

It is generally a good idea to prepare backup slides to address the key questions that you anticipate or areas that you are likely to be asked to elaborate on if the investor is interested. This goes back to knowing your audience. You may also want to develop a system to figure out how to access particular backup slides so that you are not fumbling through the PowerPoint while the investor has to wait.

Miscellaneous Best Practices for Investor Presentations

Finally, here are some miscellaneous nuggets to consider, based on the investor presentations I’ve seen over the years:

Coordinate in advance the audiovisual requirements (who is going to have/bring what)
Have a backup plan (e.g., hard copy of slides)
Use the PowerPoint slides as a guide to the discussion, not as cue cards
Maintain eye contact with your audience, not the screen
Let your passion and excitement about your business show through
Do not say that your company does not have competition or any other naive faux pas
Walk the fine line between exuding confidence, but not appearing overconfident
Address any 800 pound guerillas positively in the presentation rather than waiting for the inevitable questions and what could be construed as defensive responses
Avoid eye charts (e.g., detailed spreadsheets, elaborate process or flowchart diagrams); more text does not yield a more compelling case for investment
Similarly, convey no more than 2-3 points per slide, with font no smaller than 24 pt
If possible, use a good mix of images and text
And lastly, rehearse, rehearse, rehearse

Best Practices for the Friends and Family Financing Round

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.

Capitalization Strategy: Begin with the End in Mind

“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.