There are a number of sites out there that appear to focus on this crowdfunding model, although most appear to be centric to the creative arts (music, painters, sculptors, fashion, etc.).  On the whole, people do not appear to be selling securities, with a few exceptions.  That is, they are not selling an ownership stake in their business.  They speak in terms of “pledging” or “contributing” or “donating” to a “campaign” or a “project” in return for a “reward” or a “perk”.  When they speak of rewards and perks, think along the lines of free samples, coupons, autographed CDs, a personal phone call or visit from a band member, copies of songs prior to release to the public, free t-shirts or a limited edition copy of original art work and the like.  Here’s a list of some of the current sites in this space:

• 33 Needs – geared towards social ventures.  Claims that the “backer” receives a percent return based on revenue.  They claim that if a backer’s core motivation is not financial return but, rather, impact or consumption, then the securities laws do not apply.
• Rockethub – geared to the creative arts.  No ownership exchanges hands.  Investors get a reward.
• Pozible – Australian based.  Geared towards the creative arts.  No ownership exchanges hands.  Investors get a reward.
• Catwalk Genius – U.K. based.  Geared towards fashion.  Claim to provide both perks as well as a share in the revenue.
• Fans Next Door – focused on the creative arts.  You can contribute and receive a reward.
• Cofundos – primarily focused on the creation of open source software.
• Profounder – claims to be focused on raising money for your business.  This appears to be the only site involved in businesses outside of just creative arts projects.  That being said, they claim not to be selling ownership shares but rather selling a portion of revenues over a fixed period (we can argue about whether or not that is still a “security” under the Securities Act of 1933).
• Peerbackers – you can contribute money in return for rewards or perks.  No offers of equity or shares of ownership.
• Kickstarter – you can pledge money in return for a reward.  Rewards are typically produced by the project itself – think, if they were raising money to make soup, you’d get a bowl of soup.
• IndieGoGo – focused on the creative arts.  No equity investments.
• Spot.us – geared towards journalists.  Open source project pioneering “community powered reporting”.
• Pledge Music – geared towards funding music artists.  Investors get no rights in the end product.  In return, you get music or signed merchandise.
• Artist Share – geared towards music arts and funding recording projects in exchange for access to the creative process.  This site appears to be the oldest, dating back to 2003.

I’ve had a few entrepreneurs recently ask me whether or not crowdfunding is an alternative financing route for start-ups.  Crowdfunding certainly appears to offer an alternative to raising a few thousand dollars from friends and family.  And if not an alternative, maybe simply a way to augment a friends and family round.  Although the average dollar amounts raised aren’t very high, they still might be sufficient enough to put towards some market research, early concept exploration, product samples and the like.  Beyond the friends and family round, I am not sure that the current crowdfunding models could support the significant dollars that an emerging growth stage company might need.  In addition to not supporting the dollar level, you’d lose out on the advantage of raising money from committed partners with experience in building companies and that can provide additional resources (e.g., contacts, connections, advice) above and beyond simply writing a check.  If you plan on bootstrapping your company into positive cash flow and never taking on investors, crowdfunding might be an interesting place to start.

That being said, if you want to try crowdfunding a friends and family round, or just match some other friends and family money, then my first suggestion would be to stick with the sites that offer rewards or perks in return for a contribution (out of all the sites above, only 33 Needs, Catwalk Genius and Profounder appear to go beyond rewards and perks and get into ownership or revenue streams).  Of course, this assumes that your business model lends itself to doing rewards or perks.  But be creative!  You could turn anything into a reward or a perk.  Why do I suggest that you stick with sites just offering rewards or perks?  Here are a few reasons:

You Want to Avoid Selling a Security

Why?  Because there’s a lot that goes into selling securities (even privately) and none of these sites appear to be structured for doing that.  The rewards and perks, like free copies of CDs or t-shirts, will not put you in the realm of securities.  However, selling equity and potential future interests in revenue streams might.

• Is it a Security – First, know whether or not you are even selling a security.  You should understand that the definition of a security is a broad one – see Section 2(a)(1) here.  Broader than most people think.  Every early stage growth company that is raising money by either selling equity or taking on a loan (including convertible debt) is generally selling a security.  Under the Securities Act of 1933, if you sell a security you need to either register that security or fit within an applicable exemption.  Selling ownership in a company or a revenue sharing or royalty financing structure (see this article explaining royalty financing) could be interpreted to be a security, thus requiring compliance with the securities rules – not something you want to screw up in the beginning stages of starting a company.  Consult your lawyer on this type of structure.  Profounder is selling a future interest in a revenue stream but takes the position that since there is no promise of a profit that it is not a “security” (similar to the argument posed by 33 Needs above).  Here’s a message board response by one of the founders of Profounder in which they lay out the legal basis for what they are doing.  Even though Profounder appears to take the position that it is not a security, they nevertheless claim to rely on Rule 504 under Reg D as a transactional exemption to the requirement that securities be registered for sale.  Not sure why they would indicate the securities exemption they rely on if they don’t believe they are selling a security.

• Have you Found an Exemption – Second, if you are selling a security, you need to find an exemption for that transaction both under federal and state securities rules.  Some exemptions require certain disclosures and have other restrictions built around them.  The crowdfunding sites do not appear to be structured to handle this issue.  For instance, most companies raising angel or venture money rely on Rule 506 under Reg D for their exemption.  Under Rule 506, if you sell to accredited investors only then you can avoid much of the disclosure requirements.  If you sell to non-accredited investors (which is most likely what you would find by crowdfunding), you are limited to 35 and you need to provide certain disclosures which would require a fair amount of coordination and help from a lawyer.  You might decide to rely on Rule 504 as an exemption (which Profounder appears to do), but Rule 504 has its problems.  At first blush it appears useful because it has no limitation on the number of non-accredited investors (although your total dollar raised over the past 12 months is capped at $1,000,000) and it has no disclosure requirements for non-accredited investors.  One issue with Rule 504 is that it can be very difficult to find state securities exemptions (unlike Rule 506 where most states accept the Rule 506 filing along with some filing fees).

• No General Solicitation or Advertising Permitted – Third, the prohibition on general solicitation or advertising could impact your ability to crowdfund securities.  Rule 502(c) under Reg D prohibits general solicitation or general advertising when relying on Reg D (with some very narrow exceptions).  Best practices require that you treat this restriction with broad interpretation.  Crowdfunding runs a serious risk of violating this restriction.

• 500 Shareholder Rule – Fourth, Section 12(g) of the Securities Exchange Act of 1934 requires companies with 500 or more equity security holders (along with a few other factors) to register under the Exchange Act.  What’s this mean?  Well, you are now a public company for purposes of reporting under the Exchange Act.  Not exactly where you want to be as a start-up.  Is this likely to happen in most angel and venture rounds?  No, because you never have that many investors.  But with crowdfunding, you could easily end up with 500 or more people – and if you are selling securities, intentionally or by mistake – then you have 500 or more “equity securities holders”.  See here for the letter where a few years back Facebook tried for an exemption from that rule because it had so many employee security holders, only to run into it again with the recent Goldman deal.

You Want to Avoid Giving Non-Accredited Investors Preemptive Rights

Another quick practice tip on selling securities to non-accredited investors.  Avoid giving those investors preemptive rights or, if you must, make sure the provision states that at the time of exercising any preemptive rights those investors are no longer non-accredited but now meet the accredited investor rules.  Preemptive rights generally give equity security holders the right to participate in future financing rounds of the company, with some customary and limited exceptions.  If you successfully structure a financing round with non-accredited investors, regardless of whether or not you use Rule 504 or 506, and you provide the non-accredited investors with preemptive rights then you may have a difficult time structuring a future round of financing.  Why?  Because if the non-accredited investors have a “right” to put money into the round and you cannot structure another Rule 504 round (maybe because you’ve exceeded the dollar cap) and you now need to structure it as a Rule 506 – you’ve just created a situation where you’ll need to make all of the disclosures that Rule 506 requires for non-accredited investors.  Had you not made this mis-step, you could have relied on Rule 506 and sold only to accredited investors and provided only the minimum disclosures required.

Two Birds, One Stone

If you go the crowdfunding route, try and kill two birds with one stone by leveraging the crowdfunding model to create a community of supporters, early adopters or product evangelists.  Even though the average amount raised through crowdfunding may be small, you might still be able to drive some significant PR if your story gets picked up, or if the social networks become well stocked with your new supporters that have contributed money to your business and received some cool rewards.  If you can make crowdfunding double as viral marketing, then there are extra benefits to be reaped.

As always, I welcome your comments and questions.  Thanks.

Chris McDemus is founder of VC Deal Lawyer, a blog devoted to providing insights on start-up and emerging growth companies.  Chris is also founder and owner of MCD Law Partners, LLC, a boutique corporate law firm serving start-ups, early stage and emerging growth and middle market companies.

People in the start-up community have long called for a set of standard financing documents – a set of financing documents whose structure and substance were widely viewed as acceptable to both the entrepreneur as well as the financier (e.g., angel, super-angel, early stage venture fund) and that fulfilled each side’s legal/business needs.  Why standardize financing documents versus any other corporate set of documents?  Well, one of the greatest needs for a start-up or early stage technology company is the capital needed to fund growth.  The lack of capital lies at the very heart of building an emerging growth company.  Entrepreneurs also don’t have the patience for long drawn out procedures so early in a company’s existence.  Speed is viewed as a competitive advantage to some.  Given that lack of capital, as well as the quick need for it, both entrepreneurs and angel and venture financing groups have long wanted a standard set of financing documents that could quickly result in a closed financing round.  A round of financing quickly closed on mutually acceptable terms and costing the least amount of money (i.e., legal fees) would be the goal.  If both goals couldn’t be achieved, I think reduced fees would be favored over speed when it comes to standardized financing documents. 

With that being said, if I had to argue against standardized financing documents, I’d probably point out the following flaws:

• Not all Deals are the Same – the earlier the financing round, the more homogeneous the terms, however, the later the round of financing the less likely standardized documents are going to work.  If standardized financing documents were a reality, I think for this reason they would be limited to either angel or series seed deals.  Growth rounds have more complexity built into them (e.g., recapping, taking out early investors, letting founders take money off the table, wash-outs or cram downs, etc.), and therefore may not lend themselves to a “canned” document.
• As Much as People Love to Knock Lawyers, Getting Deals Done is an Intelligent Process -  as much as people like to knock lawyers, some of us love the start-up space and work very hard to provide real value to early stage companies.  Many of you have probably witnessed first hand the value add from these types of lawyers being involved in these types of rounds.  Create standardized documents and I can guarantee you lawyers of all walks (read:  lawyers without the proper start-up or early stage financing experience) will start offering these types of services to early stage companies because of the comfort that “canned” documents give them.  Just because you attend a CLE (continuing legal education) course on mergers and acquisitions, and walk with your book of forms, does not an M&A attorney make.  Look at every venture blogs’ posts (including my own) and you’ll see advice about hiring the right lawyers early for this type of work.  Start relying on “canned” documents and this problem will grow worse by a magnitude.  The fact that most lawyers that do this work have learned the trade in the old apprentice fashion (having been taught by those that have done it for generations prior) is a barrier to entry.  Remove that barrier and the goals of speed and saving money will produce leagues of early stage companies with inexperienced advisors. 
• Do You Really Want to Feel Like You Just Bought a House When You Close Your Series AA Round? – look at the areas that do use standardized documents and look at the lack of leverage in those deals – buying a house, taking out a mortgage, leasing a car, renting an apartment.  These form documents certainly save money for the person with the leverage (i.e., the person selling the house, offering the mortgage, leasing you the car or renting you the apartment), but they don’t create a level playing field.  The person taking the product or service generally carries the risk that the form documents are adhesive.  The old adage – he who has the gold makes the rules, applies here.  I think over time, the standardized document might shift to the party with leverage.
• Attempts to Date Have Failed- other than the form documents that are used specifically inside a model (think TechStars, YCombinator, etc.), most form documents have not taken off.  In particular I think of the NVCA form documents.  The only time I hear or see them referenced in a deal is when one party is trying to convince the other that a particular provision is or is not industry.  To the extent that provision is or is not in the NVCA form documents, I’ve seen parties reference that fact as proof that they are correct.

Leveraging off of the second bullet point above, I think my greatest argument against standardized documents requires one to think back to the industrial revolution.  Prior to the industrial revolution, goods were made by craftsman.  A trade taught to the young by those with more experience, and passed down over the years.  Following the industrial revolution, mechanization (read:  standardization) was the key to saving time and money.  The industrial revolution killed the craftsman, much the way big box retailers killed the mom & pop store (for those of you that remember the days when customer service actually meant something).  I think standardized financing documents will have the same effect.  It will destroy the legitimate skill set that some of us possess in the start-up and early stage space.  And it will rob the younger associates of the real skills required to represent great start-up and early stage companies in financing rounds. 

My Solution:  Okay, but come on – for those of us touting the fact that we are innovative start-up lawyers and providing value to these young companies, we cannot just end it there -right?  If I am right, that saving money is at the heart of the problem, then there must be some way to reap the same savings but maintain the valuable process of drafting and negotiating financing transactions.  I think the answer lies in how lawyers bill for this work.  I think you can get to the same result of standardization if lawyers would just agree to cap the fees they charge.  For those of us that possess the right experience for this work, most of the problems or hurdles we hit in closing financing rounds have been seen before and dealt with.  I have yet to come across an issue in getting a round of financing done that isn’t somehow derivative of some other issue I’ve run into before, and therefore I probably already have some way of dealing with the issue.  I see no reason lawyers cannot come up with flat fees for closing these rounds that solve the “expense” issue and still allow the deal to move quickly and close inside a time frame that any of us would consider reasonable.

Just my two cents.  I welcome your comments and/or questions. 

Chris McDemus is founder of VC Deal Lawyer, a blog devoted to providing insights on start-up and emerging growth companies.  Chris is also founder and owner of MCD Law Partners, LLC, a boutique corporate law firm serving start-ups,  early-stage and emerging growth and middle market companies.

Here are some of the articles that popped up since my last piece:

• What’s Really Going on in the VC Industry?  What Does it Mean for Startups? (Mark Suster) – I put this post first for a reason.  In Mark’s usual style, it kicks ass.  He covers so many valid, timely points that I’d rather just link to it than have written about them on my own.
• Angel Investor Ron Conway:  Every Entrepreneur Should Get Funded (Anthony Ha – VentureBeat) – Ron believes there still aren’t enough angels out there.  On the other hand, Mike Arrington was quoted as saying that angels are training “an entire generation of entrepreneurs who are building dipsh*$ companies” that sell to Google for $25M.  This division shows that not everyone agrees with the direction the market is taking.  I can see one of the points that Arrington was making and it is going to be the basis for my next post on the “fat/lean” start-up and how all the talk on that subject hasn’t necessarily filtered down to the entrepreneurs in the correct way.
• It’s Still Expensive to Build a Great Product (Redfin) – I like this article because it helps give some context to the capital efficiencies everyone keeps talking about.  I’ve heard the saying lately (which I think can be attributed either to Brad Feld or Fred Wilson) that it’s cheaper to start a company today (I’d re-phrase this piece to limit that to Web 2.0-type tech companies) but it costs the same amount to grow it.  This article helps flush out that issue.
• Moneyball for Startups:  Invest Before Product/Market Fit, Double-Down After (Dave McClure) – Dave hits many issues using his lively fonts, colors and language.  What I like about Dave’s posts is that you know where he stands, which you cannot say about most people.  Part of his post is devoted to his assertion that the traditional VC model is dead and that the super-seed/super-angel model will prevail.  I hate saying anything is dead, because there are no certainties in life, just cycles in my experience but Dave has some valid points.
• The Buzz on Angel and Seed Investing Continues (Brad Feld).
• Thoughts on the Seed Fund Phenomenon (Fred Wilson).
• The Rush to Early Stage Seed . . . (John Boyd).
• Understanding a VC’s Seed Funding Policy is Crucial (Mark Suster) – this is an important article to read for those of you debating between super-angel funds and raising full-on VC funding but at the seed stage.  If a VC fund puts a small seed investment into your company in order to preserve a “toe-hold” for down the line, understand that if that fund opts not to do a follow-on investment with you it could be the kiss-of-death.  Others will wonder what the VC fund (being a current investor) knows about the company that others don’t and why they opted not to invest.  They might have opted out for the most mundane of reasons, but the crowd will assume the worst and it could hurt your fundraising.  Of course, the same might be said of super-angel funds unless people begin to believe that some of those funds just don’t have the bandwidth to follow-on in all the deals they would like to.
• Why Micro-VCs are so Damn Friendly (Gregory Huang – Xconomy).
• Y Combinator’s Paul Graham:  Say Goodbye to Traditional Venture Rounds (Anthony Ha – VentureBeat) – again, I don’t believe in the “this is dead” assertion, but I do see many changes in the works.

Not only does it appear that super-angel (or micro- or super-seed) funds are filling some of the gaps and taking early stage investors off the endangered list, it may be that the pendulum is swinging back in the other direction.  Some are now forecasting a seed-stage bubble in the near future.  See the article by Liz Gannes on GigaOm, the article by Gary Whitehill, the article by Paul Kedrosky and the article by Chris Yeh at VentureBeat.  The theory goes that if too many companies receive seed stage funding, there will not be enough VC funding down the road to move those companies along to the next level and thus they will flame out due to lack of follow-on funding.  This is very similar to the bubble that occurred in the early 2000’s as a result of the ramp-up in VC funding that occurred mid-90’s to end of the 1990’s.

Comments and questions welcomed.  Thanks.

 Chris McDemus is founder of VC Deal Lawyer, a blog devoted to providing insights on start-up and emerging growth companies.  Chris is also founder and owner of MCD Law Partners, LLC, a boutique corporate law firm serving start-ups,  early-stage and emerging growth and middle market companies.

Considering that most companies completing venture or angel financings seek transactional exemptions from federal and state securities laws under Rule 506 of Regulation D, and considering that selling only to “accredited investors” under Rule 506 gives the issuing companies the broadest reach (e.g., no limit on number of accredited investors, no dollar limit, minimal disclosures), one can surmise that how we define “accredited investor” is an important concept.  As an individual, you can qualify as an accredited investor by satisfying either net worth or income level tests.  The income level test has not changed as a result of the Act, however, Congress has directed the SEC to, no sooner than 4 years from now and then every 4 years thereafter, study and consider amending all aspects of the individual accredited investor qualifiers.  Therefore, the income level test may change in the not-too-distant future.

The net worth test has changed as a result of the Act, and the change takes effect immediately.  Going forward, the value of the investor’s residence cannot be factored into that individual’s net worth for purposes of meeting the net worth qualifier.  This will certainly reduce the number of individual accredited investors, although probably not as much as the earlier versions of this Act would have done (see the link the my earlier post above for estimates on the effect). 

Start-up and emerging growth lawyers would be advised to change their accredited investor qualifier questionnaires they use with individuals to properly reflect the new definition of net worth.  They would also be advised to start monitoring the SEC’s process in the next 4 years for further changes to both the net worth and income level tests.

Chris McDemus is founder of VC Deal Lawyer, a blog devoted to providing insights on start-up and emerging growth companies.  Chris is also founder and owner of MCD Law Partners, LLC, a boutique corporate law firm serving start-ups,  early-stage and emerging growth and middle market companies

This early stage gap is a problem that desperately needs a solution.  According to Bloomsberg Businessweek, in the 1st Quarter ‘09, venture investments plummeted to $3B (down 61%), and only $169M of that total number went to companies raising seed stage financing.  The longer this early stage gap continues without a workable solution, the greater chance the institutional venture funds and growth capital players will see a widening gap in the number of companies that reach their respective stage of investment.

The reasons for this widening gap are numerous and varied.  It’s complex, to say the least.  Here are some of the contributing factors, in my opinion:

• Angels groups, and some individual angels, are now co-investing in larger deals or later stage companies – a portion of the early stage gap (i.e., $100k – $500K) used to be purely the realm of angels (for a description of angels, see my earlier post).  In th0se early days, you’d fill in an angel round like with 1-10 individual angel investors.  Recently, however, angels have begun to form groups or networks in order to better source and diligence deals – this made finding angels a lot easier.  The law of unintended consequences though has intervened.  These groups are now easier to find, but they are also now banding together with venture funds, and in some cases individual angels, and doing syndicated rounds.  Syndicated rounds used to be the realm of just institutional funds or large private equity houses.  According to the Angel Capital Association, in 2008 the greater majority of angel groups or networks looked to invest between $250K – $500K, with $0 – $250K running a close second.  Now, two years later, rather than have one angel group put $250K in an early stage company and run the risk that such company couldn’t raise any more money down the road, angel groups are now co-investing with other angel groups or venture funds so that the total round is more like $1m or $2m or more.  With that much money, and the fact that most of these syndicated deals are occurring with expansion stage companies rather than in the early stage gap, the angel groups are able to significantly reduce at least one of the risks inherent in these deals – the company running out of money and not being able to raise more.  As I mentioned, this method of co-investing has trickled down to individual angels also.  A perfect, recent example is Swipely, a company still at the invitation-only beta stage.  Swipely recently raised $7.5M from both venture funds (First Round Capital, Greylock Partners and Index Ventures) as well as several well-known angel investors (Ron Conway, Chris Sacca and others).  What does all of this mean?  Well, the angels (both individuals and groups) that used to be putting $100K or more into a company in the early stage gap are no longer doing so.  Couple that with the fact that there is no one to step in and fill that role, and you have a significant reduction in companies being funded at the early stage gap phase.  Having angels invest at such an early stage was crucial.  Even Harvard reports that they’ve gathered evidence that angel-funded firms are less likely to kick the bucket and that improvements of 30-50% can be seen within businesses funded by sophisticated angels.  Talent like this is really needed in that early stage gap.
• It is hard to raise true early stage funds in today’s economy - it’s not the mid-90’s any more when, historically, the most venture money was being raised by old and new funds.  A lot of that money was put to use in ways that produced zero results.  In the early to mid-2000’s, many venture funds got hosed and, in turn, their limited partners got hosed too.  Limited partners, like pension funds, endowments, insurance companies, started to realize that the late 90’s bubble produced some very heady exits, but for the most part also produced a large number of duds.  It also took 8-10 years to figure out which were duds and which weren’t if you had invested at an early stage.  Nowadays, limited partners are hesitant to back true early stage funds because they don’t want to wait 8-10 years to find out where the investment is going.  Later stage funds that may only have to wait 2-3 years for an exit aren’t having those same money-raising problems.  Without limited partners supporting early stage funds, those funds are disappearing at a fast clip and with them goes what were, historically, core investors in the early stage gap. 
• There is a lot of competition right now trying to raise money in that early stage space – given the fact that this early stage gap exists, and given the fact that the creation of start-ups hasn’t seemed to wane, the competition for raising money in the early stage gap is increasing at an alarming rate.  There are lots of deals chasing very little money in that early stage gap right now. 

So – how do we fix this?  I don’t believe that a silver bullet exists (it never does), but here are some of the self-executing solutions popping up in the marketplace: 

• Capital efficiency – capital efficiency is all about doing more with less.  Don’t confuse this though with bootstrapping mentioned below.  Whereas bootstrapping generally implies that no outside money has been raised, in a capital efficient business model companies still raise outside money, but they deploy the money in a model that uses that capital efficiently.  By that, I don’t mean that the officers of that company sit around pontificating the best use of their dollars but, rather, I mean that the company uses technology to reduce their operating costs.  Recent improvements in open source software, the outsourcing of development and reduced customer acquisition costs have allowed capital efficiency to thrive in certain sectors.  It is these advancements in technology that allow companies to achieve the same level of performance but for less money.  Not everyone is a fan of capital efficiency, however.  In this article, the author does a good job critiquing capital efficiency and arguing that it does not deliver.  Eric Wiesen, a partner at RRE Ventures, argues in his article that capital efficiency leads to building incremental products with no real innovation. 
• Super-angel funds- Paul Graham, co-founder of Y Combinator, says it well on his blog when he writes “instead of making one $2M investment, [venture funds should] make five $400K investments.”  In essence, he is describing the super-angel model employed by First Round Capital, Founders Collective and Mike Maples’ new fund Floodgate.  First Round Capital’s current fund is approximately $125M (which is much smaller than some of its competitors which have $500M funds).  Nevertheless, First Round did 41 deals in 2009 which made it the 4th most active investor.  Typically, First Round’s initial investment is only $500K – $600K.  These funds are referred to as super-angels because they invest amounts reminiscent of angel investing but they are doing this out of funds that clearly exceed any angel fund in terms of overall size (e.g., First Round’s $125M fund).  Super-angel funds attempt to spread the money around in a large number of start-ups.  But super-angels also provide more than just a check.  As this article makes clear, super-angels offer at least one of three values:  (i) a networking mastermind, (ii) geniuses ability-usually in the technology arena, and (iii) deep expertise in certain fields that would simply take years to replicate.  In my opinion, super-angel funds are really trying to take seed and early stage investing back to its roots.
• Incubators – incubators can be a very effective way to bridge the funding gap because they provide free resources that can help reduce an early stage company’s overhead.  Examples of well-known incubators include TechStars, Y Combinator, and DreamIt Ventures.  States also frequently create incubators to deploy state money and resources with the main focus being the creation and retention of jobs.  The best known, and most successful, in Pennsylvania is Ben Franklin Technology Partners.  However, incubators generally deal with companies in their earliest stages, as that is the time that incubators can deliver the most value.  Some incubators provide money (either in the form of a stipend or in the form of a loan with warrant coverage), whereas others provide free access to office or lab space, office supplies and advisory resources like legal and accounting (which can be just as good as money).  Some provide both.  However, the later stage you are, the more “real” money you’ll need - it becomes less about free office space and more about being able to hire competent workers and pay them a salary.  So the incubator model certainly helps, but it only goes so far.
• Bootstrap – as mentioned above, bootstrapping a company means not raising any outside money and essentially growing the company at a pace set by retained earnings.  Bootstrapping is all about getting a lot done on very little cash.  For instance, the software industry has come up with bootstrapping methods such as minimum viable product and microtesting.  For a good article on bootstrapping see this one by the Kauffman Foundation.  Or see Guy Kawasaki’s tips on bootstrapping.  Taken to the extreme, however, bootstrapping can seriously restrict a company at a time when that company could be hitting it out of the park.  Bootstrapping can be very effective if the timing is right and if it is used early in the company’s history to overcome the initial financing hurdles.  If the company really needs to grow at a later stage then outside financing will most likely be needed.  If you are still bootstrapping a company after 5 or 10 years, it’s more likely you are running a lifestyle business that cannot even support a revolving line of credit from a bank.  For companies entering that early stage gap, bootstrapping can be an effective way to bridge that gap and reach a level where serious expansion money can be raised.  It just might take you longer to get there.

In my humble opinion, super-angel funds and incubators currently have the best opportunities to solve the early stage gap, with capital efficiencies and bootstrapping helping out in other limited area.  Questions and comments welcomed.  Thanks.

Chris McDemus is founder of VC Deal Lawyer, a blog devoted to providing insights on start-ups and emerging growth companies.  Chris is also founder and owner of MCD Law Partners, LLC, a boutique corporate law firm serving start-ups,  early-stage and emerging growth and middle market companies.

Two years ago, DormNoise Founder and CEO Jay Rodrigues was fed up with Facebook before it was the cool thing to do.   As the Rhode Island-native was graduating high school and transitioning to life as a student at Wharton, he saw all of his high school teachers had begun to friend him on Facebook.  “I thought it was kind of awkward, I wasn’t sure how much of my college life I wanted to share with them,” he says.  He then sought out to build a more closed social network for college students, eventually fine-tuning the idea as a closed online calendar for students. By his first semester of Penn, Rodrigues raised $200,000 from friends and family before raising a second round of $500,000 this month.

So how does a college freshman have an extensive enough rolodoex to raise two rounds of funding before he can buy a beer and before signing more than five major customers?

Read the rest here on Technically Philly. . .

Chris McDemus is founder of VC Deal Lawyer, a blog devoted to providing insights on start-ups and emerging growth companies.  Chris is also founder and owner of MCD Law Partners, LLC, a boutique corporate law firm serving start-up, early-stage and emerging growth companies.

• Section 412 – Section 412 of the bill directs the SEC to increase the qualifying thresholds for individual accredited investors as the SEC deems appropriate in light of price inflation.  This section also directs the SEC to adjust those thresholds going forward not less frequently than once every 5 years to reflect percentage increases in the cost of living.  The current accredited investor levels for individuals are $200,000 (or $300,0oo combined with spouse) of income for the past 2 years (and including the current year) or having a net worth of at least $1,000,000.  Based on estimates of the inflation percentage, Section 412 could put the income qualifier at $450,000 and the net worth qualifier at $2,300,000.
• Section 926 – in a nutshell, Section 926 requires a 120-day review period for all Rule 506 filings with the SEC.  This would be an unprecedented step in the early stage financing process.

Three other points worth mentioning up front.  First, a third provision, Section 413, directs the Comptroller General of the U.S. to conduct a study on the appropriate criteria for determining the financial thresholds or other criteria needed to qualify for accredited investor status and the results of this study must be submitted within one year.  There is no indication what that study will be used for.  Second, a fourth provision existed in prior versions of the bill which restored the power of states over Reg D offerings, effectively repealing the federal preemption granted in that area by the National Securities Markets Improvement Act of 1996.  This fourth provision appears to have been dropped at this point – thankfully!  Lastly, Sen. Jack Reed (D-RI) recently introduced an amendment to the bill requiring funds (venture/hedge/PE) with more than $100M of assets under management to register with the SEC.  This amendment mirrors (albeit with a different triggering value – previously it was $30M) an earlier version he attempted to introduce.  Under this amendment, funds with less than $100M would have to be either registered and examined by a state regulator or registered with the SEC. 

I, personally, do not support either Section 412 or 926 for a variety of reasons.  It’s peculiar to me that these provisions have found their way into a bill geared towards financial stability.  Neither of these provision, in my opinion, further stabilize our financial system.  If anything, they choke a valuable portion of it.  To understand this point, just read the National Venture Capital Association’s joint study entitled “Venture Impact:  The Economic Importance of Venture Backed Companies to the U.S. Economy“.  According to this study:

• 11% of private sector employment is at venture-backed companies;
• Revenues of venture-backed companies total $2.9 Trillion;
• Venture-backed companies as a percent of U.S. GDP – 21%;
• Venture-backed companies as a percent exceed job growth and revenue growth versus the aggregate; and
• Total venture investments from 1970 – 2008 equal $456 Billion in 27,000+ companies.

Clearly, venture-backed companies have an significant impact on the economy.  But for a company to reach a venture-backed stage, it needs to raise early stage money and very often that comes from individual accredited investors.  Even more so in this economy where institutional early stage investors are few and far between.  The accredited investor thresholds are important as angel and venture financing transactions most frequently use Rule 506 of Reg D as the security exemption for such transactions.  If Congress increases those thresholds, thus reducing the potential pool of investors, less and less early stage companies will find funding and less and less will ever become venture-backed.  In all honesty, I’ve been telling people over the past few years that the SEC ought to reduce the accredited investor threshold.  I know plenty of people that could intelligently invest in the early stage space that don’t make that kind of money or have that kind of net worth.  Dodd’s view is that the thresholds should be increased due to inflation, and I’d suggest that they should be lowered as today’s worker is far more knowledgeable about finances, economics, technology and the risks of attached thereto.

Section 926 is equally perplexing to me.  Why in the world would Congress think it wise to put the early stage financing process under a 120-day review.  If it’s not broken, don’t fix it.  I could understand if there were evidence that the deals done under Reg D were negatively affecting the economy, but all data points the other direction.  I’ve read one or two articles where the North American Securities Administrators Association claimed that a good portion of Rule 506 deals are fraudulent.  I think that is an irresponsible statement to make without clear proof.  I sense some self-serving comments here by the NASAA – I would assume they’d benefit if the bill passes as written.  I am aware of no data that points to a need for a review period in Reg D deals. 

Much has been written and debated about this bill already in the public forum and I’ve included some links below:

• “Angels Sing:  ‘Frankly Ridiculous’ Restrictions Might ‘Destroy Silicon Valley” – VentureBeat article (3/26/10), contains good quotes from well-known angel investors on the topic;
• “How Dodd’s Reform Plan Hurts Startup Finance” – Business Week (3/19/10);
• Letter from American Bar Association’s Business Law Section (4/23/10) – focuses primarily on Section 926 of the bill and contains good background information and excellent points on why Section 926 should be deleted from the bill;
• Save Reg D website – trying to build a case around deleting Section 926 of the bill;
• Angel Capital Associationwebsite – ignore ACA’s support for the bill as it relies on an earlier version of the bill that was much more palatable.  The website, however, has a good laundry list of other articles written on this topic;
• “Barney Franks Says:  Don’t Mess with VCs or Angels” – peHUB article (5/11/10);
• “Startups Get Hit By Shrapnel In The Banking Bill” – Fred Wilson’s post on www.avc.com, includes links to other relevant articles and posts.

If you haven’t already done so, sign a petition or write your Congressman about this bill and let them know how you feel.  Let me hear your comments if you have any!  Thanks.

Chris McDemus is founder of VC Deal Lawyer, a blog devoted to providing insights on start-ups and emerging growth companies.  Chris is also founder and owner of MCD Law Partners, LLC, a boutique law firm serving start-ups, early-stage and emerging growth and middle market companies.

Common Stock in venture-backed companies never have liquidation preference rights.  You will only see liquidation preference rights attached to Series Preferred Stock – the kind that VC funds purchase.  The Series Preferred investors will have a priority in receiving distributions from a liquidation, sale, merger, IPO or dissolution.  Each series of Preferred Stock will have its own liquidation preference and those rights will always be found in the company’s certificate of incorporation.  If you have multiple series of Preferred Stock liquidation preferences, then the preferences get stacked on top of each other with priority generally running “last in first out.”  The size of the liquidation preference is calculated by taking the original purchase price per share (or some multiple thereof) for the respective Series Preferred Stock plus, in some cases, accrued or declared but unpaid dividends.  The more layers of liquidation preference built into a company’s capital structure, the less sale proceeds that will be available to the holders of Common Stock (who typically sit at the bottom of the stack). 

There are three ways to structure a liquidation preference for Preferred Stock: 

• Non-Participating Preference – (a/k/a - straight preference).  In this case, the VC fund gets back its original investment plus, in some cases, accrued or declared but otherwise unpaid dividends.  In some cases, the VC Fund may get a multiple of its original investment, meaning that the liquidation preference may be something like “three (3) times the Original Purchase Price plus accrued but unpaid dividends.”  If the VC fund originally invested $2,000,000, then under the example of a 3X multiple the VC Fund would receive $6,000,000 off the top.  If you happen to be raising money in a difficult funding environment, then you can expect that the multiple will be higher.  Multiples in a regular market range from none to 2X.  Multiples creep up towards 4X – 5X in a difficult funding environment or if the company presents additional risk;
• Participating Preference without a cap - Participating Preferred Stock without a cap provides that after the VC fund gets its liquidation preference on the Preferred Stock, the VC fund then shares in the balance of the sale proceeds with the Common Stock holders on an as-converted basis (meaning that Preferred Stock will be treated as if they converted their shares into Common Stock).  In this case the VC fund may also have a multiple, although some company’s will argue during negotiations that the participating feature eliminates the need for a multiple at the preference phase; and
• Participating Preference with a cap – Participating Preferred Stock with a cap is effectively the same stock in the preceding bullet point with the distinction that the Preferred Stock holders will stop sharing in the balance of the sale proceeds once their aggregate return reaches a negotiated cap (usually being some multiple of the original purchase price per share).  As an example, if the VC fund negotiates for Participating Preferred Stock with a 5X cap, then it will stop sharing in the balance of the proceeds once its aggregate return (i.e., preference piece plus the shared piece) equals 5X its original investment.

All things being the same, companies gravitate to Non-Participating Preferred Stock and investors naturally gravitate towards Participating Preferred Stock without a cap.  The middle ground is Participating Preferred Stock with a cap.  It should be noted that not all VC funds just default to Participating Preferred without a cap.  Many funds save that structure for companies that pose extra risk, and thus should result in extra return.  Most funds, in an average funding environment, stick with Non-Participating Preferred Stock with some form of multiple. 

A fourth option exists for the VC fund.  Some cases exist where the investor may earn back a larger return if it voluntarily converted its Preferred Stock into Common Stock (a common right in venture deals).  What the VC fund obtains as a Common Stock holder may be considerably larger than its preference, participating or otherwise – it’s a matter of doing some calculations ahead of time and figuring out which is the best to own immediately prior to an exit. 

The following table shows in clear terms the return outcomes for stockholders in various levels of exits and with different structures of liquidation preferences.  Some interesting facts to note from the example below:

• The company in this example raised significant money.  The Series B investors put in $25,000,000.  In the case of a tiny exit (like the $10,000,000 example), no one other than the Series B investors will make any money off of the deal.  There’s no incentive for any of the Preferred Stock holders to voluntarily convert to Common Stock in this scenario. 
• In the $100,000,000 example, note the larger return to Common Stock holders in the Non-Participating Preferred scenario.  Also note the difference between the capped and uncapped Participating Preferred scenarios and the shift in returns from the Series A holder to the Common Stock holders because of the cap.
• In the $1,000,000,000 example, the capped and uncapped Participating Preferred differences should be noted.  In this scenario, if the Preferred Stock holders held the Non-Participating Preferred or Participating Preferred with a cap, those stockholders would be better off converting to Common Stock as it would increase their return significantly. 

So, as you can see, liquidation preferences have a great impact on how the proceeds of a sale are divided – more so than valuation, in my opinion.  If you are trying to figure out where to divide up your negotiating capital, I’d suggest putting a good piece of it behind this provision.  I welcome your comments or questions (use the “Ask VC Deal Lawyer” button on the homepage of the website at www.vcdeallawer.com).

Chris McDemus is founder of VC Deal Lawyer, a blog devoted to providing insights on start-ups, early-stage and emerging growth companies.  Chris is also founder and owner of MCD Law Partners, LLC, a boutique law firm focused on providing corporate, transactional and operational legal services to start-up, early-stage  and emerging growth companies.

If you hear the traction response from an angel or fund, don’t fret.  It does not mean the door is closed, but it does mean that they need to see more.  Ask lots of follow up questions to find out how they define traction and what exactly they are looking for.  Be specific.  The more info the better if you hope to return some day and demonstrate how you’ve overcome this hurdle.

Traction is sought for a reason.  The more traction that exists the less risk that is present.  This topic touches on another issue I see out there -the fact that there seems to be less and less true early stage investors.  There used to be a subset of early stage funds that did concept stage deals or pre-revenue rounds.  They wanted in before a company validated their model.  They bet early and were paid handsomely with great valuations.  To some degree these days are gone.  Investors can now get those same valuations but at later stages.  That is, they are investing in companies with lots of traction but at lower valuations.  VC funds need to obtain returns for their LPs, so investing later at lower valuations is a smart strategy.  If you are an early stage company looking for funding, you may feel differently.  Even angel investors are joining other angels and funds and syndicating later stage deals.  A sign of the times?  Yes.  Built to last?  Not likely.  Not if anyone wants there to be middle and later stage technology companies to invest in during the next few years.  If no one is backing concept stage companies, no such later stage companies will exist.

Chris McDemus is founder of VC Deal Lawyer, a blog devoted to providing insights on start-ups and emerging growth companies.  Chris is also founder and owner of MCD Law Partners, LLC, a boutique law firm focused on providing corporate, transactional and operational legal services to start-up and emerging growth companies.

If you are raising money from angels or institutional venture funds, then you will most likely utilize an executive summary format as your initial contact.  Angels and institutional venture funds play a more active role in valuation and deal terms.  Taking the time and expense to draft a private placement memo makes no sense when dealing with investors that have their own sense about valuation and deal terms.  The executive summary may eventually lead to a meeting, and then to a more formal company presentation that would involve a PowerPoint deck.  (For a good example of how to structure such a PowerPoint presentation see the template provided by Originate Ventures here and also see my earlier post and post).

Everyone has an opinion on what the executive summary should look like.  Most importantly, remember that the executive summary is meant to provide just enough information to pique the investor’s interest and lead to a more formal meeting where you can present the company on a broader scale.  The executive summary is a teaser, but it needs to contain the right information for the “tease” to turn into a meeting.  An executive summary should be 1 – 3 pages max.  Don’t include a cover sheet (just put your contact info and a JPEG of the company name in the header portion of the first page).  The following are the sections you should include.  Start all sections (excluding the intro paragraph) with a small section header.

• Intro Paragraph - it should be no longer than 2 or 3 sentences and should hit the two most important points head on:  (i) what’s your value proposition, and (ii) how big is the market.  I would suggest that investors who receive a lot of executive summaries lose interest and do not read past this introductory paragraph if these 2 or 3 sentences don’t grab their attention.
• Background - this section should lay out the background facts on the problem you are trying to solve.  If you assert real data then briefly show your source in a parenthetical after the sentence.  You want to leave the investor feeling as if there is a real problem to be solved here. 
• Solution - this is where you lay out your solution to the problem discussed in the “Background” section.  This is a description of what your company does and how you do it – your value proposition.  If there is proprietary technology, discuss it here. 
• Market- this section should discuss the size of your market as well as any barriers to entry.  If any section requires real data, this is it.  Show strong support for how big the market is.  Remember that investors are only interested in markets that they believe provide room enough for the returns they need to make.  That being said, don’t make the mistake of showing the top level market if your target is only a smaller subsection.  Don’t show how many consumer products are sold in the entire world if you are only focusing on selling widgets (a smaller subsection of all consumer products).  Don’t mislead.
• Financial Model – very simple.  How do you plan on making money.  Also, you should include projections here.  If the projections are based on any major assumptions, include those as well.
• Team - discuss the members of your team.  Provide their names as well as a very short bio.  Also include their title if they have one.
• Capital Raise – in this section, start out discussing any money that has been raised to date, including money put in by the founders.  Real founder money shows that the founders take this seriously and have some skin in the game as well, beyond just sweat equity.  You want to conclude this section with how much money you are asking for, how much of the company it buys (i.e., your valuation), and a short sentence on use of proceeds.

Another good resource for executive summary structure is Guy Kawasaki’s article.  His model aligns closely with mine, but he provides some additional sections and a bit more color on what those sections should include. 

Feel free to email me any questions or comments.