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How to Raise Seed Capital Without Spending a Lot 9.17.14 Benjamin M. Hron [email protected] 617.449.6584 @HronEsq

How to Raise Seed Capital

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How to Raise Seed CapitalWithout Spending a Lot

9.17.14

Benjamin M. Hron

[email protected]

617.449.6584

@HronEsq

Overview

♦ Framing the Issue

♦ Means of Raising Seed Capital

♦ Costs of Raising Capital

♦ Controlling Costs

Framing the Issue

Q: What is Seed Capital?

A: Small amounts of capital invested in a business in the idea or concept stage to fund initial product development and cover operating expenses until the company is able to raise venture capital.

Typically < $1M

Framing the Issue

Q: How should we think about the cost of capital?

A: Two ways:

– Absolute Cost v. Cost:Capital (Capital Efficiency)

– Explicit Costs v. Hidden Costs

Means of Raising Seed Capital

Sources of Seed Capital

♦ Government (esp. grants)

♦ Public (ex. donations via Kickstarter or Indiegogo)

♦ Friends and Family

♦ Angels and Angel Groups

♦ Venture Capitalists

Means of Raising Seed Capital

Sources of Seed Capital

♦ Government (esp. grants)

♦ Public (ex. donations via Kickstarter or Indiegogo)

♦ Friends and Family

♦ Angels and Angel Groups

♦ Venture Capitalists

A “security” is an ownership interest in a common enterprise where the holder is led to expect profits solely from the efforts of others.

Securities Transactions

Means of Raising Seed Capital

Q: What’s missing from the list?

A: Securities-based Crowdfunding.

♦ Raise ≤ $1M from the public through a “portal”

♦ Authorized by the JOBS Act in April 2012

♦ Rules proposed by SEC in October 2013

♦ Still waiting on final rules

Means of Raising Seed Capital

Securities Used in Raising Capital

♦ Common Stock

♦ Convertible Debt

♦ Preferred Stock

Means of Raising Seed Capital

Securities Used in Raising Capital

♦ Common Stock

– Same stock as founders

– Usually valuation is the main issue negotiated

– Best for raising small amounts from friends and family

Means of Raising Seed Capital

Securities Used in Raising Capital

♦ Convertible Debt

– Loan that is intended to convert to stock

– Handful of terms to negotiate (*not* valuation)

– Usually simpler/cheaper than preferred stock financing

– Best when company and investors can’t agree on valuation

Means of Raising Seed Capital

Securities Used in Raising Capital

♦ Preferred Stock

– Equity with preferences over Common Stock

– Variety of terms to negotiate adds complexity/cost

� NVCA forms facilitate “Series A” financing

� No standard, yet, for “seed” stage preferred

– Best when raising > $500K from angels or micro-VCs where there is a clear lead investor and parties agree to a valuation

Costs of Raising Capital

Q: What is the largest expense in a financing?

A: Legal Fees (of course).

Q: What are typical legal fees for company counsel

in a financing?

A: It depends (of course).

– Common Stock: < $5,000

– Convertible Debt: $5,000 to $15,000

– Seed Stage Preferred Stock: $5,000 to $25,000

– Series A Preferred Stock: $20,000 to $50,000

Costs of Raising Capital

Q: Why haven’t we established universal terms and standards that would reduce legal fees?

A: It’s not as easy as it sounds …

– Broad agreement among lawyers, VCs and angel investors about appropriate terms;

– “Model” forms available from NVCA and others;

– BUT, getting everyone to agree to a single set of terms is unlikely because everyone has a different risk profile.

Costs of Raising Capital

Q: What variables impact legal fees?

A: Complexity of terms and deviation from “norms;” presence/absence of a lead investor; sophistication of investors; number of investors; risk profile of investors and entrepreneurs; need for “clean-up” of company records; quality and rates of attorneys.

Q: How can I minimize legal fees?

A: Control the variables.

Controlling Costs

1. Hire a good attorney

2. Get your house in order

3. Choose an appropriate financing structure

4. Stick close to “standard” terms

5. Start with a detailed term sheet

6. Select your investors carefully

7. Find a strong lead investor

Controlling Costs

1. Hire a good attorney

– Cost is not (necessarily) indicative of quality

– If you don’t know enough to evaluate expertise, get recommendations or references

– Think long-term

� Mutual interest in an ongoing relationship is key

� Trust must go both ways

Controlling Costs

2. Get your house in order

– Sloppy capital structures and poor records can delay or even derail a financing

– Investors may use unresolved issues to drive down valuation or negotiate more favorable terms

Controlling Costs

3. Choose an appropriate financing structure

– Evaluate the key issues

� Economics

� Control

– Be pro-active in proposing terms so you anchor the negotiation

Controlling Costs

4. Stick close to “standard” terms

– Be pro-active in proposing terms so you anchor the negotiation

– Incremental changes in most terms have little long-term impact

– Don’t sweat the small stuff

– Don’t be greedy

Controlling Costs

5. Start with a detailed term sheet

– Much more cost effective to work out material terms before documents are drafted

– Involve your lawyer in drafting the term sheet (better yet, have him/her draft it) – the cost up-front will save you much more on the back end

– Get buy-in from your lead investor(s) before definitive documents are drafted

Controlling Costs

6. Select your investors carefully

– Only include “accredited” investors

� Significantly reduces regulatory burdens

� Reduces risk of future claims

– If possible, select investors with ample experience investing in early stage companies

� Less likely to needlessly haggle over terms

Controlling Costs

7. Find a strong lead investor

– Someone who understands what terms really matter

– Someone more interested in long-term payoff than scoring short-term points

– Someone who has the clout to dictate terms to other investors

Final Thoughts

♦ Cost of raising capital depends on several variables

♦ Companies can reduce costs by controlling variables

♦ Absolute cost is not always as important as capital efficiency

♦ Hidden costs can dramatically increase the long-term cost of capital

♦ Hiring a good attorney can help reduce costs. Seriously.

McCarter & English LLP

Benjamin M. Hron

[email protected]

617.449.6584

@HronEsq

Questions?

Appendix

♦ Summary definition of “Accredited Investor”

– Natural Person with

� Net Worth (w/ or w/o spouse) >$1M (excl. home)

� Income >$200K in past 2 years and current year

� Joint income >$300K in past 2 yrs and current yr

– Director, executive officer or general partner

– Business in which all the equity owners are accredited investors

– Entities with > $5M in assets