You want to buy a new company, expand operations, acquire a business, or raise capital. You’ve decided to go for venture capital funding versus a bank loan for a multitude of reasons from the risks involved to the amount you need to carry out your plan.
Do you know as much as you’d like about gaining capital? Most people don’t. Their expertise is in their business, not in capital funding. Here are ways to protect yourself from vultures, deals you can’t afford, and the nightmares of both.
Some quick explanations:
A venture capitalist (VC) is a person, group of people, company, or group of companies with money to invest in your business.
A VC broker represents you (or possibly a VC) and arranges the parties to create a deal. This article is about working with the broker.
Since many brokers are ethical, why such a negative slant? Over two months, two of our consulting clients nearly lost their shirts dealing with brokers. One broker tried to quadruple dip on a VC deal by taking a commission, bringing in another broker (who needed a commission), taking excessive points on growth targets, and adding interest fees into a contract making the deal impossible. Had our Boston-based client signed with his current and (estimated) future numbers, his decade-old business would have perished.
Another broker wanted a client in Connecticut to sign a broker-exclusivity contract, forcing our client to pay commissions on any type of financing, regardless of whether the deal originated through the broker or not. If an SBA loan or unrelated VC came through, our client would pay $400,000 in unearned commissions.
(With each client, the broker used four or more of the nine strategies below that would be harmful to your fulfilling your capital needs.)
Every deal has its own merits and challenges. Regardless, nine general tips to consider are:
1. Don’t sign exclusivity contracts barring you from finding your own funding. A) On one hand, a broker has every right to protect his intellectual property by preventing you from bypassing him and striking a deal with one of the contacts he’s introduced you to. B) On the other hand, beware of anything preventing you from gaining funding from any other source without going through the broker.
2. Avoid long-term cancellation clauses that hold you hostage for a year or more. Sixty to ninety days is reasonable. You’ve got to be able to move on. A broker’s objective in creating a long cancellation clause is to prevent you from securing funding with the VC they’ve introduced you to while at the same time making it difficult for you to find any funding. Keep your options open and agree to 90 days giving you time to find new opportunities.
3. Prevent double dipping. A savvy broker has multiple compensation channels: initial commission, commission on additional funding you get during a 1 or 2-year term, compensation if the business is sold during specified time frame, percentage of interest on monies lent, etc. Read fine print, several deals that have passed over our desks in the past 6 months have had hidden compensation clauses that would have made any deal difficult to swallow had they had signed with the broker. (Have legal representation from an expert in VC funding.)
4. Know the type of funding you want before you start searching, and bind your broker to the specifics with a contract. Looking for a VC with an equity position who wants shares and is interested in growing the firm, or do you just want financing? Initially, the two can appear similar. In one VC deal, the company looking for funding thought they were getting an equity partner, but the VC only wanted to achieve 3.5 times their ROI in 5 years in monthly fees and interest. The final terms of the agreement: the “receiver” would get $2.9 million, but would pay back $6 million in 5 years. It was not the deal he expected.
5. Remember that VC funding is all negotiation–between you, the VC, and the broker. First, never let the broker think that you don’t have other options. If they think you’re between a rock and a hard place, you’re in trouble. Second, VCs know the financing game in and out, and often they will tell you the deal is dead and not call back for weeks just to get you hungry. Sometimes the broker is in on this strategy. You must be patient. Third, even with contracts, the broker may only secure a few deals a year to make a great living. If they’ve invested four months on the project, they want the deal as badly a you do. Then ask for concessions. Realize they might jump up and down and scream as part of their negotiations. It’s a common strategy; look past it. In every deal, conditions change, and you must remember that commissions, fees, and terms can also change.
6. Know your broker’s loyalty, and make sure it’s to you, not to the VC, or solely to the broker’s own best interests. Think of real estate. The seller’s agent’s loyalty rests with the seller: the buyer’s agent’s with the buyer. Work only with people you trust.
7. Be careful of brokers in disguise. Some mask themselves as venture capitalists and yet have no money. What’s the problem? You think you’re working with an investor whose income is contingent upon the growth and success of the deal/business; in fact, you’re working with a commissioned salesperson who hasn’t invested a cent in the venture and only stands to gain as long as he links two parties. The only way you may ever know is when the deal is being written up and you catch the fine-print line for commission to XYZ firm.
8. Use a VC’s leverage if the broker is unreasonable. One of our clients worked with a broker whose stubbornness kept on getting in the way of the deal. Everyone was giving in a little to make the package work. Our client told the VC he couldn’t afford the deal, because the broker was not participating in the concessions. The VC (with greater financial leverage) wanted the deal enough that he negotiated a compromise with the broker, and everyone was happy.
9. Lastly, brokers, like you, are looking out for their own pockets. To combat this, try to put more emphasis on bonuses based on the long-term viability of the funding and the growth of the business rather than solely on the introduction. Incentives encourage brokers to build the most potentially successful deals.
Most brokers are ethical. They don’t want to take you to the cleaners. Their future successes rest on their reputations for making good deals. But just in case you get a vulture, you now have ways to find out early and prevent yourself from getting in a jam. And as you probably know, always consult with your attorney when entering into a relationship with a broker or investor.
Acquiring capital to fund future projects is exciting and daunting. Although common sense will guide you to avoid pitfalls and seize opportunities, you won’t know everything about this area. Therefore, gaining outside help from experts in this area is wise no matter how many times you’ve done it. After all, you’re strongest doing what you do best: leading and managing your organization.
© David and Lorrie Goldsmith