Is Your VC a Chicken or a Pig? Part II: The Role of the Lead Investor – From Term Sheet to Closing (and Beyond)

In Part I we talked about the critical importance of focusing your fund raising efforts on identifying a lead investor – a “pig” – and reaching agreement on a term sheet with them before you spend significant time lining up “chickens” to “follow” along in the deal. Today, we’ll look at what role your lead investor plays post-term sheet agreement when it comes to getting your deal closed.

The first role of the lead investor post-term sheet is working with the company to build out the investment syndicate: that is, to find and close on chickens/followers. The lead becomes, in effect, a part of your pitch team – albeit, without abandoning its primary role as an arms-length investor/skeptic.

The “selling” role of the lead includes identifying, prioritizing, and even pitching potential followers. That typically includes folks the lead brings to the table from its own network as well as appropriate candidates the company suggests. While the company will still be front and center in pitching chickens, the lead is usually the primary due diligence source for potential followers, both “deal” and “legal” due diligence, and actively shares their own thinking on why the deal is compelling with various chickens.

This dual role, working with the company to build the syndicate while also being the principal due diligence resource for the syndicate, makes managing the company/lead relationship complicated as well as critical. The lead, at this point, wants the deal to happen and is committed to making it happen. But only to a point. The lead’s enthusiasm is tempered by its continuing obligation to act in the best interests of its own investors. In addition, its credibility is on the line with other investors, which is something that can cut both ways in terms of how it reacts to any bumps in the road on the journey to closing.

The lead also manages the “deal” part of the deal: that is, the concerns of followers about the terms of the deal. On that score, the lead should focus on convincing followers that the term sheet is “good to go” as is. Indeed, the company should resist any material changes to the term sheet based on follower concerns, just as it would if the lead was the only investor. The whole point of agreeing on a term sheet was to finalize the material terms of the deal. As a practical matter, one or more immaterial changes to accommodate a valuable follower may be acceptable. Any material changes, though, should be viewed as putting in play changes the company might want in exchange, or even grounds for the company backing out of the deal altogether.

The lead also manages the legal process associated with negotiation of closing documents and related legal requirements. Typically, there is one counsel for the investment syndicate, and that counsel works through the lead investor and is paid by the company out of closing proceeds from the financing. (If a follower wants to have an independent legal review, they should pay for it, and that counsel should work through the lead and its counsel in terms of communicating any concerns to the company.) If a lead can’t persuade followers to work through the lead and its counsel, that’s a good sign that the lead is not up to the job.

Once the deal is closed, the lead is usually the “point” investor for the rest of the investment syndicate. If the investors have a director on the Board, it will usually be someone from the lead investor. (Someone that should have been identified at the term sheet stage). When the company has news to share with the investors – good, bad, or indifferent – the lead is usually the first to get it, and often has input on what to share with the rest of the syndicate, when, and how. As with the period of time from the term sheet to the closing, this dual role of investor/advisor can be complex and must be managed carefully.

Lead investors make deals happen, and typically play central roles even after the closing. Smart entrepreneurs know that raising money is first and foremost about getting a credible lead’s name on a solid term sheet. Be a smart entrepreneur: don’t waste time and energy collecting followers until you’ve got a lead for them to follow.

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Those Who Do it All… Shouldn’t

Paul Jones, co-chair of Venture Best, the venture capital practice group at Michael Best, has been selected as a regular contributor of OnRamp Labs, a Milwaukee Journal Sentinel blog covering start-ups and other Wisconsin technology news. Paul’s most recently contributed piece, “Those Who Do it All…Shouldn’t” can be found under their Business Tab in the Business Blog section: Click here to view his latest blog.

A short excerpt can be found below:

“In more than thirty years in and around the high impact entrepreneur and investing space, I’ve come to the conclusion that every entrepreneur, even and in fact particularly the most successful, has at least one serious personality flaw.

One of the more common flaws is the “I can do it all” personality: the entrepreneur who insists that they are not only good at, but the best at everything involved with making their business a success.

What really makes the “I can do it all” entrepreneur so frustrating is not so much that they are almost always wrong about their capabilities. Rather it is that even if an entrepreneur really is the best at everything actually doing everything is still a bad idea.”

Click here to read more.

The Silver Linings in the Fundraising Cloud

Paul Jones, co-chair of Venture Best, the venture capital practice group at Michael Best, has been selected as a regular contributor of OnRamp Labs, a Milwaukee Journal Sentinel blog covering start-ups and other Wisconsin technology news. Paul’s most recently contributed piece, “The Silver Linings in the Fundraising Cloud” can be found under their Business Tab in the Business Blog section: Click here to view his latest blog.

A short excerpt can be found below:

“Entrepreneurs generally think of fund raising as a real drag. For all but the sainted few, it is a time-consuming distraction from growing the business. A bothersome exercise courting folks who think they are smarter than you are (and sometimes are). And all too often at a time the cash clock is rapidly ticking down to zero.

But it’s not all bad. Really. As dark as the fund raising cloud is, there are several silver linings (besides closing on the capital) that make the process useful, if not pleasant. Herewith a couple of those silver linings.

Click here to read more.

SEC Issues Proposed Rules to Increase Financial Thresholds Applicable to Smaller Reporting Companies

The U.S. Securities and Exchange Commission (SEC) has proposed rules that would amend the definition of a “smaller reporting company” by significantly increasing the applicable financial thresholds. In an effort to promote capital formation and reduce compliance costs for smaller companies while maintaining important investor protections, the proposal to update the definition would expand the number of companies that qualify as smaller reporting companies, thus qualifying for lower levels of required disclosures in prospectuses and periodic filings (such as requiring disclosures for a reduced number of annual periods and the elimination of the need to include risk factor disclosures and certain financial data).

Smaller reporting companies may provide scaled disclosures under the SEC’s rules and regulations. Currently, smaller reporting companies are generally defined as companies that have less than $75 million worth of company shares that are held by the general public (i.e. public float), or companies that have zero public float and annual revenues less than $50 million.

The proposed rules would revise the definition of smaller reporting company to qualify a company with:

  • less than $250 million of public float, or
  • no public float and less than $100 million in annual revenues.

In addition, as in the current rules, once a company exceeds either of the thresholds, it will not qualify as a smaller reporting company again until public float or revenues decrease below a lower threshold. Under the proposed rules, a company would re-qualify as a smaller reporting company again once its public float is less than $200 million (instead of $50 million under the prior rules) or, if it has no public float, once its annual revenues are less than $80 million (instead of $40 million under the prior rules).

However, we should note that the SEC is not proposing to increase the $75 million threshold in the “accelerated filer” definition. Therefore, companies with public float between $75 million and $250 million may qualify as smaller reporting companies, but still be subject to the requirements that apply currently to accelerated filers, including the timing of the filing of periodic reports and the requirement that accelerated filers provide the auditor’s attestation of management’s assessment of internal controls over reporting required by Section 404(b) of the Sarbanes-Oxley Act of 2002 (unless a company is an “emerging growth company” under the JOBS Act).

Many smaller companies are challenged to meet the excessive reporting and compliance costs that come with being a public company, which the SEC has estimated to be about $2.5 million for initial compliance costs in the case of an IPO and $1.5 million annually for ongoing compliance. The proposed rules, however, would offer substantial compliance and regulatory cost savings to an expanded number of companies (for example by reducing certain financial and executive compensation disclosures in periodic reports and proxy statements).

This may lead to mid-size companies who are currently reluctant to go public to more readily consider that option. However, companies may remain reluctant to go public due to continuing concerns of an increased potential for claims made by investors and related liability.

Public comment on the proposed rules should be received by the SEC no later than 60 days after publication in the Federal Register.

For more information, please contact your Michael Best attorney; Michael H. Altman at mhaltman@michaelbest.com or 414.225.4932; or Daniel J. Gawronski at djgawronski@michaelbest.com or 608.283.0124.

What Good VCs (Don’t) Do

Paul Jones, co-chair of Venture Best, the venture capital practice group at Michael Best, has been selected as a regular contributor of OnRamp Labs, a Milwaukee Journal Sentinel blog covering start-ups and other Wisconsin technology news. Paul’s most recently contributed piece, “What Good VCs (Don’t) Do” can be found under their Business Tab in the Business Blog section: Click here to view his latest blog.

A short excerpt can be found below:

Venture capitalists are not the most popular folks in the entrepreneurial community, for a lot of reasons, some of which are understandable if not necessarily good.

At least one reason for not liking VCs is clearly a good one, albeit one that doesn’t apply to most VCs. The reason is this: Some VCs take compensation – cash, equity, etc. – for serving on the Board of Directors of their portfolio companies, or for providing the kind of “value added” mentoring and networking that good VCs routinely provide. That’s just wrong.”

Click here to read more.

Freedom is Just Another Word for Nothing Left to Lose — sung by Janis Joplin, “Me & Bobby McGee”

Paul Jones, co-chair of Venture Best, the venture capital practice group at Michael Best, has been selected as a regular contributor of OnRamp Labs, a Milwaukee Journal Sentinel blog covering start-ups and other Wisconsin technology news. Paul’s most recently contributed piece, “Freedom is Just Another Word for Nothing Left to Lose – sung by Janis Joplin, “Me & Bobby McGee” can be found under their Business Tab in the Business Blog section: Click here to view his latest blog.

A short excerpt can be found below:

High impact entrepreneurs come to the arena with a wide range of handicaps their bigger, established competitors largely don’t face.

Startups are notoriously short of capital, talent and time. They typically compete with better-armed, established businesses with ample capital and human resources, and substantial brand equity. It is a wonder, to me, that even a small portion of startups succeed.

But they do. And so you have to ask how. How can small, undercapitalized startups with nothing but ideas and small overmatched teams, in the space of a few short years, not just compete in, but win sizeable markets. They must, it seems to me, have some advantages; some assets that, when properly deployed, more than make up for their obvious liabilities. What are those assets?

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Startup Valuation on the Back of an Envelope

Paul Jones, co-chair of Venture Best, the venture capital practice group at Michael Best, has been selected as a regular contributor of OnRamp Labs, a Milwaukee Journal Sentinel blog covering start-ups and other Wisconsin technology news. Paul’s most recently contributed piece, “Startup Valuation on the Back of an Envelope” can be found under their Business Tab in the Business Blog section: Click here to view his latest blog.

A short excerpt can be found below:

“Over the years, I’ve developed a deck of slides and some related spreadsheets walking through how venture investors think about valuing startups.

I’ve given the talk to dozens of audiences mostly consisting of entrepreneurs and angel investors. It usually takes about an hour. Recently, I was asked to cover the subject in about ten minutes. Honestly, my first thought was that it couldn’t be done.

But then, as most entrepreneurs discover early on, necessity proved the mother of invention. So, if you are looking for the basics – just the bottom line, actually – on startup valuation here it is.”

Click here to read more.