Panel: Valuation, control key to seed financing

In the early stages of investment, startup company founders need to make sure
their venture capitalist partners have both the industry expertise for a deal
to make business sense, as well as the compatibility to make sure the partnership
works in good times or bad.



The Brown Venture Forum finished its 2003-04 session on May 20 with a discussion on valuation and control as a company moves through various rounds of financing. Showing the audience breakdowns of how shares and percentages can become more lucrative or diluted over time, the panelists stressed the importance of finding more than one venture capitalist investor during Series A financing and investors who have experience with a variety of exit strategies – be it through liquidation, a merger or an initial public offering.



On the discussion’s title, “Money and Power: Valuation and Control,” panelist Duane DeSisto said regardless of how the shares are divvied up in the early stages, the control of the company’s day-to-day operations will usually remain with its founders – just so long as they continue to execute their business plan.



“You don’t go this route if you want to own 51 percent of the company,” said DeSisto, president and CEO of Beverly, Mass.-based medical device company Insulet Corp., one of several companies he has led through the venture capital process. “This path is about creating wealth,” he said.



Mark Canha, an advisory board member with Westwood, Mass.-based Prism Venture Partners and a member of the Slater Center for Interactive Technologies’ board of directors, said control issues can be kept simple during the seed round of financing, when a company is little more than an idea. He said a good rule is to keep the shares of a company at one-third for the founders, the initial seed investors (friends and family) and for contributions from any institutions.



At the Slater Center, Canha said there are four things he’s evaluating in a startup: the team in place and their background, the product or service, the market for the product or service and only then, the deal itself. “If the rest is in order, getting the deal done is a normal and natural thing,” he said.



By the time a company has a prototype of its product and an understanding of the marketplace, they’ve reached a point where it’s ready to seek out Series A financing or what moderator Margaret Farrell, an attorney with Hinckley, Allen & Snyder, called the “serious money.”



Canha added that a solid management team should be in place, a company should have customers willing to speak about the beta products and metrics, including price points and profitability margins illustrating changes that will come when development is being done at scale.



DeSisto said venture capital firms need to be looked at as potential partners, not potential wallets. Entering into a deal, he said the sides can expect to work together for three years if things go really well, or more likely, they can expect to stay together for five years or more. Today, he said most companies are going through two or three rounds of financing before going public or being sold.



Canha said venture capitalists should expect to be given measures on a monthly basis of how things are going and that founders should welcome a bit more involvement from the venture capital side.



“A partner who is just concerned about putting the money in is going to be concerned just about the money coming out,” said Canha, noting that venture capitalists are primarily in a deal to make money. “They’re not doing this to find broken ideas and take over operating them,” he said. “The last thing a venture capitalist wants is to be in an operating mode at a company.”



Panelist and entrepreneur Vincent Giordano, managing partner of e-Business Properties, a real estate investment firm he founded in 1999 that specializes in technology-specific properties, said seeking out venture capital usually happens when a startup company is in debt or having trouble paying salaries. He said it’s important to not get captivated by the money.



“Spending millions,” he said, “believe it or not, is difficult.” He said there are questions of what sort of a return on investment a partner expects and noted that taking too much cash quickly can easily dilute a founder’s own shares.



Farrell said it is important for founders to pay attention during early series financing to terms describing what happens during liquidity. She said oftentimes investors will settle valuation concerns by requesting a “preferred double dip” should a time come for liquidation. She said the practice was common in 2001 and 2002 when the industry was struggling, and it allows investors to pull out their own money plus additional dollars before anyone else is paid.



DeSisto said liquidity preferences are often much more important than the initial valuation and when signing a deal, it is reasonable for founders to request severance package provisions. When it comes to signing the deal itself, DeSisto said in good business times, the terms are essentially “meaningless.”



Canha said it’s also good to talk with Series A partners about how much their venture capitalist firms are willing to reserve should the company want to look for a Series B “up” round. If a group doesn’t have the money reserved, they may drag their feet in looking for more financing, not wanting to see its shares diluted in a second round where they can’t pay to play. A Series B round usually comes when a company is continuing to grow, needs more money to reach market and decides to bring in another, bigger partner.



DeSisto and Canha said it’s best to have more than one partner firm during Series A, so that during any future “down” rounds, when investors are leaving the company, the terms are still fair. Canha said when things don’t go well, it’s important for a venture capitalist to have experience with exit strategies. “It’s not a game for amateurs,” Canha said.



A networking reception sponsored by Hinckley, Allen & Snyder followed the meeting and the law firm of Partridge Snow & Hahn was the host for the night.

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