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Friday, April 29, 2011

Beyond Rumsfeld by (Stephen A. Boyko and Willard C. Rappleye Jr.)

Introduction

Like him or dislike him. Agree or disagree with his policies. Donald H. Rumsfeld has had substantial careers in both private and public sectors. Yet his greatest governance contribution may have come in writing his memoirs when he segmented the randomness of policy making into known knowns, known unknowns, and unknown unknowns. This parallels a main point made in “We’re All Screwed (WAS)!” which emphasized the segmentation of randomness to provide better information for capital market governance.

Randomness is the range of variability of a complex adaptive system. A constant test to effective governance —the capability of systemic functions to do the right things, and efficient governance — the capability of systemic functions to do things right, is the relationship between the connective concept of randomness to its component parts of predictability, risk, and uncertainty. WAS reflexively provides the subjects to Rumsfeldian predicates for the construction of randomness sentences where:
·       Predictability is the known-knowns.
·       Risk is the known-unknowns. and,
·       Uncertainty is the unknown-unknowns.
Randomness sentences are complete thoughts that are more robust than foundational listings and enable greater innovative efficiencies to go “Beyond Rumsfeld.”

 Effectiveness

Effectiveness speaks to the capability of systemic functions to do the right things. Effective capital market governance requires structural change by segmenting one-size-fits-all deterministic metrics into WAS subjects of predictable, risky, and uncertain governance regimes. They form complete governance thoughts when joined to their related Rumsfeldian predicates of known knowns, known unknowns, and unknown unknowns. This description better enables information to correlate between governance metrics and their underlying economic domains’ randomness.

Managing randomness is a reflexive process between risk and uncertainty. Uncertainty is a separate and distinct concept not an extension of a “riskier form of risk”.[1]  The dictionary defines risk as the chance of loss. Risk deals with and is synonymous with probability. Risk presents foreseeable consequences. By comparison, uncertainty is indeterminate and characterized by unforeseeable consequences.

Risk and uncertainty are operationally different and require different approaches. With risk, one can insure (i.e. buying put options for portfolio insurance) and one can hedge (i.e., Ford and Exxon stocks in a portfolio). With uncertainty, one can insure against natural disasters, but cannot hedge. Uncertainty has no bounds.

Progress, in the form of innovation, takes place when uncertainty becomes risk. The uncertainty—risk conversion provides greater control over the underlying economic environment. Unless and until risk is differentiated from uncertainty errors of conflation will continue to result in noncorrelative information that produces larger and more frequent boom-bust bubbles.

Efficiency

Efficiency speaks to the capability to do things right by minimizing the functions of cost, effort, and time. Efficiency enables innovation to go “Beyond Rumsfeld” to 3-dimensional governance models.

Cost must be analyzed relative to its potential benefit. Expenditures that do not provide a societal “net benefit” are a subsidy to the inefficient and a disincentive to adaptive innovations as opined by two former SEC Commissioners who stated that “regulatory action aimed at eliminating every vestige of fraud in a given market would place such a heavy and costly burden of compliance upon issuers that investors would be safe but unable to achieve any meaningful return on their investments.”[2] Thus, regulatory proposals designed for risk-management regimes tend to be disproportionate when applied to uncertain instruments. Not so much from the capital expended but from the lack of commercial relevancy to the societal net benefit to be derived.

Effort represents the number of interested parties or amount of resources allocated to complete a transaction. Think of regulation as operational insurance. As Drivers’ Education reduces the cost of insurance for newly-licensed drivers; knowledge-driven consumerism is an efficient way to lower the cost of capital market governance.

To illustrate, there were three corruptive information errors that were causal to the subprime crash and required a greater regulatory effort:
1.     Mischaracterization of no-money down, NINJA—an acronym for “No Income, No Job or Assets,” mortgage-backed securities (MBS) that conflated risk and uncertainty to misprice subprime debt as AAA.
2.     Misuse of wrong tool (e.g., using hammer to drive a screw) where owners gave property rights to renters that created perverse foreclosure incentives.
3.     Misapplication of correct tool (e.g., using hammer handle to drive a nail) where uncertain[3] MBS portfolio tranches improperly used the standard deviation as a measure of variability. Attempting to hedge noncorrelative assets minimizes the value of both resources as the reliability of price information is corrupted.
Any effort that reduces informational deficiencies will have the added benefit of limiting the diversions from fundamental value.

Time: Commercial throughput processing speed as measured by time is directly proportionate to the level of systemic complexity. The function of time evidenced the largest increase during the transition from the Information Age to the Conceptual Age (Daniel H. Pink, 2005).[4] This requires a whole new mind-set that is built on innovation and big-picture capabilities as the society and economy move from high tech to high concept framed in a 3-dimensional context (think GPS vs. maps).

Three dimensional models drive economies of speed to expand enterprise parameters. Capital market policymakers, however, too often chose overly simplified responses. These responses were formulated within the context of a relatively narrow, two-dimensional perspective resulting in unintended consequences (i.e. Sarbanes-Oxley).

A 3-D conceptual change must take place in order for the US capital market to remain competitive in a global economy. Critical to governing a complex adaptive system is the timing and sequence of order to be processed.

To this purpose a 3-D regulatory Rubik’s Cube[5] is suggested to enable policymakers to mix-and-match individual cubes irrespective of market scenarios and different beginning regulatory configurations. Events and competitive responses can be modeled for effective and efficient governance. Dr. Tomas Rokicki Ph.D. and his team proved that any configuration of a Rubik’s cube could be solved in 20 moves or less.

Conclusion

Capital markets are complex adaptive systems with dynamical and non-linear properties. If there is complexity, then there is uncertainty. How can uncertainty be governed deterministically with one-size-fits-all regulatory metrics? If Citigroup’s financial supermarket could not cross-sell, can cross-regulation solve the problem of non-correlative information and related discontinuous market functions?

Managing randomness requires the reflexive integration of risk and uncertainty. To correct market ineffectiveness requires planned change to segment one-size-fits-all governance metrics into predictable, probable, and indeterminate underlying economic environments. To expedite market throughput requires 3-D models for processing leverage (3-D GPS vs. 2-D Maps). Before one can think outside the box requires thinking outside the square. Otherwise unplanned change, or chaos, sees risk become uncertainty resulting in the troubling, non-linear trend of larger and more frequent boom-bust cycles.



Authors

Stephen A.  Boyko is the author of "We're All Screwed! How Toxic Regulation Will Crush the Free Market System" http://readingthemarkets.blogspot.com/2009/10/boyko-were-all-screwed.html . He has over forty years of financial services industry experience that include formulating regulatory policy for the National Association of Securities Dealers (now FINRA) and providing a practitioner's perspective for the privatization of the former Soviet Union in corporate governance and regulatory development of the Ukrainian Capital Market. Contact: n2keco@bellsouth.net


Willard C. Rappleye Jr. has spent a lifetime as a financial journalist. He was the National Economic Correspondent for Time, Editor of American Banker, Founding Editor of Financier, the Journal of Private-Sector Policy, and Vice Chairman of FinancialWorld.

Endnotes



[1] This distinction between risk and uncertainty was made famous by economist Frank H. Knight in his seminal book, “Risk, Uncertainty, and Profit” (1921).

[2] Registration Under the Advisers Act of Hedge Fund Advisers File No.: S7-30-04 Dissent of Commissioners Cynthia A. Glassman and Paul S. Atkins http://sec.gov/rules/proposed/ia-2266.htm#dissent

[3] Uncertain investments lack cash flow and mark-to-market valuations.

[4] The governance evolution matrix below provides an historical context that reflects the factual realities for events that took place and how those historical events have influenced current decision making.

Age
Thought Dimension
Descriptors
Governance Metrics
Example
Agricultural
1
Linear, unidirectional
Progenitor, Malthusian
Dominoes

Industrial
1
Linear,
Binary (on-off)
Usage depreciates
Checkers
Information
2
Dynamic, Nonlinear, CAS
Usage appreciates
Chess
Conceptual
3
3-D GAAMA  (GPS vs. Maps)
Risk – uncertainty
Segmentation
Rubik’s Cube

[5]  The proposed “Regulatory Rubik’s Cube” see: http://www.sfomag.com/article.aspx?ID=1353&issueID=c  is built upon proven market and mathematical decision metrics to uncover principles of governance rather than simply profiling patterns of governance. While it is currently fashionable to criticize regulators, rating agencies, Congress, Government Sponsored Enterprises (Fannie Mae and Freddie Mac) Wall Street etc., we argue that “governance goofs” are more attributable to systemic structural obsolescence rather than individual shortcomings. Inefficient, under-regulation from two dimensional metrics that have to address three dimensional market realities lack processing speed. This is similar to using maps instead of GPS to navigate downtown traffic at rush hour. How efficient can that be?


 ______________________________________________________________________________________________________

I want to thank the authors for their excellent article for the Blog.  They continue to publish articles and books of importance to the financial and regulatory sector.  Steve published the book "We're all Screwed!" and has been on active speaking engagements.  I am pleased to call him a friend and he has agreed to be an active contributor to the blog!

You can follow Taffy Williams on Twitter by @twilli2861 and you can email me with questions at twilli2861@aol.com and my company website is at http://www.ColonialTDC.com .

Wednesday, April 27, 2011

Staff & Money or Money & Staff

At this point in the process, you should have a business plan, a slide show, an elevator pitch, and maybe you practiced your presentation at a venture fair, a local angel meeting, or some event.  Hopefully, you got feedback which is useful to improving your presentation and business plan.  Perhaps, you have a deal with the inventor who is continuing to develop the product or a prototype and you have the future rights if new inventions come about.  All of this is good progress, but you still do not have staff or money.  Which comes first?  A bit of chicken and egg right!

You are constantly thinking about what type of staff you need, how much they will cost you, and where you will get money to pay them and other expenses.  The team you create is a reflection of the quality of the company, technology, and your leadership.  The higher the qualities of your team, the better your chances are to attract money.  I actually presented to a venture firm a few years back and was told that they just invested in a company that had inferior technology.  The entire investing syndicate was in love with the team.  Their thinking was that the technology was not important, and that the team was so good that they would eventually turn the company into a valuable asset. The morale is that having an A class team, is generally superior and helps get money. 

A great team will be able to find the path to create value and overcome adversity in most situations.  Take a look at public companies that have had technical or product failures in the past, but have bounced back.  This usually happens because the management team mapped out changes to improve performance and then executed effectively on the strategy. 

The most senior people are your most critical hires. As you need help, it is possible to find it via part time or consulting arrangements.  Your overall objective is keeping the expenses low until you can afford to add.  Cutting staff is extremely painful for them and for you. I usually recommend that full time hires be kept to a minimum and the company work semi-virtual until there is a real need to add a significant head count.

So what type of people do you need to start with?  A few suggestions below of key hires:

·       Chief Scientific Officer, Chief Medical Officer, or Chief Technology Officer (CSO, CMO, CTO) – Your inventor is likely not an employee in the company and you licensed the technology.  Even if the inventor is in the company, he/she may not have the key corporate development experience. The product development must be advanced and you really need experience to do this right.  This hire is a critical position and I prefer filling it with a highly experienced professional from industry; a “Been There, Done That” person. 

·       Chief Business Officer (CBO) – This is a person that can help get deals done, map out partnering programs and go after partners, help define your business strategy, and maybe introduce you to funds with money, maybe do a few early deals, etc.  This should be someone with relevant experience in the field and they must come with a database of contacts.  You want them to hit the ground running.

·       Chief Financial Officer (CFO) - You need a financial person to keep track of your funds, expenditures, and to help with budgets etc.  This could be a CFO, but in the early years of your company it could even be a part time financial services firm.  You can upgrade the position when you are ready to go public or enhance company growth; then you really do need that experienced CFO.  When the time comes, get the best you can afford. 

·       Technical staff - You are likely to need a few technical staff.  Especially, if you have lab or development space and need hands to advance the projects.  If they are experienced, they can even help write grants to funding agencies.


How do you pay for the senior people?  This will be a real negotiation and a sales job when you have no cash and you are in your startup mode.  To complicate the negotiation and sales, you are likely seeking mid-six figure salary employees.  This is where you need to be creative in structuring a compensation package. 

There are many former senior executives around that may be able to take on risk for some real upside.  You will find them via extensive networking!  You may be able to convince them to assist as an advisor, consultant, or employee for an equity stake in the company.  Most difficult is the ability to convince them to forgo salary because you cannot pay.  Give this consideration when you determine the equity stake as it will require you to give them more equity than if you could pay.  You may need to cover their out-of-pocket expenses if they travel. This will cost a bit, but you can’t ask them to spend their funds and not make a salary.  That will not work well for long.  You can also consider setting limits in their agreements that stipulate a salary of a certain amount when the company completes a capital raise of a certain amount.  For example, you will provide a salary of $200,000 per year once the company completes a financing of $5MM.  You offer them for example 3% of the equity of the company starting immediately and add a buyback or vesting provision that goes to zero in a 3-4 year timeframe.   The buyback or vesting ensures they have to work for a period to keep the stock or options.

It is possible to find experienced staff with little or no funding, but you will have to do some real networking and negotiating.  Remember, they are not getting paid for a while so don’t expect them to move until the company is adequately funded.  On an occasion, you may need to consider having them work from a distance even after funding has been achieved.  This can be managed, but you really do not want everyone doing this.

Which comes first the money or staff? If you are creative, you may be able to get the staff on board with minimal cash in the bank.  Then you can use that to help increase your chances for getting the money or argue for a higher valuation of the company.   Maybe, the staff will come up with a way to advance the company with much less money or via grants. 

All the above said, I never like to turn away money. If you can get someone to give you funding with no management team, you should consider taking it. 

I hope this has been helpful.  I am always available to discuss the topics in the blog or others you may find of interest. 



You can follow Taffy Williams on Twitter by @twilli2861 and you can email me with questions at twilli2861@aol.com and my company website is at http://www.ColonialTDC.com .

Monday, April 25, 2011

DISPUTES – THE GOOD, BAD AND UGLY (by Matthew Hafter)

In Taffy’s March 30, 2011 blog entry, Inventions & Patents are Critical – the Technology Still Needs Development, he mentions the difficulties entrepreneurs have in protecting their early stage technology through the court system.  With this problem in mind, many clients ask about alternative dispute resolution (ADR) as a way to reduce uncertainties about the outcome of a dispute and the related costs.  While ADR has its place in any business arrangement, this is the wrong question.  Instead of asking how to resolve disputes, we should be asking how to avoid disputes.

The nightmare scenario for any technology startup is that a large, well-capitalized competitor will sue your company for infringement of its patents or other intellectual property rights.  Litigation can stretch on for years, it costs vast amounts of money, and the uncertainties it creates interfere with raising capital, relationships with key business partners, employees and others.  The risk for a startup is that the larger company can, regardless of the merits of the claim, “run your legs off” and force you to capitulate simply because the costs of further litigation are prohibitive.

But aspects of disputes can be constructive:  disagreement provides a way to rigorously explore facts and business and legal issues.  Resolution can provide finality and certainly; and, if done well, can provide a rational result.  Finally, dealing with disagreement provides a forum for people who are at odds with one another to satisfy the key need to be “heard.”

The key is to assume that disagreement will arise in any business relationship – whether with a licensor, distributor, supplier, joint venture partner, investor in your business, etc. – but to plan for procedures to maximize the likelihood that a disagreement will not spiral into a dispute.

To achieve this goal, you should take some time to think about how to deal with disagreements in the business relationship at its outset.  At this stage, the parties usually share goodwill and a goal of working together effectively.  However, once a dispute is on the horizon, motives are different and parties will opt for the dispute resolution process that each perceives favors its own interests.  At the beginning of the business relationship, the parties together place a high value on controlling the resolution of the disagreement themselves – a higher value even than getting the exact result each wants – because they can resolve the issues faster and for less cost than a third party (a judge or arbitrator).  The parties themselves will know more about the industry, the business and the facts of the dispute, and can therefore fashion a resolution that is superior to one created by a judge who knows little and cares less than the parties about the resolution.

Here are some features you can build in to the agreements that govern the relationship to make it more likely that the parties themselves will avoid destructive disputes.

-        Provide for regular meetings between the parties.

-        Establish procedures to assure a free flow of relevant information between the parties.

-        Adopt decision making procedures (for example, voting on key issues) the parties perceive as fair.

-        Structure the relationship to recognize a shared commitment to the venture so that both sides lose if it becomes dysfunctional.

It can also be helpful to establish more formal dispute avoidance procedures at the outset of the relationship.  Ideally, these procedures maximize the likelihood that the parties will resolve disagreements largely themselves with the least cost.  Examples include mandatory meetings between senior executives to discuss resolution of a problem, or non-binding mediation.
Mediation is a procedure many startups find useful.  Essentially, mediation is a form of facilitated negotiation with participation from the parties (usually a party representative with authority to settle from both sides must be present at the mediation) and their lawyers.  A meditation will typically follow a pattern:
-        The parties submit a written mediation statement educating the mediator about their positions.
-        At the mediation, the parties make opening statements.
-        Then the mediator will conduct private “shuttle diplomacy” sessions with each side to find areas of common ground, point out to each party weaknesses in its case and risks of proceeding to trial.
-        If a resolution is achieved, the parties may document the essential terms at the mediation (often in handwritten bullet points) to create a binding agreement (even if additional details must be written up later in a formal document).
Good preparation helps to assure a successful mediation.  The mediation statement will often be the best opportunity to make your case directly to the principals on the other side.  You should also be prepared with responses to anticipated weaknesses in your case, and a plan for concessions and what you want in return.  It is also important during the mediation session to take caucuses when needed to recalibrate your plan and strategy. 
The success of a mediation also depends on the skill and persuasiveness of the mediator.  Selecting the right person for this role is important.  The mediator must be skilled in dispute resolution – someone who will listen but also push toward a resolution; he or she must have a strong personality to stand up to both sides.  The mediator also must be someone both sides have confidence in to provide recommendations that are objective and credible.
Startups need to stretch limited resources and to secure the benefits of the constructive elements of disagreements.  The best way to do this is to plan for the inevitability of disagreement and establish procedures to avoid disagreements evolving into disputes at the beginning of what is hoped to be an ongoing relationship where the incentive to collaborate outweighs the incentive to gain advantage.

By Matthew I. Hafter

Matt Hafter is a corporate lawyer who works with many startup and venture backed technology companies.  He is a principal in Grippo & Elden LLC, a Chicago law firm that concentrates on complex commercial litigation and transactions.  Please visit http://www.grippoelden.com/ for more information about the firm.

Grippo & Elden LLC
111 S. Wacker Drive, 51st Floor
Chicago, IL 60606
Phone:   312.704.7700
Fax:        312.558.1195


A note from Taffy Williams:

Matt Hafter is an excellent Attorney that I worked with extensively over the past several years.  He is experienced in corporate and SEC law and a great person to have on your legal team.  When I asked him to help with the blog, he graciously accepted.  As usual he is able to communicate key points which we hope you will find helpful as an entrepreneur.   I am grateful for his input and enlightenment. Thank you Matt!

You can follow Taffy Williams on Twitter by @twilli2861 and you can email me with questions at twilli2861@aol.com and my company website is at http://www.ColonialTDC.com .



Friday, April 22, 2011

Licensing Technologies from Universities – Tips for Start-up Companies (by Carl Mahler)


Anyone who has ever received training in negotiation has heard that it is advisable to take the time to learn about your negotiating partner, to understand his or her perspective, and to take his or her incentives and obligations into account when trying to find a mutually acceptable agreement.  This is particularly true when dealing with research universities because their motivations, constraints, and rewards are frequently very different from those encountered when dealing with for-profit businesses.  This posting is intended to serve as an introduction to the motivations and constraints one typically encounters when negotiating with universities and hopefully will lead to better and faster deal making.
In the thirty years since the passage of the Bayh Dole Act universities have broadened their mission to include transferring the technologies developed on their campuses out into broader society.  There are numerous reasons why they do this:  sometimes to serve as the final stage of research, taking discoveries out of the lab and into common use; sometimes to provide an institutionally-approved outlet for entrepreneurial faculty, staff, and students; sometimes to help with economic development; and sometimes to make money (although if revenue generation is the ultimate criterion for success then most universities are spectacular failures).  Knowing the specific goals of the university from which an entrepreneur wishes to license a technology enables the negotiators to craft a better deal for all those concerned.
When an entrepreneur knows the university’s goals then he or she is in a better position to offer appropriate consideration for a license.  For instance, if one of the university’s goals is local economic development then an agreement that the entrepreneur’s company will not locate more than, say, five miles from the university for the first ten years that the license is in effect may be a term which the university would want to include and which may cost the licensee very little.  If the university sees spin-out companies as potential sources of research funding, an agreement that the university would be the company’s preferred partner for any SBIR, STTR, or other types of grants could be mutually beneficial.  If the university sees spin-out companies as a source of employment for alumni, then including a university researcher who has direct experience developing the technology being licensed as a founder of the company could make a substantial impact on the terms of the license  – many universities (such as UNC Chapel Hill, Carnegie Mellon, and many others) have special terms that are available for start-ups formed by “university personnel” – often including soon-to-be graduates and post-docs – that are not made available to other companies.  An entrepreneur may well find that if he or she is willing to include terms such as those described in this paragraph in a licensing agreement then the university will be willing to decrease the royalties and/or equity stake that it will receive under the license.
Virtually every license agreement involves some transfer of money and perhaps equity to the university, but a well prepared negotiator who understands the other side’s perspective can frequently find ways to adjust the size of those transfers to a level that all the parties will find acceptable.  Savvy universities have learned that bleeding cash from new companies is not in the best interest of anyone, so requiring a start-up company to pay large up-front fees is counterproductive.  However the university does need to ensure that it covers its costs, so at a bare minimum the start-up should be prepared to repay the university all costs incurred for patent and other IP protection on the technologies being licensed and to pay all future costs incurred for that IP protection – after all, it is the company, not the university, that receives most of the benefits from IP rights.  In most cases some additional payments will be required to cover the technology transfer office’s expenses and to demonstrate that the new company has finances available to commercialize the licensed technology.  In many cases the university will want to have a mix of both royalties on sales of products embodying its technology and some equity stake in the company; providing realistic projections of sales and of company valuation at various stages of its growth will help both sides craft a realistic and appropriate mix of royalties and equity.
Universities have an obligation to ensure that their technology benefits society, so due diligence provisions should be a part of every license.  Depending on the type of technology being licensed these provisions can take the form of minimum annual royalty payments which act as a prod to make the licensee either develop a product or terminate the license, “success payments” to the universities when certain milestones are reached (this is quite common for biomedical technologies, especially as products move closer to regulatory approval), fundraising goals, and achievement of a certain level of sales by a specified date along with payment of royalties to the university based on those sales.  Failure to meet these obligations may result in termination of the license, but if the licensee keeps the university informed of its efforts to move forward, advance notice if it appears that a milestone may not be met on time, and the reason for delays in meeting milestones then the university will frequently be willing to adjust the terms of the license or grant a waiver for failure to meet specific license terms.
Universities generally try to be businesslike in their licensing agreements, but the fact is that research universities are not for-profit businesses and for a variety of reasons they cannot agree to terms that are typically included in agreements between businesses.  For example, virtually all companies understand that doing business involves taking risks and so companies keep reserves of money to cover the cost of risks that go bad.  Universities receive money to perform research and educate students; they simply do not have funds available to cover risks that are typically taken by business ventures.  For this reason universities virtually never agree to indemnify licensees or provide warranties of any type.
Another term typical in agreements between businesses is that the licensor will provide the licensee with rights to improvements that the licensor may make to the licensed technology in the future.  Universities do not do this for a number of reasons.  First, virtually no one will fund research if another party, such as the licensee, will reap most of the benefits of that research.  Second, being non-profit institutions the university can only transfer rights for fair market value and it is not possible to determine fair market value of an invention or improvement that has not yet been made.  Finally, university researchers usually work independently of one another so it is fundamentally unfair to Professor X for the university to obligate rights to results that might arise in Professor X’s lab solely because a license has been granted to technology previously developed in Professor Y’s lab.  If a company wants to obtain rights in future research results, its best course of action is to fund the research that might lead to those results.
Although universities are not like for-profit businesses, the knowledgeable entrepreneur will find that the same advice applies when dealing with them as when dealing with companies – the better you know your negotiating partner, the better the deal you are likely to end up with.  Find the motivations, goals, and constraints that the university places on the technology transfer office and you may well find that the final agreement includes more favorable terms than you initially expected.
Carl P.B. Mahler II, JD
Executive Director
UNC Charlotte, Office of Technology Transfer
9201 University City Blvd, Charlotte, NC 28223
Phone: 704-687-8016  Fax: 704-687-8014

A note from Taffy Williams:
Carl Mahler is a licensing professional with many years of experience.  He graciously prepared this article to help entrepreneurs understand better the issues with licensing technology via Universities.  I am grateful for his input and enlightenment. Thank you Carl!

You can follow Taffy Williams on Twitter by @twilli2861 and you can email me with questions at twilli2861@aol.com and my company website is at http://www.ColonialTDC.com .

Wednesday, April 20, 2011

7 Questions You May Get from Potential Investors

If you have completed the steps outlined thus far, you have the proper materials to start your search for funding and partners.  You will need to create a management team and have them properly displayed in your slide show.  I plan to discuss options for hiring them when you have no cash in a future article.  For now, I want you to start thinking of questions you may get from investors and potential management and sharpen your answers to those questions.  The Q&A during your initial presentation is part of the first impression a fund manager gets of you and the company.  The answers and discussion and will guide them to determine whether your company is a fit with their investment strategy and current needs.  Below are a few more common questions I have gotten in the past.  There will be many others, but I thought it worth starting with these:

1.    What is your exit strategy?
This is important question.  Translated by me: Is your baby and you intend to keep it forever, or can I count on a cash-out event within my fund horizon?”  Keep in mind the first prospect means you may be seeking a lifestyle while the second relates to your always seeking a way to make money for the investor base.  My usual honest answer is, “I am not in this for a religious experience.  We will evaluate all offers and do what is best for all the shareholders.  If I have to, I will stay and grow the business until we can get a reasonable offer.”

I actually ask this from companies I consider as potential clients or where I may consider working.  For me taking equity has no value if there is no liquidation event; I do not need wall paper in the form of stock certificates.

A second point I wish to make is that you consider developing your personal exit strategy.  Many founders have eventually been replaced by investors or the board at some point in the development of the company.  You should consider adding language to your employment  agreement to cover your parachute; protect your equity and salary for some period post removal from the company.  This does not need to be articulated to investors, but you do want to take precautions to protect yourself since you did create the company!

2.    Review the timeline and cash needed to the next inflection point.  What is the minimum you can get by with to the next step-up in valuation?

The inflection point is thought of as the next step in the valuation increase.  This can happen based on a great deal with a partner, positive data from proof-of-concept, a major advancement in development, or other such value creating events. 

I actually heard this question posed to a client recently.  The fund was trying to determine the least amount of money they could invest to take the company to a significant step-up in valuation.  A rework of the financials taking out everything not related to the primary product opportunity generated that minimal number for this company.

3.    How much cash have you invested in the company so far?

You have no obligation to make cash investments.  Some investors may insist that you co-invest in a round.  In fact, some technology areas will not be considered by investors without them thinking you have “skin in the game”.  Lucky for me, Biotech (my personal favorite) is currently not one of them! 

4.    How many months of cash do you have left?

I actually dislike this question and always interpret it in the most negative way.  To me, it says “how long before you run out of money so I make a very low offer which you have little choice but to take.”  There is nothing but the truth you can offer in reply if you are private.  If you are public, you can say see our last Q report which disclosed our financials.

5.    What is your company’s pre-money valuation?

I always try to establish a fair value to the company.  I also try very hard to not give the answer unless we are approaching the investors with a very specific deal structure for the investment.  If you are dealing with a lead investor, they usually go by the “golden rule; I got the gold I set the rules.”  Most of the time, the investor tells you what valuation they would invest at for your company.  They will also add a lot of other terms.  You never have to take the deal offered and can try to negotiate a better one.  In the end, it depends on your other options for funding.

6.    Will your current investors participate in this round?

It is common that certain investors will chose to invest in subsequent rounds, if they have the resources.  The previous investors are getting diluted out in their percent ownership and many will invest in the follow on rounds to maintain the percent ownership.  You want to take their temperature in advance so you will know their appetite for investing in follow on rounds.  One way this helps is if they are willing to invest 25-50% of the next round, the new investor pool needs only to find the remainder.

7.    What other investor groups have you spoken to?

This is another of those questions that I dislike.  I always translate this to “who can I call to see if they like you?”  You can count on one thing; fund managers will call around to their friends to get their opinions of you and the technology.  It is a herd mentality group.  If their friends want to invest, the fund manager does not want to be left out.  If someone does not like you, the fund manager may not even go to the next steps.


I am certain I will come up with more questions later. I wanted to provide you with a few of the more common questions I have gotten and provide some flavor.  Please let me know if you have questions or comments.



You can follow Taffy Williams on Twitter by @twilli2861 and you can email me with questions at twilli2861@aol.com and my company website is at http://www.ColonialTDC.com .