Beware the Entrepreneurship Industry

This may be a controversial post. You’ve been warned. This post is from my point of view as an advisor to small business. I realize that I occupy a place in the “industry” landscape, and that like the bigger wheels in the machine, I too turn a profit from providing services to small business. As a lawyer, however, I have a duty of loyalty to my clients – called a fiduciary duty. It isn’t optional, it’s the law. This means a bunch of things – to be competent and diligent in my work, to act in my clients’ best interest, honesty, and to keep your information confidential. Most of the other people you’ll come in contact with in the business world don’t have such a duty – and therein lies the risk that we call “doing business.”

I’ll get to the point.

I’ve noticed a trend towards the industrialization of entrepreneurship these days, and the more I think about it, the less comfortable I am with it. When I say “industry”, I’m talking about making labour systematic. The same business model that created the assembly line to make business more “economically efficient” is now being applied to entrepreneurship. There’s big money to be made. Investors and big business have realized that in many cases it’s more economically efficient to buy innovation than to innovate.

But how do you groom small, innovative businesses into ones that will slip neatly into the world of big business, and global financial markets as they grow? The answer is to industrialize entrepreneurship. As this system gains momentum, there’s an explosion of organizations which provide ready-made solutions to most of your small business needs.

Most of these organizations exist to make money….

… off of you…

… and none of them owe you a duty of loyalty.

I’m not saying that these organizations are out to get you. There are plenty of amazing collaborators out there. All I’m saying is that a healthy dose of caution, and an unhealthy dose research before getting into bed with them is in order. Any time you give up equity (shares) in your company it’s like taking on a business partner. They invest time, money, and resources in making your company grow. With the money comes the expectation of profit. You, as the one with the business or idea, will want to be assured that your partners will pull their weight, and that you’ll have a way out if they don’t. In return, there are some pretty thick strings attached to the investment. They’re gamblers in a way. Gamblers with a much bigger stack than you, more experience in these kinds of deals, and an uncanny ability to lawyer plucky little startups into the ground if they feel wronged. Choosing the wrong horse to hitch your wagon to could cost you your business.

In this article, I’ll talk about two of the big growth sectors in the entrepreneurship industry – high risk investors, and growth programs. I’ll deal with high risk investors first – angel investors and venture capital. Then I’ll move on to the growth programs – incubators and accelerators.

High Risk Investors

The starting point to understanding high risk investors is to understand the basic business proposition from the investor’s point of view. Angel investors, and to a greater extent, venture capital, are betting on the success of your business. In return, they demand returns commensurate with that level of risk. Particularly for VC, they may invest in ten companies, and only get a return on one – meaning the one that hits, they’ve got to make all the money back that they invested in all ten, plus a healthy profit margin – otherwise they’ll be out of business. That means they’re going to do almost everything in their power to make sure that they get their money back. This includes attaching strict, investor-friendly terms to the financing. This also includes using their networks and contacts to spur growth. They’re putting a lot of eggs in your basket, and approach the deal accordingly.

Angels

An angel investor is a wealthy person or group of investors who are willing to pony up startup capital for businesses that they think will succeed. Some angels specialize in raw startups, while others are only interested in companies that have already reached a certain critical mass. While the term “angel” might make them seem benevolent, they’re planning on making money off of your work. Their investment buys a part of your company – between 10-50% typically – and often gives the investor a say in how the business is run. They think they can make money on your idea – and if you don’t do it for them, they may take the reins and do it themselves. Angels see the end-game too, where they can realize the return on their investment. Cashing in. This often means selling the business – either to a third party or by taking the company public. If your end game is different, you may have found the wrong angel. If selling isn’t their goal, they might intend to grow your company in a way that benefits their other business interests.

Angel investment is attractive because as soon as they’re on board, it’s in the angel’s interest to use their connections and experience to help the business. A good angel can open up supply or sales channels that were previously out of reach, guide you through tough negotiations, and provide mentorship to help you develop your business skills. On the other hand, an angel whose intentions aren’t so angelic could take control of the business, fire you, and force you to sell them your shares at a discount. If they have a bad reputation in the business community, you could be tainted with that as well. I’ve seen all of these things and more. Do your homework, and get advice before, during, and after negotiations with angel investors.

Venture Capital

Venture capital is a different beast altogether. VC is usually a fund where many professional investors, serial entrepreneurs, large companies with innovation budgets pool their money together. The fund is managed by specialists who look for high-growth, high-potential businesses to invest in. Usually they’re looking for an “adolescent” business, rather than a raw startup, will invest for several years, and expect a return of around 10 times what they invested over that time. VC will usually get paid out first – often within 1-2 years – and take a percentage of ownership of the company. Venture capital is usually a one-way ticket to an initial public offering, and your investors will do what they must to ensure they get a return. They’ll appoint board members to shepherd their investment, and often have a good deal of say in hiring for key positions. They may replace you as the CEO if they have someone who’ll do better. The investment will usually be a high-interest loan, and secured with shares in the company which will pay the VC back first if the company goes belly-up. The exit plan almost always involves taking the company public. VC is more complex than that – but the important take-away here is that it’s very, very pricey money.

VC is attractive because, if it works, you get rich when the company is sold or taken public. VCs will lend based on their valuation of the idea, rather than their ability to secure their investment on the assets of the company, like a bank would. The downside is, once the VC comes on board, the business ceases to be your baby. Your interests aren’t aligned – the VC is looking out for their investment, not for the best interests of you, the company, or the employees. Most venture capital funds focus on building up the pool of money they manage, rather than mentoring and guiding the business – they’ll often appoint outside board members to represent their interests. The strings attached are large, and tied tightly.

Dealing with High Risk Investors

High risk investors can take your business to the next level in a hurry, and are sometimes the only viable option to fund your research and development. This is especially true for businesses built on ideas, rather than physical assets. Be very, very careful about who you’re dealing with, and understand the deal that you’re making before you sign on the dotted line. Do your research. Get legal and accounting advice. Shop around, and keep these in mind when you’re exploring your options:

  • First, foremost, and always remember – if they’re willing to fund you, then you have something they want. You have leverage in negotiations, and should only take a deal that works for your company.
  • What’s the business/industry background of the people you’re dealing with? What other companies have they worked with, and what results did they get? Talk to those companies, and get a no-bullshit assessment.
  • Who will be appointed to your board? How many other boards do they serve on?
  • Who are their advisors – accounting, legal, etc – and do they come as a package deal? Are they encouraging you to get independent advice before signing?
  • What’s their exit plan? Does it mesh with your vision for the business?

If the investor can’t give you a good answer to those questions, or stands in the way of you finding the answers on your own, run away as fast as you can.

Predatory investors can be hard to spot… until it’s too late. I’ve got a bunch of horror stories from people in my network who jumped at what looked like a good deal… and when they landed, the investor owned the company, and the founder ended up with only a fraction of the value they’d built. They’re smart people who make their living by getting other people to do the grunt work for them… and unscrupulous investors know how to cover their bases. Be cautious, and put in the time and effort to understand them, their goals, and what they expect of you before committing.

Growth Programs

Incubators & Accelerators

These two get lumped together because they fulfill roughly the same role at different stages of a company’s growth. They are, at their core, great business models, and can do a whole lot to nurture the development of your company, and your business skills as a founder. The basic premise is that they’re in the business of investing in startups. An established business person, or group of ‘em, will bring in a company, or group of ‘em, and invest in the company in hopes that it will grow. Most will invest a combination of money, marketing, office space, production and design support, mentorship, and access to their personal networks. They’ll set a pretty rigorous training schedule in business skills, which members are required to go through. In return, they take a piece of your company.

Incubators are typically a long-term involvement, around 2-3 years’ worth, with no set schedule for growth. Most will bring in companies of a similar type into a common working space in hopes that ideas will flourish. Often, incubators will put their own management teams in place – directors and officers – once the grunt work to bring the idea to fruition is complete. Incubators typically take up to 20% of your company for the role they play in incubating your idea.

Accelerators are usually a set business development program to spur rapid growth – hence the name. The program takes place over 3-6 months, and is aimed at companies that have reached a certain stage of development. That program typically involves a couple of “funding rounds” from VC, and may also involve tacking directors and officers of their choosing on to your management team, or full-on replacing the founders in those roles. Accelerators usually take less than 10% of your company for their services.

Who Sails the Ship?

The most value in a growth program is the network that comes along with it. When done right, incubators and accelerators can provide value that’s almost unparalleled. You can get specialized advice and training that will help you to understand and speak the language of business, interpret financial statements, and refine your pitch. Most valuable is the access you get to their well-established business network of advisors, mentors, financiers, and other graduates of their program. That cuts both ways, however. When you climb aboard that train, you’re committing to doing business the way they teach you to do business. While some incubators and accelerators have altruistic intentions, many more are an elaborately constructed way to make money off of your efforts, or to cherry-pick talented business people for their own organizations. It’s a business farm, and you’re the cash crop.

For example, law and accounting firms view successful incubators and accelerators as a way to get new clients. I’m one of them, as an advisor at Ryerson’s DMZ, and a mentor at HumberLaunch. I’ve met several clients that way. Strangely, in the cash strapped world of startups, my competition is largely huge national law firms. These firms will offer cut-rate startup packages, as a loss-leader.  They take a hit on their fees in the short term, in hopes that you’ll grow enough by the time the discount period runs out that you’ll have enough in the bank to pay their rates. That business development strategy means that they’re looking to minimize their short term losses incurred by giving away their services. This can mean standard-form business agreements that aren’t customized to your situation and business. The work is pushed to junior lawyers, law students, and clerks to “cut their teeth” on. A free client’s phone calls are returned after the paying clients’ work is done. That said, big firms have specialized skills, particularly to grow startups into publicly-traded companies, that sole practitioners like me just don’t have. Do your homework.

Dealing with Growth Programs

Moral of the story is, as it was for investors, to know who you’re getting into bed with before signing on the dotted line. Any time you give up equity in your company, you’re taking on a business partner. Like any other partner, you want to make sure that they’ll pull their weight, and know what’s involved in getting yourself out of the deal if need be. The excitement of winning a business plan or pitch competition, or beating out hundreds of other applicants for one of a few positions shouldn’t stop you from doing your due diligence. Here’s some questions to know the answers to before you commit:

  • Who owns the incubator or accelerator?
  • How much of your company do they take, and what conditions are attached?
  • Who are their lawyers, accountants, marketers, and preferred investors? Are you free to choose your own, or do you run with theirs? What’s their interest and relationship?
  • What expectations are there of you?
  • What’s the exit plan? Are they building your company to sell, or take public?
  • Do they have your interests at heart, or do their loyalties lie with the person they have a pre-existing relationship with? What’s the advisor’s interest?
  • Who else have they launched? Did they deliver what was promised? Did their goals shift under the influence of the advisor network? Talk to their “graduates” and grill them on their experience.

Conclusion

Angel investors, venture capital, incubators and accelerators are all tools that are available to help you build your business. As with building anything, it’s important to use the right tool for the job. The right deal is a solid foundation from which to launch your company – you’ll get the mentorship, support, and training to bring your idea to market, build lasting business relationships, and make a bunch of money in the progress. The wrong deal can cram your square peg of a business into the round hole of their interests, and drag you down the long, unpleasant road to failure.

Be strategic. Think about what the end-state will be, when all is said and done. If you’re 100% owner now, and an incubator takes 20%, accelerator takes 10%, and venture capital takes 30%, what does that leave you with? Remember, you’ll be the last to get paid. What if the on-paper value can’t be pulled out for a certain number of years? Is 40% of a $10 million company more valuable to you than 80% of a smaller one? Is your product a flash-in-the-pan, or is it something that will still be relevant when you can cash out? Are you comfortable working with, and being beholden to the people you’re doing business with for that amount of time?

There’s no such thing as certainty in business. That’s what makes it simultaneously frustrating and fun. Do your research, and I strongly strongly strongly recommend getting experience, professional help to review, understand, and negotiate the deal before you sign over part of your company. At the very least, legal, accounting, and ideally an impartial business advisor/investment banker with experience in the types of deals you’re looking at.

After all, “All things will be clear and distinct to the man who does not hurry; haste is blind and improvident.”
– Livy, Ad Urbe Condita Libri, 9 BC

Mike Hook
Intrepid Lawyer
http://intrepidlaw.ca
@MikeHookLaw

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Selling Shares through Crowdfunding

One of the most important recent developments in financing for small businesses has been the rise of crowdfunding. Crowdfunding is when a bunch of people make small investments in a company through a crowdfunding portal (such as Kickstarter or Indiegogo), in exchange for some sort of reward, like an amount of the product the company makes. The pooled money is used to grow the business. Unfortunately, selling shares – aka “equity” or stock – through crowdfunding has been, and still is mostly illegal in Ontario.

Most small companies are “private issuers”, and “non-reporting companies” – which means that they can’t sell shares to the general public – including crowdfunding. To sell equity to the general public, the corporation has to jump through a whole bunch of regulatory hoops, and make detailed disclosure documents available to investors. Disclosure typically includes an offering memorandum or prospectus, and audited financial statements – which are time consuming and expensive to prepare. There are strict rules about the type and size of offering, what kinds of disclosure must be prepared for prospective shareholders, and who can participate in the offering. All of that, however, is about to change.

The Ontario Securities Commission (“OSC”), the watchdog that regulates the public trade of shares of companies, has just released its proposed rules for a “Crowdfunding Exemption”. They hope to allow small companies to raise capital through crowdfunding without saddling small businesses with expensive disclosure and reporting requirements. The tough part is how to protect investors, and make sure they get enough information to make an informed decision on whether or not to invest.

The Crowdfunding Exemption tries to strike this balance by requiring some limited disclosure from the issuing companies issuing the shares, placing strict regulations on crowdfunding portals, and limiting how much individual investors can contribute. A few of the highlights:

Requirements of Issuing Companies

  • May only raise $1.5 million through crowdsourcing in a calendar year
  • Must be a Canadian company, with its head office in Canada, and a majority of its directors must be resident Canadians
  • May be a public or private company
  • Must disclose the minimum offering amount, and whether or not there is a maximum
  • Offerings must be completed within 90 days
  • Must meet the minimum offering amount, and have the resources to execute its business plan in order to be successful
  • Equity may only be issued in the form of common shares, non-convertible preferred shares, non-convertible debt securities linked only to fixed or floating interest rates, securities convertible into common shares, units of a limited partnership, and flow-through shares under the Income Tax Act
  • May only advertise through a crowdfunding portal, its own website and social media , or with limited marketing materials.

Investor Protection

  • Maximum of $2,500 per investment, and $10,000 per calendar year, per investor
  • At the time of investment, the company must provide an outline of basic information about the company, the fundraising platform, and one year of financial statements
  • Investors must sign an acknowledgement of risk, confirming investment eligibility, and consenting to the possibility that they may lose the entire investment
  • Investors have a two day “cooling off period” to cancel the investment, in case of buyer’s remorse
  • Issuing company must continuously disclose its cash and annual financial statements, and maintain accurate records of the use of crowdfunded money
  • Four month ban on re-selling the shares of a public company, and an indefinite freeze on resale of shares of non-reporting issuers

Crowdfunding Portals

  • Must be registered with the OSC as a restricted dealer, similar to registering as a securities dealer
  • Must do background checks on issuing companies, and their directors, officers, promoters, and control persons
  • Must understand the general structure, features, and risks of securities offered, review and vet information to ensure compliance with the OSC rules, prevent fraud, and provide investor education materials
  • Can’t provide any investment recommendations or endorsements, solicit purchases or sales of securities on behalf of a client of their platform, or invest in or underwrite any issuing company

The OSC proposed rules are open for comment from investors, issuers, and portals until June 18, 2014. It’s expected that the comments will be considered, the rules tweaked, and the Crowdfunding Exemption will come into force shortly afterwards. The most vocal feedback so far has been that the limits on individual investors are too low, and the startup costs for portals to register are too high, and will make it more expensive for their clients. Regardless of the tweaks, equity crowdfunding will be a revolution in small business financing that will make big money available to companies that never would’ve been able to afford to access it before.

If you’re having trouble sleeping at night, you can find a full version of the OSC’s proposed changes as part of the jauntily titled “Introduction of Proposed Prospectus Exemptions and Proposed Reports of Exempt Distribution in Ontario” – at Appendix D – Pages 131-224. It’ll put you right out, I promise.