VC funding not the only way to get needed money

By Jennifer A. Post

You have an idea that seems to be selling, but you need more working capital to improve product performance and position your company in the market. You¹ve tapped out your "angel" investors. Where should you now look for capital - venture capitalists or corporate partners? Should you team up with a player in the industry or continue to grow on your own terms? There seems to be money out there, but who should you take it from, and in what form?

In deciding what source of financing to use to grow your company, there are a number of key considerations which should be examined. Chief among them is a determination of what, in addition to the cash, you want to obtain for your company. Is it management expertise, research support, market credibility, commitments for future investments or some other value that cash alone does not provide? Traditional venture investments, strategic alliances and corporate venture financing bring different pros and cons to the table, and you will need to determine which fits your company's needs.

Traditional venture capital investments. Traditional venture capital investments generally support the goals set by management by providing capital, management expertise and ongoing involvement in the key financial and strategic decisions of the company. Venture capitalists tend to be active participants on the board of directors, both to promote the company's success and protect their investments.

Venture capitalists can move quickly to negotiate deals and provide cash to the company. They can also be a source for critical bridge financing in the future to carry the company to completion of major events. Perhaps most importantly, venture capitalists tend to evaluate investments in terms of ideas, people and technology making them supportive of management and tolerant of appropriate risks. In short, they bring expertise and experience to startup enterprises in industries where they have navigated success in the past.

That experience, however, does come with a price. Investment valuations can be disappointing and leave entrepreneurs with diluted equity positions. The terms of the investment may be weighted in favor of the investors with exit and return strategies, such as redemption rights, dividend rights and payment preferences, which can be burdensome on management in times of critical decision making and make new sources of funding difficult to obtain. In addition, venture financing usually involves the creation of restrictions on undertaking significant corporate transactions, requiring the consent of the investors or, conversely, providing for their veto, even over the recommendation of the founders.

Strategic partnering. As an alternative to venture capital financing, entrepreneurs might want to consider whether their company would benefit from partnering with an established industry player who can provide capital resources coupled with intellectual property, dedicated research staffing and operations support. Partnering arrangements can mean shortened time to market, enhanced credibility and a built-in marketing base, supplier, distributor or ultimate acquirer. Such alliances may suffer, however, from a clash of corporate cultures, frustration in penetrating the larger enterprise's bureaucracy, and the inherent difficulties of a development team attempting to serve two masters.

A strategic partnering arrangement must be carefully considered from the viewpoint of the entrepreneurial enterprise, since the power to control the alliance is often economically derived. Exploration between the parties of such matters as who will retain intellectual property rights and products developed from the venture, how revenues and holdings will be divided, how the venture will be financed and who controls the ultimate disposition of the venture are matters which may, from the outset, determine whether the two companies are compatible partners.

While strategic alliances offer some benefits that venture financings can not provide, companies should expect that a significant degree of independence will be sacrificed from the outset. On the other hand, strategic partnering may provide the immediacy of credibility and the intellectual and financial capital required to meet a limited window of opportunity.

Corporate venture financing. Finally, a word about venture financing from the investment or capital side of high tech companies. Corporate venture investments tend to resemble traditional venture capital investments, but with some notable exceptions. For example, corporate venture investments may include the right on the part of the financing source to buy the entrepreneurial enterprise or its key intellectual property upon the occurrence of certain events.

This right could be viewed as a mechanism for outsourcing research and development, acquiring talent, or creating a presence in a market or industry populated by emerging companies. This is especially the case in Internet commerce, where well-established companies are scrambling for ways to get onto the Web. Accordingly, corporate investor goals may not only diverge from company goals, they may from time to time be in conflict.  

Corporate venture financing may also carry with it some of the risks that strategic alliances do, such as differing corporate cultures and a slow financing process, as compared to traditional venture financing.

Corporate venture groups are, however, able to provide practical advice and expertise from an "insider's" point of view. Finally, corporate financing sources may use investment teams that have, or can easily access, a better technical understanding of the product under consideration since the team can draw on the knowledge of product engineers from inside their own organization. Technical proficiency can be critical to an investment evaluation if the product under consideration contains technology which is advanced, new or complex. In such cases, if there is a shared excitement about the technology, you can expect continued faith in your company's performance goals, despite periodic setbacks.   

While careful drafting and negotiation of financing or partnering documents should identify and address significant issues up front and eliminate surprises down the line, close consideration of your company's needs is necessary to determine who you should talk to about financing and why. The pros and cons of venture financing and strategic partnering should be considered in light of your company's current stage of development, capital needs, market strategy and industry position, and whether your investor's strategy aligns with your vision of your company's future.

Jennifer Post is an associate attorney with the Boston law firm of Peabody & Arnold. She concentrates in emerging growth companies.

Reprinted with permission. All rights reserved. Mass High Tech 1999

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