In my last post I provided some cautions to investors when they are determining whether to invest in a privately held company. This post discusses the investment relationship from the company’s side.
Summary: Do not agree to sell or trade equity in your company until you have vetted your prospective investors.
Recently I attended a board meeting with the president of a growing Maine company and several of its new board members. Some board members attended via phone conference from other states. One crucial agenda item was evaluating the completed initial angel investment round and determining the company’s immediate capital needs as it moves toward a public securities offering – otherwise known as “taking the company public.” However, the president was exasperated throughout the meeting as he wrestled with this thought: “I gave away 20% of my company to a couple of crooks (or at best, quasi-crooks), and I cannot get rid of them any time soon.”
At the board meeting, one of the company’s new shareholders, a financial consultant from New York City, attended via phone conference to provide insights on raising private capital from investors to carry the company for the next several months. In essence, he was reprising his role from the initial angel investment round. This new shareholder and his business associate, also a new shareholder, had each become involved with the company and facilitated the initial round of financing by introducing their investor contacts to the company. As a result, the company raised approximately $275,000 from investors, and the investors received approximately 6% equity in the company. The successful financing round established the value of the company at approximately $5,000,000. For this service each of the business consultants required a 10% equity stake in the company plus warrants for additional shares if the company went public. The president agreed to this arrangement for three reasons: (1) the company needed funds, (2) the president trusted that these men could help his company, and (3) the president did not consult an attorney to determine whether this service-for-equity arrangement was reasonable or legal.
In retrospect, the president recognized his errors and continued to stew. By signing a vague two-page consulting agreement that was purposely drafted by the consultants to fall within a gray area of federal securities laws, he had granted each of these men a 10% interest in his company, even before they had helped raise capital for the company. He could have ended up with no investor funds and two unfamiliar minority shareholders with large minority stakes in the business. At least he received some funds, but at what cost? At a $5,000,000 company valuation, these consultants received in excess of $1,000,000 in value for helping the company raise $275,000, and if the company went public, the value of their shares could increase significantly. The president failed to conduct due diligence on these new investors before he agreed to their help. After receiving the investor funds, he learned that one of the consultants’ businesses was shut down for fraudulent activities 15 years ago by the New York Attorney General. And now this consultant was an entrenched shareholder. What would the future hold? Uncertainty, at best.
The president did not try to hide his displeasure. He was furious but stuck, and he was frustrated with himself for initially proceeding without adequate legal counsel or due diligence on his prospective investors. He was especially perturbed at those financial consultants who became owners without providing any investment funds to the company or putting much “skin” in the game.