Tuesday, November 11, 2008

Startup Empire: Notes on the Side

Preparing for Startup Empire this week? It's important to come away from these things not only with an informed view of what your investors want, but with a view to the potential pitfalls of those requirements. You'll save yourself a lot of time if you develop your own view of what terms are acceptable risks for you to take with an investor, and what terms need some adjustment. Take, for example, term sheets, and preferred shares versus debentures. As you listen to the presentation on this, I want you to keep in mind a few things:

1. In the current environment, everything is relative. The investment you get in may be the only source of ready cash you see for the next two years. As a captive investee, you therefore need to carefully consider how the balanced control provisions your investors request are.

2. A convertible debenture financing now perhaps a more dangerous instrument than before, since it can place significant control in the hands of the lender. Debt holders have rights that shareholders don't - they can call their loan and request their money back. This means that a debenture holder can shut you down if you don't have the cash to pay them and they want out.

3. In Canada, most VCs (and some angels) will insist that a debenture be secured. This allows the investor to take certain actions upon non-payment of the loan. This means that if there is a default, the investor may take possession of and sell the your business' assets and apply the proceeds to the repay the debt.

4. A VC will tell you it would be irrational for them to actually do this, as the return would be pennies, and that's logical in most cases. HOWEVER, there are several scenarios when an investor may decide it wants any remaining cash back from the business.

5. One way to mitigate these risks is to pay very close detail to the "boilerplate" language in the security agreement you're asked to sign. Make sure the events of default are narrowly tailored - they should NOT include insolvency or other standard items that make it easy for the debenture holder to trigger repayment. This is the same conversation you have with any investor, but in a different language (the language of debt) - make sure you have it.

6. Related, but different point: increasing numbers of US resident angels and friends and family are joining rounds of investment here. There are a few implications to keep in mind:

- US residents are typically taxed on conversion of debentures to shares if part of the amount converted is interest. Interest-bearing debentures need to be altered to debentures plus warrants (one example) to provide the same risk of return.

- even if your US investor wishes inerest, usury laws in some states (including California) limit the amount of interest that can be charged on a debenture to rates well below norms up here (depending on size of debenture and size of investor)

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