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Introduction to Early Stage Financing April 16, 2012 Lecture 6 of NCET2 Research Commercialization Introductory Course PowerPoint Presentation
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Introduction to Early Stage Financing April 16, 2012 Lecture 6 of NCET2 Research Commercialization Introductory Course. Pasadena, CA Cambridge, MA Naples, FL (310) 993-9664. 600 Madison Ave # 22 New York, NY 10022

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Introduction to Early Stage FinancingApril 16, 2012Lecture 6 of NCET2 Research Commercialization Introductory Course

Pasadena, CA Cambridge, MA Naples, FL

(310) 993-9664

600 Madison Ave # 22 New York, NY 10022

(212) 355-4390

stephen p rothman esq
Stephen P. Rothman, Esq.

(310) 993-9664




  • Bootstrapping – getting by without investors or grants, usually on a shoestring budget or by generating early revenue
  • SBIR –Small Business Innovation Research awards from Federal agencies
  • Friends and family
  • Super-angel – funding from a single extremely wealthy individual (e.g. > $1 billion); can fund entity alone and may prefer to.
  • Valuation – pre-money; post-money; what do terms mean and how is valuation determined?



  • Angel investors (group) –
  • moderately wealthy individuals (not necessarily in the super-angel category)
  • typical deal might be $200,000 - $800,000 from 5 – 40 individuals
  • there now exist many angel investor groups around the country that meet periodically; investment decisions still usually made by each individual 
  • Venture capital – Funds organized to invest in new ventures
  • Money often raised from pension funds and university endowments
  • Full-time fund managers both raise and then invest the funds
  • First round deals usually $3 million to $10 million; later rounds may be larger
  • Funds often have 10 year life
  • Comparison to angel investors
  • Typical terms 



  • Strategic investor
  • A large company in a field related to the startup
  • Distinguished from angel or VCs, which are referred to as “financial” investors
  • Differences from angel and VC deals as far as non-investment aspects of deal (joint venture, sublicense, supply relationship)
  • Valuation, negotiation process
  • Pros and cons
  • Use of intermediaries
  • Finder and brokers – someone else getting the money for you



  • Securities law constraints (excluding Crowdfunding topic)
  • Brief outline of legal framework of raising business funding
  • Federal Securities Act of 1933
  • Public / private offerings
  • Regulation D
  • Disclosure requirements
  • State securities (“blue sky”) laws
  • Crowdfunding - “Jumpstart Our Business Startups” (JOBS) Act signed April 5, 2012; regarding raising money online.



  • Why?
  • Maintain ownership percentage
  • Maintain control
  • Case in point: Nike was started in 1964 with $1,000; $500 from each of the founders.

Getting by without investors or grants, usually on a shoestring budget or by generating early revenue




  • Suitable cases:
    • low capital outlay requirements – not much plant or equipment (software / Internet company)
    • short time to revenue (not biotech)
    • no time to revenue (ability to sell some initial product immediately that is not your final product)
      • lite version to which features are added later
      • product for small niche that establishes brand that is then broadened (Nike started as only running shoes for elite distance runners; designed shoe but used contract manufacturer to supply; then 5 of 7 top finishers in Olympics were wearing Nike shoes – made name; expanded to tennis; then other shoes; then other clothes; etc.
                • WARNINGS
                  • lite version ok; bad version not ok
                  • don’t sell research tool that will later enable you to discover / produce products; this enables competitors who then may beat you to the punch
      • Consulting services
      • Day job
    • nerves of steel
    • no dependents 




  • Personal savings
  • Mortgage home
  • Credit cards
  • Outsourcing



  • Was covered in more detail the prior lecture in this course, so this will be brief.
  • Phase I. to establish technical merit, feasibility, and commercial potential of proposed R/R&D

Up to $150,000 total costs for 6 months.

  • Phase II. continue R&D efforts initiated in Phase I, based on the results achieved in Phase I and the merit and commercial potential of the project proposed in Phase II.

Up to $1,000,000 total costs for 2 years.





  • U.S. small businesses
    • place of business in U.S.
    • at least 51% owned by U.S. citizens or permanent residents (or subsidiary of company meeting that requirement)
  • Organized for profit
  • Not over 500 employees (including affiliates) [but over 50% of awards in fact go to companies with under 25 people and 33% go to firms with under 10 employees]
  • Principal investigator must have primary employment with the SBC 



  • Pro’s
  • No equity dilution!!!!!!!
  • Will fund very early stage, high-risk projects
  • Can increase valuation for later private financing by establishing proof-of-concept and removing some risk, allowing the entrepreneur to maintain a larger equity stake and more control
  • Con’s
  • Potential for diversion from principal focus to line up with award criteria
  • Limited size
  • Government cost accounting system required
  • Delay between proposal and funding
  • Comments
  • Best as first step with later move to private financing, unless capital needs are extremely low.


Friends and family

  • Pros
  • Generally you maintain complete control (cf. Activate Beverages)
  • Generally you determine the valuation (share of equity given to investors) 
  • Cons
  • If the business fails and you lose all the investors’ money, if they were angels or VCs, you don’t need to see them over Thanksgiving dinner every year for the rest of your life. General risk of mixing personal and business matters (business failure can affect the personal relationship).
  • You have to consider the capacity of the friends and family to lose their investment, keeping in mind that most new ventures fail.
  • Lack of added value in expertise, may come with angel, VC or strategic investor.
  • Lack of committed source of follow-on funding



  • Extremely wealthy individual
  • Different situation from syndicate of multiple moderately wealthy putting in $20,000 each.
  • Simplification, reduced time dealing with shareholders
  • Avoids securities law issues
  • Potential for additional financing as needed
  • Potential for opening doors
  • A lot depends on who the individual is
  • May want control from day one
  • May not want control at all
  • Situation-specific but may get better valuation than with VCs
  • Less likely than VCs to have short-term focus; pro is that you won’t get sold out early if your business takes time to develop; con is that an exit that appeals to you may not to someone super-wealthy
  • May be hard to identify and get their attention


Strategic investor

  • An established commercial enterprise
  • There is always another side of the deal other than the exchange of money for ownership – something else they want:
    • a sub-license to your technology in some field
    • a right to acquire your company
    • to be your supplier or customer


Strategic investor

1. Equity.

  • LargeCo strategic partner may not care too much about the equity value, if they are primarily motivated by something else
  • Opportunity to split up fields of use and get significant funding without giving up significant equity

2. Acquisition.

  • Startup should avoid granting option to buy / right of first refusal; notice in advance of sale, to the extent not prohibited by contract, ok
  • Formula buyout – may not come out right; opportunities to game it
  • Sometimes you will see an option of LargeCo to buy at a price high enough that the founders are ok with it. 


Strategic investor

3. Unsuitable case

  • startup core technology has a single application and that is LargeCo’s field.
  • Better case – startup’s target market is unrelated to LargeCo’s field, but its technology also has application there.


Strategic investor

4. Control

  • If LargeCo is taking equity:
  • Who has control?
  • Conflict of interest situations due to transactions between startup and LargeCo – sales of products; reseller; sublicenses
  • If there is a JVCo, does one party designate a majority of the directors? Or 50/50?
  • Equal representation with an independent third party to avoid deadlock.
  • Mutually agreed budget; annually (agreement to agree)
  • Veto over major events – sale, dissolution, merger, others?
  • Partners have veto rights over many things, or hire JVCo management and get out of the way?


Strategic investor

5. Intellectual Property Issues

  • Who is putting it in?
  • One party will develop as part of the deal
  • Both parties contributing IP to the venture, and they will be integrated
  • One party owns background IP, but JVCo will improve
  • Third party, such as university, owns
  • Who will own / have rights to / the IP?
  • SmallCo, LargeCo, JVCo?
  • Assignment v. license
  • Duration of license
  • Co-ownership (usually considered a bad idea)
  • Divide by field
  • Startup / Largeco / University deal, where university owns key IP – does startup license from university and sublicense to Largeco; or JV entity takes direct license from university;
  • Where does the IP go if the deal fails and is unwound?
  • Where does the IP go if the startup fails? (software source code escrow)


Strategic investor

6. Exclusivity Issues

  • Where LargeCo is customer, startup not allowed to sell to competitors
  • LargeCo, having perhaps paid JVCo or SmallCo for development, or assisted with it, doesn’t want technology used by competitors
  • JVCo or SmallCo doesn’t want to limit its market size
  • Compromises:
    • Can’t sell to limited list of specified competitors; leaves rest of market available.
    • “Head-start” provision - no sales to others for a specific period of time

7. Where strategic partner is a customer, avoid them also being an equity holder.

  • Too much information


Strategic investor

8. Competition and Corporate Opportunities

  • Can LargeCo compete with Startup or JVCo?
  • If not, what is the scope of the non-compete?
  • LargeCo often wants waiver of corporate opportunities doctrine

9. Strategic deals are more complex than straight financial investments

  • Takes a longer time to work out a deal with a large company; from inception to final signing papers can easily take a year; layers of decision makers; person you are dealing with probably needs to sell deal internally; fairly bureaucratic; legal fees higher
  • Heavily lawyered; documents less standardized and often long;


Strategic investor


  • May get better valuation; retain more equity
  • May get expertise / market knowledge.


Use of intermediaries

  • Not very common in startup context
  • Founders should be wary
  • Some investors don’t like cash or equity going out to “finder”
  • Problem with granting exclusivity if intermediary doesn’t produce or you find money from another source
  • Legal issues – requires federal and state broker-dealer registration, which intermediary often does not have.
securities law issues
Securities Law Issues


  • Federal

Reg D private placement safe harbor

      • No general solicitation
      • Rule 504 or Rule 505 or Rule 506 – alternative dollar and purchaser limitations
      • For Rule 505 and 506, if any purchasers are not accredited, must make prepare a substantial disclosure document, with the exact scope depending on offering size
      • File Form D with SEC (simple)
    • California or other state requirements may also apply


Securities Law Issues

Purchaser and Dollar Limits

  • Rule 504: $1 million limit (in a 12-month period); must be registered under a state’s securities laws, or, if state-exempt, then must be only to “accredited investors;” no prescribed disclosures (other than anti-fraud rules)’
  • Rule 505: $5 million limit (in a 12-month period); 35 purchaser limit (not counting accredited investors)
  • Rule 506: no dollar limit; 35 purchaser limit (not counting accredited investors); non-accredited purchasers must have such knowledge and experience in financial and business matters as to be capable of evaluating the merits and risks of the prospective investment
  • Regulation D Detail


Securities Law Issues

  • Accredited Investor Definition
  • A person with a net worth (or joint net worth with spouse) over $1,000,000
  • A person with an income in excess of $200,000 for the last 2 years (or joint income with spouse over $300,000) and a reasonable expectation of reaching the same income level in the current year
  • Most institutional investors, corporations with total assets over $5,000,000, and directors and officers of the company issuing the securities


Securities Law Issues

  • State Securities Laws
  • If offering meets the Federal Rule 506 exemption, the most any state can require is a post-offering notice filing and a fee (National Securities Markets Improvements Act of 1996)
  • Otherwise, look for registration exemption in each state


Securities Law Issues

  • California Private Placement Exemption
  • California Corporation Securities Law §25102(f)
  • Sales to not more than 35 persons (including outside California)
  • All purchasers either have a preexisting personal or business relationship with the company or with its officers or directors, or by reason of their business or financial experience could be reasonably assumed to have the capacity to protect their own interests in connection with the transaction
  • No advertisement
  • File Form 25102(f)


Securities Law Issues

  • Broker – Dealer Registration
  • Transaction exemption not enough
  • Who is selling the securities?
  • Federal and state broker registration requirements
  • Exemption for employees of the issuing company, provided that their compensation is not “commission” based
  • Pitfalls
    • Individual raising funds is a consultant not an employee
    • Compensation is tied to fund-raising
    • Individual has worked as a stock broker



Stephen P. Rothman, Esq.



(310) 993-9664