Will a past bankruptcy matter in an IPO?

January 2008

"Seven years ago, I was a partner in a startup that went bankrupt. I'm now the CFO of a company that's likely to go public in a few years. Will my past role in a bankrupt company be a problem during an IPO? If so, should I start looking for a new job?"

Mike: A lot depends on how the bankruptcy was handled. If there was an orderly dissolution of the business and the assets (if any) were fairly distributed to creditors, you'll probably get respect for doing a good job in a tough situation. However, be careful if the bankruptcy was messy--lawsuits, shareholder fights, accusations of fraud, and the like. Even if the disputes weren't your fault, the investment bankers handling the IPO may be nervous about any association with past problems. It's unfair, but prospective investors want absolute confidence in the CFO's competence and integrity when a company goes public.

Your best bet is to have a heart-to-heart talk with the investment bankers when you get closer to the IPO process. They'll tell you up front if they're concerned about your history.

Is it okay to raise money with a temporary COO?

November 2007

"I'm in discussions with a venture group that's offered to buy a third of the company and eventually help us do a merger deal. The one point that troubles me is that the VCs reserve the right to appoint the investment banking firm that will handle the company sale. I'm not sure how this could hurt us (hidden kickbacks? giveaway employment contracts? personal guarantees?), but it makes me uncomfortable. Should I go ahead anyway?"

Mike: It's a reasonable condition. Venture firms generally have years of experience working with investment bankers, and they tend to have a good feel for who will do the best job. In fact, they may start talking to a couple of firms six months before you officially put the company up for sale. The VCs don't want those discussions derailed at the last minute to give someone's brother-in-law a shot at the deal.

As for hidden payoffs--I suppose it's theoretically possible, but I don't see how it would be done. Closing documents are incredibly detailed about every aspect of the transaction. Every check is itemized, every employment contract, every future obligation on both sides. If you have competent legal counsel to review the documents, you're more than safe.

Who picks the investment banker?

July 2007

"I'm in discussions with a venture group that's offered to buy a third of the company and eventually help us do a merger deal. The one point that troubles me is that the VCs reserve the right to appoint the investment banking firm that will handle the company sale. I'm not sure how this could hurt us (hidden kickbacks? giveaway employment contracts? personal guarantees?), but it makes me uncomfortable. Should I go ahead anyway?"

Mike: It's a reasonable condition. Venture firms generally have years of experience working with investment bankers, and they tend to have a good feel for who will do the best job. In fact, they may start talking to a couple of firms six months before you officially put the company up for sale. The VCs don't want those discussions derailed at the last minute to give someone's brother-in-law a shot at the deal.

As for hidden payoffs--I suppose it's theoretically possible, but I don't see how it would be done. Closing documents are incredibly detailed about every aspect of the transaction. Every check is itemized, every employment contract, every future obligation on both sides. If you have competent legal counsel to review the documents, you're more than safe.

Can a majority shareholder dilute everyone else?

May 2007

"I've been promised a one-third ownership in a sweat equity startup, which will vest after the first year. I expect to be diluted a little if we raise money, and that's okay because I'll still have shares that have a solid market price. But how do I prevent the current owner and his wife from issuing a million shares of *free* stock to themselves, which would essentially wipe out my position.?"

Mike: Legally, you have some basic protection because a corporation may not “discriminate” among shareholders. For instance, the majority shareholders could vote to have the company issue a pile of shares as compensation for services provided, but they would also have to give shares to all common shareholders who provided the services, and the shares would have to reflect a reasonable valuation. Similarly, the corporation could pay a dividend (again, in cash or stock), but the dividend would have to be distributed to all shareholders according to their relative share ownership.

To remove any ambiguity, you should probably insist on what's called an "anti-dilution" clause in your contract. Whenever new shares are issued, this type of clause gives minority shareholders the right to purchase a proportional percentage of the issue (in your case, 33%) at the same price as other investors. As a result, it becomes pointless for the majority shareholders to issue a lot of underpriced shares.

Bear in mind, however, that venture capital investors often insist that original shareholders waive any anti-dilution rights as a condition of providing new funding. So if your company is not in a strong negotiating position when you begin to raise money, you can expect to give up more than a "little" of your ownership percentage

Will new investors give me some cash?

March 2007

"My partners and I are thinking about bringing in a few investors to fund a new product. However, we don't want all the money to go into the company--we want to take a chunk out for ourselves personally. Is this okay?"

Mike: There's no legal or accounting problem with your plan, and I know founders who have negotiated a cut of invested funds. But as a general rule investors want every penny to go toward future growth and development. They definitely don't want to hear the notorious 'great sucking sound' (the sound of new capital going out of the company) right after the company deposits their checks.

Moreover, you're not doing yourself any favors by cashing in any equity at this stage. Presumably, you're only selling enough stock to fund your company's future needs. If you divert some of your new capital to personal needs, you'll either end up undercapitalized--or you'll have to sell more shares and dilute your present equity position. Unless you're desperate for cash, this is not a smart strategy.

How many VCs should we pitch

September 2006

"After dancing around with a local investors group for six months, we just
got shot down for a really stupid reason. My partners say that next time we
should hold discussions with at least a dozen VCs at the same time, so we
don't get caught like this. Is that considered legitimate?"

Mike: Venture firms don't look kindly on people who carry on multiple
negotiations, and they'll almost certainly find out. Good firms will spend
four to eight weeks on due diligence (calls to customers and prospects,
discussions with technical experts, developing an exit scenario) and
document preparation. They won't make this investment if they feel you may
dump them for a higher bidder.

Of course, it's okay to talk to several firms simply to assess their
interest in the deal. The delicate question is how to decide when these
discussions get serious enough for you to stop talking to other VCs. It
sounds like your first group wasn't ever convinced you were an investable
prospect, or else they were distracted by with internal issues (for
instance, partner turnover or raising new funds). If you sense a lack of
enthusiasm on their part, look elsewhere.

But you may not have wasted the six months you spent "dancing around" with
your first VC firm. Why not ask them for a referral to a few other funds
that might be a better fit? After all, they already know a lot about you
and might be happy to do a little matchmaking. The venture community is
pretty small and favors tend to be remembered.

Should we warn new investors about bad news?

July 2006

"We're about to close a venture financing deal that we really need. We told the investors we had four big deals in the pipeline for this quarter, but now I'm not sure any of them will close on time. I'm worried that the investors will either back out or change the terms if I tell them, and I feel equally nervous about letting the investors talk to my customers.What's the worst that can happen if I just hope for the best?"

Mike: Never, ever withhold negative information from your future partners. I saw a company recently that hid a big year-end dip in sales from investors. By the end of the next quarter, the CEO had been replaced. Remember that most investors aren't stupid. If they know that you're in a delicate situation with a prospective customer, they'll be careful in their due diligence--after all, they'll suffer too if a big deal falls through.

They also recognize--or they should recognize--that it's tough to forecast closing dates exactly. If your investors are really so inexperienced that they demand perfect forecasts, maybe you should find smarter investors.

Is it risky to work with a delisted public company?

July 2006

"We signed a large, two-year contract with a public company and just found out that it is about to be delisted by NASDAQ. The customer says this is not a big deal. Are they being straight with us?"

Mike: Maybe. Companies are delisted if their market capitalization or equity fails to meet certain minimum standards. Either of these situations could occur without affecting the company's ability to pay its bills or honor long-term contracts. The easiest way to find out what's going on is to look at the latest Form 8Ks that the company has filed with the SEC (www.sec.gov). These reports describe significant financing and operating events at public companies. You may find some red-flag issues in the 8Ks that are a legitimate reason for concern--for instance, the company has changed auditors, or restated its financial statements, or missed a filing deadline, or even declared bankruptcy. Most of these are symptoms of serious financial problems, and they often trigger defaults on borrowing agreements that can make the situation even worse.