In today’s challenging times it is a strong possibility that companies/investors may be faced with a cram-down financing round. Depending on how well or not well this is handled can have a big bearing on the future success of the company and the investor’s potential for return. So what does this mean?

Here is how a typical scenario would go:

• An early stage company is seeking funding to get their company to the next stage (i.e. get their initial prototype to market, achieve cash flow break even, expand to the US, etc).
• They do pitches to investors and close out an investment round.
• Everybody is happy and optimistic of future success.
• According to management’s ‘conservative’ projections the funding will allow them to execute their plan to reach a milestone (say cash flow break even) in 8 months.
• 7 months later, the investment group is told things have gone slower than expected and the company needs to raise more money to meet their original milestone.
• The investors, having not been engaged, decline to put more money in.
• The company finds another set of investors that is willing to put money in, but only under their terms.

Such terms can include:

Lower valuation – the new investors’ shares are priced cheaper than the previous round shares. This means the new investors will get a larger stake in the company based on the amount they put in compared to the previous investors. Previous shareholders have a smaller percentage of ownership and their holdings are worth less than when they closed their financing round.

Board seats – the new investors may require the current board to be dissolved and re-constituted with a composition that allows them to control the board.

Management – the new investors may require the current CEO to step down and be replaced with a CEO of their choice.

Liquidation preference – the new investor’s shares will receive liquidation preference. In other words, on sale or wind-up of the company, the new investor’s shares are paid out first (could be 1x, 2x, etc) then the remaining proceeds are pro-rata split (i.e. if things go south, the new investors will ensure they get their money out).

So you ask, what about the previous round’s term sheet that you collectively spent hours negotiating and thousands on legal bills? There could have been very well thought out anti-dilution and control mechanisms. However, the new investors will simply state their investment is depending on prior shareholders forfeiting their rights in the old term sheet. The existing shareholders can either refuse to sign and most likely the company will run out of money and go bankrupt or accept the conditions of the new investors.

At best case, the company closes the deal and lives on. However, the investors are not happy since their investment is not on favourable terms and the management, if they have not been replaced, are under control of the new investors.

The way to be more proactive is to:

a) Ensure there is a good investor management program in place where investors are kept apprised of the successes and failures of the company.

b) With an engaged investor base, start the ground work early to plan for potential future financing rounds. Ensure investors are kept up to date with the realistic future funding requirements the company is facing and get a feeling for current investors’ appetite for participating.

c) Leverage investor’s networks to tap into co-investment initiatives between angel groups.

Bryan Watson, executive director of the National Angel Capital Organization sums it up nicely:

“At the recent National Angel Summit the panel called Co-Investment – Taking It To The Next Level discussed this topic. This is a real concern for many Angel investors they often represent some of the first outside money invested into a company.

The panelists noted that operational failure is understandable in an investment. That is, even though best efforts were put in, the company failed because of the market, team, technology, etc. What is unacceptable, the panel noted, is financial failure where Angels are crammed down because they didn’t reserve enough capital to participate in future rounds.

Through co-investment, Angels are able to syndicate with more investors and, while still raising significantly sized rounds, ensure they retain enough capital in reserve to ensure that when the next round of funding comes along they have the capital to participate and avoid being crammed down.”

craig at mapleleafangels.com

Maple Leaf Angels and the RIC Centre are excited to announce a new partnership initiative.

Maple Leaf Angels is Ontario’s largest and most active angel investor groups having invested close to $6m in financings since its launch in 2007. Maple Leaf Angel’s membership base is largely in the core of Toronto and the partnership with the RIC Centre allows Maple Leaf Angels to establish a chapter to serve the western part of the GTA.

“In order to ensure that we have a large pool of investors who are looking to make deals, we were looking for a way to effectively tap into the Mississauga/Burlington/Oakville areas” says Rob Koturbash, managing director of Maple Leaf Angels. “The RIC Centre is an ideal partner as it allows Maple Leaf Angels to integrate with the start-up ecosystem they have fostered through their early-stage company mentoring and advisory services”.

The RIC Centre is based in Mississauga and is one of the Ontario government’s 12 regional innovation networks. The RIC Centre offers advisory, mentoring, networking, and industry outreach programs to help companies commercialize ideas in the aerospace, advanced manufacturing, life sciences, and emerging technology fields. RIC is currently active with more than 60 companies.

“We are excited to team up with the Maple Leaf Angels” says Pam Banks, Commercialization Director of the RIC Centre. “We feel this partnership offers an excellent opportunity for some of our promising clients, who are looking for funding, to have access to Maple Leaf Angels. We are also looking forward to being able to leverage the experience and networks of angels that want to get actively involved with helping and supporting their investee companies”.

The first Maple Leaf Angels – West chapter meeting will be held on November 19th and is open to all current or potential angel investors. The meetings will be held at the RIC Centre and will provide a convenient location for angel investors in the western GTA to access Maple Leaf Angels’ deal flow and leverage the due diligence expertise of the existing 40+ members to help evaluate deals. Maple Leaf Angels has provided its members access to early round investments in some of Canada’s leading start-up companies such as Well.ca, Homestars, Regen Energy and Streamlogics (acquired by Thomson Reuters).

craig at mapleleafangels.com