Three Reasons Your Start-Up Might Not Get VC or Angel Funding

Does this scenario sound familiar? You’ve spent months woodshedding either alone or with partners on an idea that you’re sure will take the marketplace by storm. You finally get it off the ground on a shoestring budget but realize that if your new start-up is going to ultimately succeed, you’re going to need angel or VC funding.

What follows are three things that will almost certainty insure that you will not get the funding you desire. In other words, avoid these mistakes like the plague, and if you have a truly viable idea, you might just nail down the funding you need.

You Don’t Have a Business Plan

Not having a business plan in place is like trying to sail a ship without a rudder. First, a business plan helps you crystallize the overarching goals for your business, and how you intend to reach them. Second, the existence of a business plan will help determine whether your day-to-day activities are run according to a well thought out design, or without one, haphazardly and reactively.

Any prospective lender, whether it be a bank, a venture capital firm, or an angel investor, will want to see a business plan because it will provide (1) confidence that you have been thorough in considering future competitive scenarios and (2) evidence of your company’s ability to meet its debt but still operate effectively. More importantly, a business plan should “sell” your business idea to the prospective investor because it demonstrates:

• what your unique selling proposition is to an investor;
• what your unique value proposition is to potential customers;
• why it is better to invest in your company rather than just leaving money in the bank or finding another investment opportunity.

Books on how to write business plans can be found in bookstores or online, but make sure that your business plan does not use any cookie-cutter templates that are not relevant to your particular industry or situation.

Ownership of Your Company Is Unclear

In the haste to open their doors to the public (whether those doors are brick-and-mortar or virtual), many entrepreneurs grant stock options or equity interests in their companies to early-stage employees or service providers in lieu of cash based on oral agreements, email exchanges, or shoddy written agreements drafted without legal advice. These types of agreements invariably result in disputes about whether an employee or provider’s performance was adequate enough to justify vesting. When disputes like these exist or are likely to occur because of bad deal-making and inadequate documentation, confusion arises about who exactly owns the company and at what percentages.

In the course of due diligence, these problems, if they exist, will almost certainly manifest to investors, who will view them as a big red flag that they might be buying a lawsuit rather than making a clean investment in a new company. The best solution is to be proactive and engage legal counsel early on to assess your companies needs, or to at least retain counsel to try and clean up any messes that may have been made in the early stages of the start-up. This “clean up” may entail (1) identification of any suspect transactions, (2) renegotiation of some agreements if possible, and (3) instituting protocols to be followed in any subsequent equity or option grants.

Ancillary to this point are situations where companies have either not been organized as separate entities from their principles, or sufficient thought was not given to what type of entity was formed around the start-up. Failure to organize your company as a separate entity will almost always be a non-starter for investors. Alternately, some potential investors may shy away from investing in new businesses if they were not formed as a preferred vehicle in a preferred jurisdiction (i.e., C-corporations in Delaware, where corporate law is very pro-business and provides certain advantages to investors). Therefore, detailed legal advice taking into account the start-up’s goals and relevant legal considerations should be obtained before any business formation takes place.

Ownership of Your Company’s IP Is Unclear

The last red flag that will almost certainly scare away potential investors is any indication that your company has not protected any value-laden intellectual property it may possess, which can often be the “family jewels” of a new business. Similarly, if a company relies on outside IP that it does not have a clear right to use, angel or VC investors will view this as another situation of buying a lawsuit rather than making a sound investment.

The classic situation where this problem can arise is when a founder brings a key piece of IP to the table, the start-up fails to secure a written assignment of the founder’s rights to the company, and the parties have a falling out resulting in the founder’s ouster. In this situation, as a recent case demonstrated, the law is clear: nothing short of a written assignment agreement will suffice. Thus, any oral grants will fail, and the founder can hold the company hostage by threatening an infringement action if use of the IP continues and his/her demands are not met.

Another common situation occurs when a company uses a foundational technology as the basis for its product or service, but doesn’t have a valid license to do so, or its use exceeds the scope of an existing open source or other type of license.

The easiest solution to this problem is a blanket approach where all employees, contractors, and even founders sign an IP assignment agreement that has been drafted by counsel. If a founder insists on retaining ownership, then at the very least an appropriate license granting a clear right to use the IP and to allow major corporate transactions (such as mergers or sales of the company) should be executed. If applicable, licenses to foundational technology or content used by the start-up should be reviewed to make sure the right to use is clearly established, and if these licenses don’t exist, counsel should be utilized to draft the necessary agreements.

Conclusion

Avoiding these and other legal mistakes can save your company a lot of headaches down the road, and pave the way for enticing outside investment to propel your start-up to further success.

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