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Start-up and funding issues for entrepreneurs

By John A. Knapp, Esq.

So you have developed an idea for a new product, device, or service—perhaps health care related, perhaps not. Where do you go from here? How do you turn that idea into a business? Where do you go for financing? How do you keep control of your business as others become involved? These and dozens of related questions face entrepreneurs every day. They are particularly daunting issues for entrepreneurial physicians and other health care providers because, typically, the entrepreneurial health care provider attempts to commercialize their ideas while simultaneously working in their practice or other regular job.


Business Plan. The first step in obtaining financing for an enterprise is to develop a business plan. The foremost advantage of a business plan is that putting one together requires the enterprise to focus on and clearly articulate its business strategy, competitive forces, risks and financial projections. The process of writing a business plan often causes significant changes in the goals and strategy of the enterprise. Usually the business plan will go through a number of versions as the business changes in response to the writing.

The most important section of a business plan is the description of the business. It is here that you have the opportunity to tell others what makes the business unique or attractive. The ability to convey a clear vision of what will make the business successful is the dynamic heart of the business plan. A business plan which is strong in this area will be forgiven weaknesses in most other areas.

The second most important section of the business plan is the one with the financial projections. Many entrepreneurs lack the financial skills to put this section together in a professional manner, and the lack of professionalism here can work against the enterprise on many levels. If a prospective investor cannot get a clear financial picture of the enterprise, it will lessen not only the valuation, but also the investor’s confidence in management, which, in turn, will reduce management’s leverage in many areas of negotiations which are part of arriving at an overall investment deal.

Key personnel. It is only a slight oversimplification to say that a start-up business is only as strong as the people who run it. It is important that the founders of a start-up business be able to objectively view their strengths and weaknesses and to be willing and able to recruit skilled people to fill weaknesses. Prospective investors, particularly institutional investors, will likely have a strong preference to bring in senior management, usually, at least, a CFO and CEO, with whom they are comfortable. Often, these people move from one company to another within the investor’s “family” of invested companies. You must decide whether you intend to continue to manage the enterprise and whether you will accept new members of senior management. The answers to these questions will guide not only the choice of investors, but will also dictate the need for employment agreements, incentive compensation arrangements, control provisions in documents such as a shareholders’ agreement, and other important matters.

When negotiating an investment for a start-up enterprise, there will be many issues on the table: the amount of the investment, timing, valuation, liquidation preferences, registration and other investor rights, and control provisions. If job security and compensation are important issues for you, they will often have to be bargained for, perhaps at the expense of other items. It is important to identify priorities before starting such negotiations.

If you have already identified key personnel whom you would like to bring on board, a delicate balancing act may be required. The prospective new hire may enhance management credibility in the eyes of a prospective investor, or may not. The recruitment package may be acceptable, or may not. You may want to fill key spots before prospective investors can dictate others for these positions, but often prospective investors have wide industry contacts and can add credibility to enable the enterprise to recruit a higher caliber person for the position.

Where Do I Go For Financing?

Friends and Family. The traditional source for the earliest rounds of financing for an entrepreneurial venture is friends and family. By their nature, these are the people most inclined to trust the founders and to risk their money on an early stage investment. There are two basic problems, however, with friends and family financing. The first is that, often friends and family do not meet the requirements under the securities laws for “accredited investors” (briefly: net worth of $1,000,000 or more, or annual income in each of the two previous years of $200,000 or more—$300,000 if a spouse’s income is included, with an expectation of the same for the current year) and, consequently, additional securities requirements must be satisfied in connection with such an offering. A more detailed discussion of securities issues is beyond the scope of this article, but such issues should not be ignored at this early stage, as entrepreneurs are wont to do, or significant problems may be faced in future financing rounds. The second basic problem with friends and family financing is that they often do not have the resources to raise a substantial amount of capital, but at the same time, their investment may represent a significant commitment, and risk, to them. It can be burdensome on management to carry the additional pressure of knowing that failure will also result in the loss of investments which those near and dear may not be able to afford to lose.

Angels. Yes Virginia, there may not be a Santa Claus but there really are angels. Angels are wealthy individuals who are willing to provide an early-stage investment in return for a large share of the equity and, often, participation in the management of the enterprise. Angels may bring considerable business, and even specific industry expertise to an enterprise, but they often want a more active role and a greater return than is required by other investors. Be sure to do a thorough due diligence examination of any angel investor, as the nature of an angel investment will closely link the enterprise to the investor.

Venture Capital. There are many varieties of professional investment funds. They are roughly grouped into three categories; early-stage or “seed” funds, middle-stage funds and late-stage funds. The correct stage funds should be targeted, or considerable time and resources may be wasted. Each stage fund will have different investment criteria and objectives, based on the amount of money invested and the level of risk assumed. It is important to understand that venture capital funds themselves have investors, to whom they make fundamental commitments. These commitments usually have to do with what industry sectors the fund will invest in, what stage enterprise, what geographic area, what size investment (both initial and total) will be made, what time frames for liquidity will be targeted, and what control and investor rights provisions will be secured. For example, it is common for a venture capital fund’s limited partnership agreement (most venture capital funds are structured as limited partnerships) to specify that the fund must purchase a certain minimum percentage of an invested enterprise’s equity and that it must receive at least one board seat.

Often a venture capital fund may not make additional investments in a particular industry or geographic sector, even if it thinks highly of a particular enterprise. Similarly, a fund will sometimes make an investment in a particular enterprise because it is the best available investment that meets certain requirements, even if the enterprise has weaknesses which would make it a less favorable investment, if it did not meet these investment requirements.

It cannot be overemphasized that any investor, but particularly a venture capital investor, should be chosen not just on the basis of how much it is willing to invest and at what price—as important as these factors are. Each investor should be chosen on the basis of all the attributes that it can bring to bear on the success of the enterprise. Deep pockets, industry connections, management expertise and patience are all important virtues in a venture capital investor. It is as important for an entrepreneur to do due diligence on potential investors as it is for the investors to do due diligence on the enterprise. References should be checked, two deep, if possible. Make sure to get references from invested enterprises that experienced problems meeting stated objectives. Find out how the investor reacted. Talk to management who left an invested enterprise after the investment. Check investment banking and industry references who know the venture fund. A strong venture capital partner can bring enormous credibility when the time comes to go public or find someone to acquire the enterprise.

The fact that a venture capital fund is familiar with and interested in investing in a particular industry sector has both positive and negative aspects. Industry experience can help guide management, and industry contacts can help with recruitment, sales and contracting. But beware of conflicts of interest! Venture capital funds often have investments in multiple entities within a market sector and even if these entities are not competing when the investments are made, they may come to be competitors as they evolve. Venture investors will sit on the board and have access to all important knowledge about the enterprise’s business. It is virtually impossible to prevent information from moving from one invested enterprise to another, especially if one comes to be viewed as more promising than the other. Forewarned is forearmed.

Strategic Partners. Often the best investor for an enterprise is one that is itself a business in the same industry sector. Synergies can be created that enhance the value of an enterprise beyond what a disinterested investor might pay. Strategic partners often need less effort to educate regarding an investment because they understand the industry and can appreciate the aspects of the enterprise that represent value. There are, however, a number of drawbacks to a strategic investor which should be carefully considered before even soliciting such an investment.

First and foremost is that a strategic partner may itself be a competitor to the enterprise. To the extent that business plans and other confidential information must be disclosed to ascertain whether there is an interest in investing, the enterprise may be taking a considerable risk. Next is that a strategic partner, by its nature, may require a greater degree of involvement in the management of the enterprise than a less interested investor. While this may not be entirely negative—the strategic investor may, after all, have considerable expertise and management resources—it may not suit the interests of the founders. Finally, a strategic investor may place serious limitations on the liquidity options for the enterprise. A strategic investor may require that it be given the opportunity to acquire the enterprise or license key technology, perhaps in accordance with a pre-determined pricing formula. It may restrict a sale or other business arrangements with certain identified entities, and may otherwise dictate business terms which are not in the best interests of the enterprise or its founders.

Do not underestimate the complexity, or importance, of choosing development strategies and investment partners wisely. Decisions made at this early stage in an enterprise will affect the business for its entire existence. Health care professionals who have devoted a lifetime to acquiring a high degree of knowledge and expertise in their profession should appreciate that entrepreneurship requires its own set of knowledge and skills—which are different from those essential to their primary profession. The most successful entrepreneurs are those who recognize their weaknesses as well as their strengths. They stick by their innovative ideas when they are right, and they are not afraid to seek guidance and support when they need it. Good luck!

John A. Knapp, Esq., is a senior member in the Business Law Department of Cozen O’Connor, based in Philadelphia.

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