The Adjuvancy Library: Raising Capital

So, your company is growing and you have exceeded your cash flow. Or, you have a new idea and want to capitalize on it- but need money. It’s easy, right? No, it’s actually a process- one that requires planning and knowledge. And, it takes time- three to nine months is actually a reasonable time period to allot- and effort (just like a major product sale- which it is!).

Investments in companies are usually classified by their degree of risk and return. However, some of these stages may be bypassed and some may have very porous borders. The riskiest of the bunch is “Seed Capital”, when the company is just being formed (hence the term seed). Angel investments are typically follow-on, once the concept has been proven or the product prototype is ready. The next stage would come from more established entities, known as venture capitalists. As companies grow (and before they sell stock to the general public), they may need some “bridge” or “mezzanine” financing. Once a decision is made to sell stock to the public, the firm is in an “IPO” (Initial Public Offering) mode. Finally, even public companies may need additional funds, for acquisitions, new products, etc, which are termed “follow-on” offerings.

There are myriad sources of capital- customers, vendors (extended terms), founders savings, family & friends, banks & factors, grants, angels, venture capital, and public offerings. Not every business qualifies to use each of these sources, nor would every business want to deal with the drawbacks of some of these sources.

If customers feel you have the solution to their problem, they will make prepayments or progress payments. They don’t want to run your business; they want you to help them operate theirs. And, you need customers to validate your business plan/proposition.

On the other hand, vendors want to sell their products. If you can help them expand to new markets or provide a new distribution concept, they have been known to offer terms of up to 120 days. Of course, if they feel you are too new, they may also demand COD terms. Negotiations are critical here.

Using your own funds provides you with total control. However, you may be putting your family at risk. In addition, you need to fully comprehend your personal cash needs and payment terms (credit cards are expensive financing; second mortgages can lead to default on the family home). Moreover, most founders lack significant funds with which one can start a venture.

Banks generally capitalize assets, not operations. They generally do not understand technological ventures, either, so if that is your concept, you are further at risk. Finally, banks provide credit when business is good and pull it when business is bad- almost the exact opposite of your needs. There are all sorts of factoring entities: the most common is where you sell a receivable to a factor for a discount (a substantial one). We have had success with factors that provide a revolving line- credit is loaned against a current receivable, reduced when the receivable exceeds 60 days, but the interest rates are typically 5 to 10 points over prime.

The next step is to determine if you are a growth business or a lifestyle business. A lifestyle business is one that is profitable (all businesses must be profitable; otherwise the I.R.S. would consider it a hobby), but not set out to change the world. Examples would be dry cleaning stores, law firms, service stations, engineering firms, dance studios, etc. Now, that does not mean these entities can’t be packaged into a growth vehicle, but they generally are not. And, there is nothing wrong with a lifestyle business; but they are not prime (or even sub-prime) targets for venture capital. If you need funds for a lifestyle business, then you should be relying on the 2F’s (friends and family). . It is also possible to get some angel investment, if there is an exit available (real estate venture are prime candidates).

So, what about growth businesses? Well, they are typically built around a new product (drug, toy, game, etc.), technology (engine, water purification, etc.), or a service delivery (method to deliver packages, portable oil changes, etc.) that will grow to eight or nine figure annual sales ($10 KK- $500KK) in a few years. These offering excite angels and venture capitalists.

We need to now define “Private Placement”. Private Placements are regulated by the Federal Government under the Securities Act of 1933. Regulation D addresses private placements (three different types- 504, 505, and 506). Section 504 covers investments up to $ 1KK; Section 505 covers investments up to $ 5KK, and Section 506 covers offerings for a limited number of stock purchasers among accredited investors. Note that some private placements can be made to companies that are listed on the stock exchange (Public Companies), but we are not addressing those issues here.

Friends and Family (2F’s) know you best in the world. As such, they are most likely to be the ones willing to help you start your new venture. The problem is that your 2F’s may see their investments disappear in a failure or its return diminished as you acquire more capital (where their investment valuation may be crammed down during subsequent financings).

The 2F’s can be considered angel investors, but typically “Angels” are retired industry CEO’s, successful entrepreneurs or other high wealth individuals willing to risk their capital on your idea. These individuals don’t take out listings in the yellow pages. You find them by networking or employing consultants who operate in this arena. An angel (or angel club) varies in skills, connections, and degree with which they will interact with your venture. They are seeking a financial return, as well as a psychic reward, and are usually willing to become involved in your venture. As such, the angel(s) with whom you associate need to form a compatible relationship with you. The amount of funds invested by angels vastly exceeds the amount of funds that venture capitalists (VC) provide and they do so at much earlier stages than do the VC (which is why they are sometimes termed seed capital).

Angel clubs are also known as private investor networks and can either have committed funds or discretionary funds. A committed fund is one where the angels have provided a set amount of capital and the group is (professionally) managed, examining ventures and insuring proper returns. One with discretionary funds serves as a clearinghouse for the angels to hear proposals and to allow each investor to make its own decision to participate in the venture.

Venture capitalists (or VC fund managers) have raised funds from private and public sources and manage these investments to return profits to themselves and their investors. They are typically far more sophisticated than the Angel investors, with considerably more capital funds at their disposal. Knowing that the ventures in which they invest may fail leads them to seek out high returns in short periods. There are rosters of VC’s available and it would be useful to study those lists. Find out who operates in your geographical, technological, and corporate stage environments. You will want to target those VC’s that match your conditions.

There are no hard and fast rules, especially since many proposed ventures are screened out before they are every presented. However, you should recognize that the success rate between presentation and funding is on the order of 1 out of every 8 propositions. All investors are looking for undercapitalized firms in rapidly growing markets. Most are looking to invest in the firms before they have fully acquired their markets; a typical “inflection point” is when the firm has reached about $ 500K in annual revenue. The key consideration is the quality of the management of the venture. The best candidates have high-energy entrepreneurs who are financially and psychologically committed to making their venture a success. The team is well-balanced among the needs of technology, finance, and business acumen. And- they have a well-formulated business plan.

This is not the venue to discuss a business plan. Suffice it to say that you will need to provide information about your concept and its benefits (both the problem and its solution), the market size and opportunity, your management team, the revenue model and financial projections, your competition (and there is always competition), milestones achieved and to be developed, why you need the money, and how the investors will achieve their return. Remember that the initial review focuses on the executive summary and involves maybe five minutes. The plan must therefore be well organized, well written (no typographical or arithmetic errors, etc.), and well developed.

One factor must also be discussed. Many Venture Capital funds receive some of their moneys from pension funds. These entities are precluded by law from investing in an LLC. As such, the corporate structure of your firm may need changing or should be structured differently, if you are considering VC funding. (As a general rule, VC’s prefer “C” corporations, chartered under Delaware law.)

Assuming an investment comes, it can take various forms. The investor rarely wants or accepts common stock, choosing instead to obtain convertible debt or preferred stock. Preferred stock receives dividends (stipends) from the firm; these dividends are paid regardless of the profitability of the venture. Common stock may receive dividends (a portion of the profits of the firm). Convertible debt is debt that must be repaid and provides the rights to the owners of the debt (the investors) to convert to another vehicle- common stock or preferred stock.

The most desirous of exit strategies for the investors is a public offering (IPO) by the firm. At that time, significant funds are acquired and the ownership (part or all) of the investors is acquired. Another potential exit strategy for the investors is the acquisition of the firm by a larger entity. In the event that neither of these two exits develop, the investors would expect a third-party evaluation of the firm to set the valuation with which they may recoup their investment.

While not exactly a full-blown public offering, companies in many states can elect to offer a SCOR offering. This is a self-underwritten offering or a direct public offering (DPO). A Small Company Offering Registration (SCOR) enables corporations and limited liability entities to raise up to $ 1 KK in the twelve months following said registration. The SCOR offering document (termed a U-7) is a fairly simple form becomes the prospectus for soliciting investors. In addition, the “Merit” standards are somewhat more relaxed than those of traditional public offerings and they are exempt from registration under federal securities laws (hence the need to insure compliance with state regulations). In addition, commissioned selling agents or the company officials can actually sell the securities (including over the internet), with no requirement for accredited investors or amount to be sold to any single entity.

If you are considering retaining interests in excess of 40% of the firm, then some of the stock may also need to be purchased or held in escrow for a period of time (tow to four years. In addition, if not sold directly by the firm, the selling agents must be registered as Broker-Dealers with the state of registration. Proceeds of the offerings are held in an impound or escrow account (at an independent bank or similar institution) until the minimum amount stated by the company to achieve the stated objectives is raised. Funds may continue to be raised until the maximum amount registered has been obtained. Unfortunately, these stocks will not freely trade, due to the nature of the offering.

Accredited investor: As defined by the Securities Act of 1933. Among those so defined are individuals have a net worth of $ 1KK or have income of more than $ 200,000 for the last two years, an organization or a trust with assets exceeding $ 5KK.

Adjuvancy: An adjuvancy is an agency that augments and enhances the effects of all the components in a mixture or an agent that increases the ability of a component to stimulate a desirable response.

Angels: High wealth individuals (typically an accredited investor, as defined by the Securities Act of 1933, with a net worth of $ 1KK or more or income exceeding $ 200K) willing to risk their capital on your idea.

Common stock: This is a security interest and ownership in a corporation. Typically, they elect the board or directors and corporate policy. This is on the bottom rung of the priority ladder in a corporation. Should the company be liquidated, one has rights to the assets after the bond holders, preferred shareholders, and some other debt holders have been paid in full..

Lifestyle business: This is a for-profit entity that provides employment and or cash flow to the owner(s). The goal of the firm is to provide income and stability to the owner/operator (typically it is an owner operator). Examples: Professional services, dry cleaning stores, bakeries, music stores, etc.

Preferred stock: This stock class has a stated dividend and is paid before dividends (shares of profits) that are offered to common stockholders. In most instances, these stockholders do not have voting rights.

Seed Capital: This is money used for the initial investment in a new (startup) company. It typically is used for proof-of-concept, market research or initial product development. It is occasionally called early stage capital.

SCOR: Small Company Offering Registration. This format allows firms (corporations and LLC’s) to raise up to $ 1 KK in a 12 month period. It is exempt from Federal Securities regulations; instead it is registered with the state security office.

SBIR: A Small Business Set-Aside (from ten government agencies) that is earmarked for small, for-profit American companies, to develop a new technology, product, or service. The goal of the Small Business Innovation grant is to commercialize said concept.

Copyright © 2016 The Adjuvancy, LLC Last modified: October 27, 2016

Copyright © 2016 The Adjuvancy, LLC
Last modified: October 27, 2016