By: Peter C. Sullivan
Appropriate working capital is the oxygen of emerging and mid-sized companies; whether it comes from a traditional lending institution, from a wealthy friend or relative, from a network of angels, or from investors who find value in its products or services. Entrepreneurs and management should consider this post as an overview of critical components for raising capital.
Benjamin Franklin said, “[i]f you fail to plan, you are planning to fail.” Raising capital requires a great deal of planning. Companies need to detail all aspects of its operations, from its mission purpose, vision for future growth, product or service offerings to target audiences, production and distribution plans, and governance related structure and procedures. Today, investors are more sophisticated, and the number companies seeking capital is greater than ever; investors want detailed business plans to understand both a company’s visions and its intended use of investment proceeds.
Once the business plan is complete, Companies can begin to determine the capital raise requirements. Capital needs serve an array of purposes; initial capital is used to launch a new business venture and to position a company for its next level of growth. Determining capital needs requires business acumen and a realistic snap shot of a company’s needs. Assume projects will cost more and take longer to accomplish, therefore, build in contingencies to account for anticipated hiccups. Investors understand that early stage businesses run on shoestring budgets; they also understand just as many fail –if not more – than succeed. So, if your projections realistically show a need for a $1M round of funding, don’t merely seek $500K, seek the full amount.
Initially, you may not need to hire a professional valuation company; but, you will need to determine the potential value of your company in the market. Valuation prior to capital infusion and post-infusion is beneficial to management and investors alike. Determining valuation is helpful in determining how much equity you will need to give up to realize the capital infusion required. For example, if you need to raise $750K, and your business is worth $5.5M, you can expect to give up around 13.6% of the company. If the company’s valuation is lower, and the raise remains the same, a larger equity stake in the company should be expected. Often times an owner’s valuation and an investor’s (or valuation firm’s) valuation are drastically different; it is because of this disparity that professional valuation firms are critical to appropriately value a business and offer equity.
Debt versus Equity?
Get comfortable with letting go of a certain amount of equity in your company. Big picture thinkers understand that the inclusion of equity financing and healthy debt financing make your company an attractive value proposition. Investors appreciate a “business mindset” from founders/owners; this healthy approach will pay dividends during growth.
Debt is any form of a loan with intent to repay the lending party. In a traditional debt transaction, meaning debentures or promissory notes, the investor receives return of principal loaned plus an interest rate paid over the life cycle of the debt contract. In a convertible debt transaction, the investor possess an option to either receive repayment of principal and interest, or, convert the debt obligation into an equity security of the company.
Equity transactions should always be documented. If your company issues shares, have appropriate agreements (subscription, shareholders, warrants, options, etc.) in place and uniformly use them. Treat your company as if it was as big as Google or Twitter, and keep good records and make sure each of your equity documents comport with other governing documents (Bylaws, Operating Agreement, Limited Partnership Agreement, etc.).
Capital funding comes from a wide range of sources, from founders, friends, and family members who provide the initial seed capital to launch a new business venture. Traditional lending institution extension of credit or SBA financing, private placement offerings or brokerage firms, or even contacts with a company and its officers and directors can be other sources of seed capital. Your target audience and pool of investors with directly correlate with the capital raise, industry participation, and the problem the product or service solves.
Securities Law Compliance
Generally speaking, if you take money from someone else to use in your business, you have engaged in a securities transaction which is governed by both federal and state securities law. Good news is that emerging and mid-market companies can utilize certain exemptions to comply with both sets of regulations. However, all securities transactions, even exempt transactions, are subject to anti-fraud provisions of the federal securities law. This means that the company and its management will be responsible for false or misleading statements that the company or others on its behalf make regarding the issuer, the securities offered, or the offering itself, whether conveyed orally or in writing. Companies should always prepare for the time when the initial seed capital is exhausted. A company’s lawyer can assist and advise founders/owners with the private placement process including traditional private placement offerings, Rule 144 offerings and Regulation S offerings. Additionally, special attention should be given to the Jumpstart Our Business Startups (JOBS) Act of 2012, which legalized the offer and sale of small business securities by issuers via crowdfunding, and, Fixing America’s Surface Transportation Act (FAST Act), which created new exemptions from registration for resales of restricted securities and amends certain regulations to facilitate capital-raising by emerging growth companies.