Are You Ready to Raise Capital? - What Stage of Capitalization is the Company Seeking to Fund?

What Stage of Capitalization is the Company Seeking to Fund?

It is important to understand the stage of company development you are seeking to fund and making sure it is well matched to the type of funding sought and the sources you intend to approach.  Experienced investors have a preference for funding particular stages of a company’s growth recognizing well that company’s in earlier stages of their development many afford higher returns but are accompanied by a much higher degree of risk.   These investors will expect the type of financing sought and the uses planned for the capital to match the stage of the company’s development.

While there may be exceptions the following stages of capital generally match the stage of development of the company:

·     Embryonic capital may be sought for concept research

·     Seed or development capital may be sought for concept and business plan validation

·     Startup capital is generally sought for launch of a new company and initial operations

·     Mezzanine or growth capital is generally sought at multiple levels for expansion of mature and growing companies

Most entrepreneurial ventures find it difficult to obtain debt financing of either a traditional or no-traditional nature.  Having said this, we often encourage our clients to consider the use of convertible debt in very early stages of capital raises as it may be quite difficult to establish a realistic valuation for equity investment at this stage.  Conversion terms for this debt may be established that are tied to a discount or preferences to the valuation established in future financing rounds.  We also often suggest that interest on this convertible debt be capitalized to principal at the company’s option for a reasonable period of time or until the company reaches a certain level of positive cash flow.  This preserves the company’s cash in critical early stages of development and launch.

We also encourage our clients to be sure to consider all financing options including customer revenues and deposits, supplier financing terms, leasing rather than purchase of assets, and asset based financing (factoring) among their plans.  We find that entrepreneurs often overlook these options in developing their financing strategies.

The remainder of this article will deal with the traditional forms equity financing most commonly employed by entrepreneurial ventures.

Investors typically balance two considerations in their investing decisions:

·     Risk – the measurable probability of losing or not gaining value on an investment, and

·     Return – the expected or necessary return on investment (ROI) expected by the investor to compensate for the degree of risk associated with the investment

Most sophisticated equity investors are willing to assume a reasonable degree of risk in return for the higher returns associated with equity investments in early stage companies.

Traditional Sources of Equity Investment

Equity investors are the owners of the company.  A point often overlooked by some entrepreneurs in the way their investors are regarded.  Hearing entrepreneurs continually refer to “my company,” rather than “our company,” or speak disparagingly on the company’s investors distresses me.  Equity investors have bought ownership in the company with their investment, in exchange for the hoped for opportunity to sell that investment as a later time when the company’s value has significantly increased.  It is important to understand the investors’ expectation of a future sale of their ownership at a higher price and address this issue when seeking investors.  While they may be pleased by returns on their investment in the form of dividends, they most often are seeking long-term capital gains and the more favorable tax treatment these receive over dividend income.

The most common rounds or sources of equity investment are as follows and should be approached in this order:

• 1.     Founders
• 2.     Friends and family
• 3.     Suppliers, business vendors, relationship partners, and customers
• 4.     Angel investors and wealthy individuals (accredited or qualified investors)
• 5.     Venture Capital – A and B rounds

Founders:  Unless those closest to the company and responsible for its launch and development have “skin in the game,” it will be very difficult to attract money from any other sources.  We generally advise that Founders be responsible for all embryonic funding.  Typically, they will also be responsible for much of the seed or development capital as well.  It is extremely difficult to find funding for these stages of a company’s development from outside sources.  Additionally, when the later startup stage capital is sought, those potential investors approached will want to know that founders have already placed their own capital at risk.

We often hear from entrepreneurs that they consider their “sweat equity” as their investment.  Sophisticated investors respect the effort of the entrepreneurs they back, but assign little monetary value to it in their decisions.  This is often a harsh reality for many entrepreneurs, but a reality nonetheless.  Sources of founders “bootstrap” capital can include personal savings, self-directed IRAs, home mortgages, credit cards, and small bank loans.

A good general rule of thumb we find helpful is that by the time the entrepreneur commences the search for startup capital, the company should be able to demonstrate that the founders and/or friends and family have already contributed a minimum of 20% of the investment funding sought.  While this may not always be the case, a lower level of funding from those sources closest to the opportunity will significantly decrease the odds of successfully obtaining the startup capital sought.

Friends and Family:  Most entrepreneurs also turn for funding to friends, relatives, business associates, and other non-professional investors and acquaintances who have personal connections to the company’s founders.  These investments, generally made in the early stages of capitalization of the company are made primarily based on the relationships of the investors to the founders.  There is typically a lower level of due diligence preceding the investment than for more sophisticated angel investors.  Therefore, entrepreneurs should be careful to assign realistic valuations or use the previously suggested approach of convertible debt for these investments to avoid later ill feelings caused by unrealistic valuations.  Also, entrepreneur should not be lulled into a sense of complacency by the ease of raising these monies.  Later investors will exercise much greater due diligence and may well negotiate for more favorable terms to contribute their capital.  We often find that entrepreneurs the terms and valuations assigned in the founders or friends and family rounds are unsupportable when seeking investment from sophisticated angels.  This can easily result in either an unsuccessful startup capital raise or dilution or a “down round” for the early investors and consequent ill feelings.  If is for this reason that we always suggest the assistance of a professional and experienced capital advisor in any capital raise, even those amongst founders or friends and family.

Suppliers, Customers and Other Relationship Partners:  Most entrepreneurs totally ignore these important potential sources of financing.  Often larger companies amongst the list of suppliers have internal venture groups established specifically for the purpose of investing in up and coming young companies that could assist in expanding their business.  Such suppliers will understand your business vertical and markets well and can help ensure a steady supply of their products or services on attractive financial terms.

This same concept also applies to other potential relationship partners such as Original Equipment Manufacturers (OEMs) or Private Label partners, Value Added Resellers (VARs), Licensors, and channel distribution partners.

Early customers can also be excellent sources of funding.  They have a special interest in the success of the company, can provide market validation for your value proposition, and are often among the most committed supporters of a young company’s offerings.  Such companies are generally early adopters, always seeking an edge on their competition, and may be great sources of funding.  In return they may expect “favored nation” pricing, input on product or service development, and a close relationship with the company and its offerings.  Strong support and commitment from early customers is also a strong endorsement of the company and its prospects from the viewpoint of professional investors.

Angel investors and Wealthy Individuals:  Angel networks or groups and individual angels defined under securities regulations as accredited investors are high net worth individuals who typically allocate a portion of their investment portfolio to early stage opportunities.  A true angel investor will generally commit from $250,000 to several million dollars of their investable net worth to early stage opportunities in return for the higher potential returns.  Generally these angels will invest in 10 or more such opportunities with individual investments ranging from $25K to $250K.  Individual angels may band together into an Angel Network or Angel Group to pool their investments in early stage companies and take on opportunities of as large as several million dollars.  Angels typically expect an exit opportunity in three to seven years and ROIs ranging from 25% to 100% depending upon the degree of risk and anticipated term of the investment.

Venture Capital - First and Mezzanine Rounds:  Venture Capital and other sources of institutional investment capital are typically available only to companies having reached 3 to 5 million in revenues and now requiring growth capital.  Although there are rare exceptions, usually in the case of entrepreneurs with whom the VC has a prior record of success, VCs do not invest in early stage companies.  Also, it is rare to find a VC or institutional investor making investments of less than several million dollars – although the funds may well be advanced in multiple draws or stages based on performance benchmarks or hurdles.  Often VCs expect that several rounds of financing may be required to reach the agreed growth targets and exit point.

VCs are investing monies from funds they manage.  The VCs obtain those funds through raises from their limited partners who may be wealthy individuals, pension or retirement funds, endowment funds, or other forms of institutional investors.

VC funds have particular investment interests and guidelines for each fund they manage.  It is important when approaching a VC to be certain that the offered investment matches their interests and meets their guidelines.  Generally, these can be found on the VCs website.  Seldom does an investment opportunity “coming in over the transom” receive much serious attention from a VC.  Those most likely to receive serious attention are introduced to the VC from a source with which they have experience.  There are many such introduction sources.  The point for entrepreneurs is that blindly sending business plans to dozens of VCs is unlikely to generate any serious interest in funding your opportunity.

Often times VCs will bring strategic value as well as money to an investment opportunity.  In fact, their strategic may well be much more important than the capital they contribute.  Examples of strategic value may come from potential relationships and other synergy with their other portfolio companies, operational expertise, particular industry knowledge or experience, relationships with the market and potential customers, or other strategic value.

VCs typically seek 7x to 10x returns on their investments in a three to five year period.  This is because their typical experience is that of 10 investments, 3 to 5 will show few if any returns, 2 or 3 will produce moderate returns, and the remainder will deliver the home runs they seek.  Therefore, they need and seek the home runs to reach the levels of return anticipated by their limited partner investors.

Investment Banking Firms:  Another source of funding at the growth stage may be through an investment banking firm who may assist with a securities placement.  Investment banking firms range in size from boutique firms to very large global firms.  It is important to seek a reputable firm, with a successful track record in placements of the size being sought.  Generally, these securities placements will range in size from a low of $7 million to $10 million and up to very large raises.  The securities offering may be a registered or unregistered offering depending upon the size and nature of the raise.

Companies experiencing rapid growth and well into profitability often require significant investment to expand their sales and marketing efforts, enter new markets, launch new products, open new facilities, etc.  Later stage investments can be particularly helpful in financing these types of endeavors that may not lend themselves well to debt financing.  These later stage investors will all be of the institutional or professional investment categories and have the capability to infuse the larger amounts of capital that may be required.

Uses of Capital and Stages of Investment:  Investors will carefully consider the planned uses for capital being sought when making their investment decisions.  Planned uses will vary depending upon the nature of your company’s business and its stage of development.  However, it will be important to investors that the intended uses are well matched to the company’s stage of development.  We frequently speak with entrepreneurs who have ignored or misunderstand this important consideration and have done a poor job of matching the intended uses with the type of capital being sought or the stage of the company’s development.  The following table summarizes our thoughts on this topic.

Overview of Capital Raise Uses of Funds

	Rapid Growth	Steady Growth	Source of Funds
Embryonic	·     Research and development ·     Raise seed round of capital ·     Building prototype and pilot ·     Hiring initial management ·     Market research ·     Legal assistance ·     Writing business plan ·     Raising startup capital	·     Concept research ·     Writing business plan ·     Raising startup capital ·     Confirming market assumptions ·     Legal assistance	Founders
Seed	·     Research and development ·     Building prototype and pilot ·     Hiring initial management ·     Market research ·     Legal assistance ·     Writing business plan ·     Raising startup capital	·     Writing business plan ·     Raising startup capital ·     Confirming market assumptions ·     Legal assistance	Friends and Family
Startup	·     Operating and refining pilot ·     Equipment, facilities, and inventory ·     Sufficient working capital requirements through to positive cash flow plus contingency factors from worst case analysis	·     Launching business ·     Hiring of management and staff ·     Equipment and facilities ·     Inventory ·     Sufficient working capital requirements through to positive cash flow plus contingency factors from worst case analysis	Angel Investors
Mezzanine or Growth Capital	·     Additional capacity to support growth and scale business ·     Marketing and sales ·     Additional working capital ·     Facilities, equipment, and inventory to support growth	·     Working Capital ·     Facilities, equipment, and inventory to support growth	Venture Capital or Private Securities Placement

Understanding the company’s intended growth path and timing allows for development of a capital plan matching the company’s capitalization plans with appropriate stages of growth and uses of funds.  Capital raises should not be undertaken before building achieving appropriate stages of growth and maturity so as to optimize valuation at the time of each raise.  It is also important not to raise less capital than may be required to deal with unexpected developments.  Running short of capital prior to reaching performance targets and stages of the company’s growth will likely impair the company’s ability to successfully raise additional capital on favorable terms.