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Your Most Effective Capital-Raising Approach

“Your Most Effective Capital-Raising Approach”

Like just about any business operation, there is a process or general procedure associated with seeking private investment in your firm. This article helps the seeker of funds establish a reasonable timeline for planning on funding, attracting potential investors, meeting investor scrutiny, and carrying out negotiations.


You have the next best idea to meet your customer’s needs, or you want to expand your business to capture market share. You have charged all you can to your personal credit cards, borrowed from your family and friends, and your banker says "no" or "not yet." It is now time for you to enter the brave new world of private sector funding.

Raising funds in the private sector requires discipline, and a thorough knowledge of the rules of the game and the process. You should already know the first rule of raising money: The "Golden Rule" — he or she who has the "gold" makes the rules. The second rule is: new money funds only new or expanding opportunities. New money does not solve old problems. With these ideas in mind, here are some thoughts on the best approach to raising money efficiently and effectively.

PROJECT TIME LINE

There are no 30-day quick fixes from legitimate funding sources in the private placement market. This is due to the time required to prepare necessary documentation, market and attract potential investors, conduct due diligence, negotiate, and close the deal with the investors. The normal time for completion of a private placement is approximately four months, assuming no complications or delays. Complications can arise from such sources as management control issues, legal, government regulatory, accounting, and operations.

The four-month project time line is divided in this manner:

  • preparation of a business plan — 30-45 days
  • preparation of a Private Placement Memorandum — 15-30 days
  • attracting potential investors — 30 days
  • due diligence, final negotiations, and closing — 30 days

There is quite a bit of overlap in preparing the business plan and the Private Placement Memorandum ("PPM"). A licensed securities attorney takes the business plan (in its final or near-final form) and incorporates many components into the PPM.

BUSINESS PLAN

Many management consultants advise their clients to write a financially oriented business plan. I disagree. Have you ever seen a business plan with a poor financial forecast? Do you think your potential investors read many business plans? What do you think is their "tolerance" limit for unusually high returns-on-investment?

Focus on what the investor is buying. The investor "buys" only one thing, and it is not the proposed 100+% IRR! The investor "buys" management. Investors buy exactly what management has to offer. Investors "buy" your expression of your vision, market analysis, marketing plan, and sense of the competition for your firm.

A business plan’s five most important parts are the vision, market analysis, marketing plan, sense of competition, and management’s directly applicable experience. Did you notice the absence of financial numbers? You have to have them, and your venture should produce a 35-40% pre-tax IRR over a five to seven year term to attract an investor. However, the numbers are only the products of your vision, market analysis, marketing plan, and competitive sense. It is a mistake to misplace your priorities while you write this most important document for your business.

I’ve never spoken with an investor that believes that there is only one true format to follow. However, every investor I have ever spoken to about business plans has told me that management’s vision, market analysis, marketing plan, sense of competition, and managerial experience makes the difference in their investment decision. Do not substitute form over substance. Investors don’t care whether the document is all text or is eight-color on glossy paper. While charts are good and break up the text, keep in mind that charts are only tools for you to make your point. Use the business plan to make your point.

THE "DEAL"

For all transactions, other than borrowing money from your friends, family, or banker, your company will need a PPM. Your firm will be selling a "security." A "security" is a piece of paper that is evidence of marketable debt or ownership in your company. The "deal" is the structure (terms and conditions) of the security, or investment opportunity, you are planning to offer to your potential investors. The standard types of securities are traditional debt (similar to an IOU), traditional common stock, and convertible debt or preferred stock.

Keep in mind the general requirement to offer 35-40% pre-tax IRR to your investors. Many venture capital transactions include "convertible debt" or "convertible preferred stock." For your investor, a convertible security provides some near-term cash yield (the interest or dividend payment), and allows the investor to participate in the upside through conversion of that security into your company’s common stock. For your benefit, use of a convertible security usually means you will suffer less dilution than if you had insisted on a common stock offering. There is one very important legal distinction between convertible debt and convertible preferred stock to remember: The interest payments are legally binding obligations of your company, whereas the dividend payments on the convertible preferred stock become legally binding only as and when declared.

How much dilution should you expect? Unfortunately, there is no formula. The critical determinants for dilution are the marketing and technology position of the company, management’s expertise, product and service performance, the amount of money you seek, and general market conditions. I can offer some very general guidelines, as each transaction is different. If your firm is new with little or no track record (a more consistent venture capital situation), a good rule-of-thumb will be for 80-90% of the equity to pass to your new investors. If your company is doing well and the management team has a documented successful track record, you might suffer dilution of only 20-35%. Use of convertible securities will result in less dilution than by offering traditional common stock (due to the near-term cash yield). As you can see, the range is wide. Transactions routinely occur at both ends of this spectrum and at all points within the range.

To be competitive with deals currently being offered in the private sector, you must offer your investors the opportunity to obtain a 35-40% pre-tax IRR. This financial result should be generated over a five to seven year term. You should also keep three possible exit strategies in mind for your investor. The three standard exit strategies are an initial public offering, a sale of the company to an industry competitor, or for your company to repurchase the investor’s shares at the later time.

You are competing for your potential investor’s attention and money. Deal structures can be either as simple or as complex as the situation requires. I have found that complex deals tend not to be understood and, as a result, poorly or not at all funded.

PRIVATE PLACEMENT MEMORANDA

The PPM essentially accomplishes the four vital tasks of describing the "deal," providing full (and sometimes very revealing) risk factor disclosure, complying with relevant state and federal securities laws, and includes key portions of your business plan.

Risk factor disclosures point out the possible disadvantages of investing in your fi
rm. Risk factors assume the worst, telling the reader why the company may fail, and why the investor may lose all of their money. Risk disclosures fall into the six general categories of government, industry dynamics, technology assessment, economics of the market, management, and tax and legal issues affecting the particular investment.

While this message is not a substitute for legal advice, you need to be aware now that the only way you can legally sell securities in the private placement market is with an exemption from SEC registration. There are federal and state laws that affect securities transactions. If an offering of securities occurs outside your home state (i.e., interstate), then Federal securities laws must be coordinated with all States where investors are solicited. This is "Blue Sky" registration. Regulation D and Rules 504, 505, 506, and Regulation A govern interstate offerings. If all of the offering is done intrastate, then that particular state’s securities laws must be strictly complied with by you and your firm.

From a fund raising process viewpoint, do not leave this part of the project without first meeting with a securities attorney and fully revealing and discussing your plans. It is much better to be safe now, than to be a defendant in securities litigation with a disgruntled investor who is claiming securities fraud.

ATTRACTING POTENTIAL INVESTORS

The active process of attracting potential investors should take about 30 days. How do you identify potential investors? You have to decide if you are going to seek the investors yourself, or hire a broker or a finder to help you. If you do it yourself, you save money in contingent success fees; however, you will also divert time away from running your business.

I suggest compiling a list (called "Plan A") of prospects using the several major categories of suppliers, customers, friends and family, professional resources (lawyers, accountant, banker), and competitors. The three types of prospects that merit special attention are suppliers, customers, and competitors. Suppliers and customers have the most vested interest in your continuing success. They are naturals to be on your list.

However, the last thing you normally want to do is to reveal your proprietary market analysis, marketing plan, and competitive strategies to your competition. They always seem to have a vested interest in obliterating you, not helping you. When you get to the competitor listing, try to figure out exactly what your firm has to offer (hopefully distinct market and technology access, distribution channels, etc.) to a specific competitor.

You say Plan A won’t work for you. OK, on to Plan B. For a negotiated fee, these brokers or finders will either directly sell (brokers) your securities or arrange introductions (finders) so that you may sell your firm’s securities. The charges should be strictly contingency-based. You should pay a fee only upon closing the transaction.

DUE DILIGENCE

Due diligence is the process by which your potential investor(s) starts to ask you the specific questions about your company. Your answers will determine if you are successful in closing them and raising the money.

The investor and his or her representatives will have already read the PPM. They are now seeking reasons why they should not do the deal with you. They are willing to assume the risks as mentioned in the PPM. Investors also want to assure themselves that you have not hidden any other risks. It is imperative that you completely answer every question your potential investor may ask.

This is so much more than a "beauty contest." This is the best time to check "investor-management chemistry." There definitely are "right" and "wrong" answers. It is your job to convince the potential investor(s) that you are the right leader for this venture, and that your vision for the market, market analysis, marketing plan, and competitive sense is correct. The broker or finder can’t really help you much here. You can, however, rely on your management team and your Board of Directors in responding to questions. At the end, however, the investors will be looking at you through a magnifying glass. How do you think you should look to them?

NEGOTIATIONS

You wrote (or had written for you) an excellent business plan. The PPM is outstanding. The deal makes great financial and operating sense. It is a good deal. You have located the investor(s). They are nearing completion of the due diligence process. Now, they want to renegotiate. Is this standard?

I wish I could say that no deal ever changes after the PPM is complete. I have found that the deal frequently is revised at this stage. Once the investor has completed due diligence, they seem ready to negotiate. You thought the terms and conditions in the PPM were final. To most investors, the PPM’s description of the deal is only the starting point for negotiations.

Fortunately, the terms usually don’t vary much from the PPM to the final deal. The reason for the lack of great variability is that you will have had so many experts looking at the work product. It should already be a marketable deal. The upside potential and downside risks should already be quantified. There should not be any major surprises. Be aware, however, there can be exceptions.

Typical changes that occur during this final negotiating stage are interest rate or dividend payment amounts, conversion privileges, presence or absence of any escalator clauses for conversion, and Board of Director representation. The investor knows you need the money. You know you need the money. Can you negotiate terms that are fair to all parties? Remember the "Golden Rule?" It will probably be the underlying reason for some suggested revised deal term sometime during the negotiations. Be prepared for it.

CLOSING

I don’t have to tell you how to close. You know how to fill out a deposit slip and deposit the check in the company’s bank account. As you rush to deposit the investors’ check, don’t forget those subscription documents, acknowledgment forms, stock designation certificates, Board of Director consents, legal opinions, accounting certificates stating no material changes, and other similar documents. To be sloppy here is very shortsighted. You must do this right the first time. Playing catch-up only costs too much money and really shows lack of diligence on your part.

EXPECTED COSTS

The total offering and organization costs in private placements should be about 10-14% of the total amount sought. Some costs are deferred until closing (most notably the contingent broker or finder fee). Other costs are paid before closing and raising even the first dollar.

In most cases, costs associated with the writing of the Business Plan (if you employ an independent writer) and the preparation of the accountants reports are paid before closing. A deferred payment schedule is usually negotiated. Accountants are not allowed to accept a contingency fee. They can, however, accept deferred payment.

A good portion of the legal fees (usually 50-67%) can be negotiated to be placed on a contingency. The balance of the fees must be paid during the offering process. Obviously, if you have other existing arrangements with a securities attorney, you can probably include their fees in your existing arrangement. The partial contingency arrangement applies to new arrangements. Other cost categories will include travel, document reproduction, transaction profile sheet preparation, shipping and courier charges, telephone, and postage.

A FINAL COMMENT

This process is daunting, and not for the timid. You are your company’s best spokesperson. All your efforts need to be committed and applied to the process of raising money. Seek the advice of professionals whom you know and trust. They can be of great assistance to you. You do not have to tread this path alone. Don’t go in with your eyes closed to possible warning signals, or closed to new opportunities. Now that you are starting your adventure: Happy
hunting!


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