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Chapter 1
Capital-Formation
Strategies and Trends
After more than three decades of being an entrepreneur, serving as a legal and
strategic advisor to entrepreneurs and growing companies, and speaking and
writing on entrepreneurial fi nance, I have found one recurring theme running
through all these businesses: Capital is the lifeblood of a growing business.
In an environment in which cash is king, no entrepreneur I have ever met
or worked with seems to have enough of it. The irony is that the creativity
that entrepreneurs typically show when they are starting and building their
businesses seems to fall apart when it comes to the business planning and
capital-formation process. Most entrepreneurs start their search for capital
without really understanding the process and, to paraphrase the old country
song, waste a lot of time and resources “lookin’ for love [money] in all the
wrong places.”
Not only is capital the lifeblood of a growing business, but it is also the
lifeblood of our economy. When its fl ow stalls, our progress stalls. And when
small and entrepreneurial companies cannot gain access to capital at affordable
costs, we all suffer. According to recent Small Business Administration
(SBA) statistics, smaller companies make up 99.7 percent of all employer fi rms,
pay 44 percent of total U.S. payroll, and have generated 64 percent of net
new jobs over the past 15 years. When small companies do not have the access
to the resources they need in order to grow, our nation cannot grow. If
entrepreneurial leaders are too concerned with what new crisis, burdensome
regulation, budget defi cit, tax hike, or economic downturn may await them to
make any new hiring, growth, or capital investment decisions, we are destined
to be in a perpetual recession. Healthy credit and equity markets are vital to
our country’s ability to foster and commercialize innovation, penetrate new
markets, seize new opportunities, create new jobs, offer raises and promotions,
and compete on a global basis. The economic downturn of 2007 to 2009 put a
dent in everyone’s pocketbook, but for smaller and entrepreneurial companies,
it robbed them of the critical fuel that they needed to keep the engines of the
economy moving forward. Payrolls were slashed, creativity was halted, inventories
were reduced, capital investment decisions were delayed, and motivation
in the workforce was virtually nonexistent.
I wrote Raising Capital to help entrepreneurs and their advisors navigate
the often murky waters of entrepreneurial fi nance and explore all of the traditional
and nontraditional sources of capital that may be available to a growing
business. I’m assuming that you, the reader, are the entrepreneur—the owner
of a business that’s looking for new money. So, wherever possible, I’ll address
you directly, as if you were a client sitting across the desk from me. My goal
is to provide you with pragmatic guidance based on years of experience and a
view from the trenches so that you’ll end up with a thorough understanding
of how and where companies at various growth stages are successfully raising
capital. This will include traditional sources of capital, such as “angels” and
private placements; the narrower options of venture capital and initial public
offerings; and the more aggressive and newer alternatives such as joint ventures,
vendor fi nancing, and raising capital via the Internet. The more likely
the option, as demonstrated by the Capital-Formation “Reality Check” Strategic
Pyramid in Figure 1-1, the more time I’ll devote to it. Look at the fi gure as an
outline—it’ll make more sense as you read further.
Figure 1-1. The Capital-Formation “Reality Check” Strategic Pyramid.
1. Your own money and other resources (credit cards, home equity loans,
savings, 401(k) loans, and so on). This is a necessary precursor for most
venture investors. (Why should we give you money if you’re not taking a
risk?)
2. The money and other resources of your family, friends, key employees,
and other such people. This is based on trust and relationships.
3. Small Business Administration loans, microloans, or general small-business
commercial lending. This is very common, but it requires collateral (something
that is tough to provide in intangible-driven businesses).
4. Angels (wealthy families, cashed-out entrepreneurs, and other such people).
These can be found by networking or by computer. You need to
separate smaller angels from superangels. This is a rapidly growing sector
of the venture-investment market.
5. Bands of angels that are already assembled. These include syndicates,
investor groups, private investor networks, pledge funds, and so on. Find
out what’s out there in your region and get busy networking.
6. Private placement memoranda (PPM) under Regulation D. This involves
groups of angels that you assemble. You need to understand federal and/
or state securities laws, have a good hit list, and know the needs of your
targeted group.
7. Larger-scale commercial loans. To get these, you’ll need a track record, a
good loan proposal, a banking relationship, and some collateral.
8. Informal venture capital (VC). This includes strategic alliances, Fortune
1000 corporate venture capital, global investors, and so on. These investors
are synergy-driven; they are more patient and more strategic. Make
sure you get what was promised.
9. Early-stage venture capital or seed capital funds. These make up a small
portion (less than 15 percent) of all VC funds. It is a very competitive, very
focused niche—the investors are typically more patient and have less aggressive
return on investment (ROI) needs.
10. Institutional venture capital market. This is usually second- or third-round
money. You’ll need a track record or to be in a very hot industry. These
investors see hundreds of deals and make only a handful each year.
11. Big-time venture capital. Large-scale institutional VC deals (fourth- or
fi fth-round level—for a pre-IPO or merger and acquisition deal).
12. Initial public offerings (IPOs). The grand prize of capital formation.
Understanding the Natural Tension Between Investor and
Entrepreneur
Virtually all capital-formation strategies (or, simply put, ways of raising money)
revolve around balancing four critical factors: risk, reward, control, and capital.
You and your sources of venture funds will each have your own ideas as to
how these factors should be weighted and balanced, as shown in Figure 1-2.
Once a meeting of the minds takes place on these key elements, you’ll be able
to do the deal.
Risk. The venture investors want to mitigate their risk, which you can do
with a strong management team, a well-written business plan, and the
leadership to execute the plan.
Reward. Each type of venture investor may want a different reward. Your
objective is to preserve your right to a signifi cant share of the growth in
your company’s value and any subsequent proceeds from the sale or public
offering of your business.
Figure 1-2. Balancing Competing Interests in a Financial Transaction.
THE DEAL
(Meeting of the
minds/compromise)
ENTREPRENEUR WANTS/NEEDS
Maximum capital/valuation
Avoid dilution/control
Affordable cost of capital
COMMON OBJECTIVES
Growth in the value of the business
Additional rounds of $ at more
favorable valuations
Mutually beneficial exit strategy
INVESTOR WANTS/NEEDS
Maximum return
Mitigate risk/downside protection
Input on future and growth of the
business/control
Control. It’s often said that the art of venture investing is “structuring the
deal to have 20 percent of the equity with 80 percent of the control.” But
control is an elusive goal that’s often overemphasized by entrepreneurs.
Venture investors have many tools to help them exercise control and mitigate
risk, depending on their philosophy and their lawyers’ creativity. Only
you can dictate which levels and types of controls may be acceptable. Remember
that higher-risk deals are likely to come with higher degrees of
control.
Capital. Negotiations with venture investors often focus on how much
capital will be provided, when it will be provided, what types of securities
will be purchased and at what valuation, what special rights will attach to
the securities, and what mandatory returns will be built into the securities.
You need to think about how much capital you really need, when you really
need it, and whether there are any alternative ways of obtaining these
resources.
Another way to look at how these four components must be balanced is to
consider the natural tension between investors and entrepreneurs in arriving at
a mutually acceptable deal structure.
Virtually all equity and convertible-debt deals, regardless of the source of
capital or stage of the company’s growth, require a balancing of this risk/reward/
control/capital matrix. The better prepared you are by fully understanding this
process and determining how to balance these four factors, the more likely it is
that you will strike a balance that meets your needs and objectives.
Throughout this book, I’ll discuss the key characteristics that all investors
look for before they commit their capital. Regardless of the state of the economy
or what industries may be in or out of favor at any given time, there are certain
key components of a company that must be in place and be demonstrated to
the prospective source of capital in a clear and concise manner.
These components (discussed in later chapters) include a focused and
realistic business plan (which is based on a viable, defensible business and
revenue model); a strong and balanced management team that has an impressive
individual and group track record; wide and deep targeted markets that
are rich with customers who want and need (and can afford) the company’s
products and services; and some sustainable competitive advantage that can be
supported by real barriers to entry, particularly barriers that are created by proprietary
products or brands owned exclusively by the company. Finally, there
should be some sizzle to go with the steak; this may include excited and loyal
customers and employees, favorable media coverage, nervous competitors who
are genuinely concerned that you may be changing the industry, and a clearly
defi ned exit strategy that allows your investors to be rewarded within a reasonable
period of time for taking the risks of investment.
