Five Things You Should Know About Raising Capital for Your Business



To successfully raise capital, you must be prepared to do so, recognize the sources of capital, be aware of the costs of the funds, be in compliance with securities laws, and have a back end strategy. 

Be Prepared:

One thing investors want to make sure of is that they are going to get their investment back with a return on their investment.  They way that is going to be generated is through business operations.   Accordingly, they want some certainty that you, yourself, as the business owner, have thought through the business, have thought through its operations and activities, to the point that you can produce a business plan.  Another thing to include in your business plan is a marketing plan with a projection and a plan of what you THINK the future will bring.  Every investor realizes that a projection is just that.  It’s an assumption, it’s a possibility of what could happen.  The fact that you have projections means you have thought through what is reasonable for your business and what is reasonable for investors to expect in return for their share.

The best time to raise capital for your business is when you don’t need it, not when you are worrying about debt.  Having a track record is extremely important.  It may be easier to raise capital at the front end when there is a big promise of a business, or sometimes when you have a good track record established.

Sources of Capital:

There are several sources of capital.  One source of capital we call angel investors.  These are individuals who want to have an investment in the business, either because they like the kind of business you are in or they want to promote the type of activity the business is involved in.   These are generally people who are named individuals who many people know. The second type of investor or source of capital are out of state or out of market competitors.  If you are running a business where you have out of state competitors who want to get into the state but don’t know how to break in, sometimes you can create a strategic alliance which allows for a capital investment in your business.  This is a cheap entry into the business and they can leverage your expertise.  Another kind of investor is Venture Capital investor, sometimes called a mezzanine investor.  A venture capitalist is looking for a company that looks like it will go public soon; it’s past the startup phase.  Some people refer to them as vulture capitalists, because there are times when these types of investors swoop in and take the best part of the company.  There is a final group called heroic investors, which are generally comprised of family and friends. A family or a friend should be treated as any other investor.  They still need the same type of protections as any other investor would need, so you need to treat them as true investors.

Cost of Capital:

Something to also think about is the cost of capital.  There are many ways to compute the amount of capital in return for the amount of money, which can be more of an art than a science. Many entrepreneurs over-value their business.  One of the things you should be aware of when raising capital for your business is capital return is always going to be more expensive than borrowing, so if you can, go to a bank and borrow money.  An investor is at greater risk in the capital, because the debts get paid before the return on investments.  Another thing to be aware of is who is putting the money in.  Different types of investors require and demand different types of returns.  For instance, an angel investor is probably someone who is an economic investor who is saying they would like a reasonable amount of rate of return and wants to look forward to some kind of back end profit.  A venture capitalist is looking for a big score when the company goes public.  There is no money more expensive than family money.  It’s expensive, in part, because of the emotional cost that this money has.  If you borrow capital from a multi-millionaire, they want a return on their investment.  You know where they stand.  If you get are loaned money from a relative, that person may want to know why you are going out to eat, why are you driving that type of car, why are you vacationing so long, what are the hours of the store, etc. and they are going to be more emotional.  Most of our clients find that when they are raising capital, and where it comes from, may not be as important as the fact that it is available because of the business needs and its operations.

There is another cost in addition to an economic cost.  That’s a managerial cost.  Some clients think they can raise money for the business and continue to run it just as they were running it before.  That is not normally the case.  What generally happens, is the investor will want to have a say in how things are run with the business.  They will want information annually, if not quarterly.  They will especially want financial, operational and background data.  The investors want communication.  Investors who are receiving a return in their investment usually need a lot less information when things are working well.  When things aren’t going so well, suddenly, everyone wants to know what’s going on with everything.  If people make a large investment, relative to their portfolio, they want a lot more information than somebody who doesn’t have a substantial proportional risk.

Investors commonly want to be a part of a Board of Directors or a Manager.  It is extremely important to have by-laws and operating agreements to define the rights.  Some issues may be resolved and decided by a majority vote and other issues may require unanimous consent.  How votes are counted is extremely important.  Normally, each manager/director has an equal vote.  Sometimes, voting is based on capital account (investment) or the number of shares or units.  There may be times when a deadlock occurs.

 

Securities Laws:

There are security laws to keep in mind.  The shares or units of your company will probably be considered a “security” like stocks on the New York Stock Exchange.  Your company would be considered the “issuer”.  If or when it comes to selling part of your business, you may or not have to register.  There are both state and federal securities laws which require issuers fo securities to make extensive disclosures to buyers who will not be actively involved in investigating the issuer’s company and industry prior to investing.  These disclosures are in writing, are designed to protect buyers from dishonest sellers, and MAY have to be filed with governmental agencies.  They are fundamentally designed to protect investors from unscrupulous issuers of securities.  They are also designed so that if the deal is memorialized in some type of writing.

There are exceptions to the need for filing full disclosure documents.  There is a small offering exemption, inter-state offerings, private placements, and “good deal” exemptions.  Generally, you will need either a prospectus or private placement memorandum or some type of circular offering for larger offerings (not for friends who may want to invest).  Whether or not you are going to do one of these securities registrations, you need to provide written documentation of what your business and marketing plan is, financial statements and a FULL DISCUSSION OF POTENTIAL RISKS Of LOSS OF INVESTMENT. Make sure you put EVERYTHING in writing.

Back End Strategy:

One type of back end is where you have a buy/sell agreement which specifies how and in what circumstances an investor can or must sell back their investment.  When certain events occur, the company may buy out the investor, the company may go public, or there is some other kind of planned back-end.  These buy/sell agreements are extremely important because otherwise, there is no way for a company to get rid of an investor (i.e. for the entrepreneur who started the business) and to really gain control of the business again.  A buy/sell agreement may be either mandatory (must buy/must sell) or permissive.  In either one, you should establish a pricing formula and terms of payment.  If you fail to plan, you plan to fail. When you begin to plan on raising capital, you should look at what you think the end result will be and how it’s going to play out.

Raising capital is more of a process than an event.  It’s something that takes many steps.  You’ve got to be ready, you have to recognize the sources of capital, be aware of who’s providing the capital, look at the legal constructs around it, and finally, you have to have a back end plan.

When your business is ready to raise capital, contact Kreamer Law Firm, P.C. at 515-727-0900 or via e-mail at info@kreamerlaw.com for experienced legal assistance.

 

 

 

 

 

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