A successful company is a good problem to have. It is thrilling to be consumed with the development of a product, a brand, a management team, strategic alliances, hiring new employees, and the like. It can be less exciting to meet the often inevitable need for additional business capital. Many business owners initially capitalize their business with their own capital and that obtained from friends and family. The advantages are simplicity, efficiency, and – usually – friendly terms. As a business grows, or if a business is operating at a deficit, personal capital and capital from friends and family may quickly prove inadequate.
As a business owner searches for new capital sources, it is important to understand the nuts and bolts of different finance alternatives, and the legal ramifications that will find their way into documents that will govern an investment relationship. Legal guidance may help identify relative risks presented by various financing alternatives and which alternative may maximize the owner’s stake and control in the business.
A brief overview of several investment vehicles and important terminology is set forth below.
Bootstrapping Capital From the Company
Additional capital can sometimes be bootstrapped from business profits. However, if the amount of internally generated capital is limited or a business is growing at a high velocity or using capital at a high velocity, the owner may soon be looking for additional capital from outside sources.
Debt or Equity
The business owner will decide whether to seek an equity infusion (i.e., sell interests in the business) or debt (there are a range of lenders to consider). The cost of capital and maintaining control and minimizing dilution is frequently a critical consideration.
Debt financing from a bank typically requires security to collateralize the loan. That security is, for example, the assets of the business. Future cash flow is not typically considered preferred security for many mainstream lenders. An advantage of debt financing is that it avoids equity dilution.
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Equity is long-term capital because it doesn’t require fixed repayment like debt, it builds the working capital base of the company, it sits below debt in the capital stack and, from an investor’s perspective, it may reinforce a business’s valuation. Equity, however, requires establishing the company’s value, which for early stage ventures may not be desirable.
“As a business owner searches for new capital sources, it is important to understand the nuts and bolts of different finance alternatives, and the legal ramifications that will find their way into documents that will govern an investment relationship.”
Lock Arms With a Strategic Alliance
Some businesses may consider a joint-venture or similar strategy to obtain growth funding. Often called a strategic alliance, it is important to recognize the motivations of the strategic partner and consider operational issues, intellectual property ownership, future flexibility and exit arrangements. In addition, it is critical that all participants share a common goal for the business and will put in the necessary effort to achieve that goal.
Angel investors are individuals as opposed to institutional money or funds. Angels often invest lesser amounts of money and are often personally involved with the company’s development. Angel investments are made individually and usually range from $50,000 to $1M. The terms of an angel investment may parallel the venture capital (VC) investor but angels do not have the infrastructure of staff and resources of a VC investor.
Venture capital is a term often used to identify investors who are very wealthy (perhaps a family office) or investment funds which specialize in investing in high-risk, up-and-coming companies. The VC investment is typically greater than the angel investment, but also more costly to the company. Investments typically exceed $1M.
VCs know their investment is illiquid as they often must leave their investment in the business for several years. VCs are sophisticated, receive numerous investment proposals in any given month, and tend to be picky about which businesses they fund. It is critical for any business seeking VC funding to not only have its story and records in good order (e.g., corporate governance, control, protection of intellectual property and executive summaries) but also to target the correct VC.
Look to Others With a Private Placement of Securities
Business owners are sometimes urged to consider a private placement of securities to raise capital. All sales of securities must be registered with the SEC under the Securities and Exchange Act of 1933, as amended, unless there is an exemption from registration.
The Impact of the Term Sheet
Investments begin with a term sheet. Term sheets seek to reflect the key elements of the business arrangement. Term sheets are not typically final agreements but, importantly, certain components of a term sheet may be binding. Therefore, it is very beneficial for the company to engage a lawyer during the term sheet drafting process.
Term sheets routinely include the form of investment and amount, valuation, redemption or put rights, future investment participation rights, anti-dilution provisions, aspects of company management, advisory boards, board rights, observer rights, term of the investment, confidentiality, exit strategy and dispute, and breach mechanics. These elements are subject to a final agreement but, at the term sheet stage, the goal is to have a basic shared understanding of numerous legal, business, and tax issues.
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For a successful and enduring fund raise, it is important to think strategically and understand one’s options. The array of structures, terms, and documentation can be complex. By reviewing the benefits and risks of different investment vehicles and structures with a capable legal counsellor, the entrepreneur can put his or herself in the strongest position to obtain funding and thrive.