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From the Publisher
“…a definitive guide for entrepreneurs and growing companies that need to raise capital.” -- Fort Worth Star-Telegram
Gone are the days when venture capital groups poured millions into every “next big thing.” Competition is fierce, and only the most viable businesses—and expert fundraising—will reap the capital necessary to drive continuous growth.
Packed with tools for building business plans, preparing loan proposals, drafting offering materials, and more, Raising Capital covers every phase of the growth cycle and helps readers navigate the murky waters of capital formation. Containing checklists, charts, and sample forms, the third edition provides insights on the latest trends in the domestic and global capital markets, an overview of recent developments in federal and state securities laws, and strategies for borrowing money from commercial banks in today’s credit-tightened markets.
Whether one’s business is a fledgling start-up, a rapid growth company, or a more established organization, this insider’s guide offers readers the strategies they need to take their business to the next level.
“…a definitive guide for entrepreneurs and growing companies that need to raise capital.” -- Fort Worth Star-Telegram
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
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
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
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
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.
(Meeting of the
Affordable cost of capital
Growth in the value of the business
Additional rounds of $ at more
Mutually beneficial exit strategy
Mitigate risk/downside protection
Input on future and growth of the
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
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
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.
Chapter 1: Capital Formation Strategies and Trends
Understanding the Natural Tension Between
Investor and Entrepreneur 4
Understanding the Private Equity Markets 6
Understanding the Different Types of Investors 6
Understanding the Different Sources of Capital 8
Common Mistakes Entrepreneurs Make in the
Search for Capital 12
How Much Money Do You Really Need? 13
Consider Staged Investment 13
Capital-Formation Strategies 14
The Due Diligence Process 16
Key Best Practices Affecting Capital Formation
in the New Millennium 19
Are You Really, Really Ready to Raise Capital? 21
Chapter 2: Selecting the Best Legal Structure for Growth
Limited Liability Company 33
Evaluating Your Selected Legal Structure 36
Establishing Effective Boards of Directors and
Advisory Boards 42
Chapter 3: The Role Your Business Plan Plays
The Mechanics of Preparing a Business Plan 52
Some Final Thoughts on Business Planning 63
Chapter 4: Start-Up Financing
Financing the Business with Your Own Resources 70
Heaven on Earth—Finding an Angel Investor 72
Other Sources of Seed and Early-Stage Capital 85
Additional Resources 99
Chapter 5: The Art and Science of Bootstrapping
Twelve Proven Bootstrapping Techniques and
Bootstrapping: The Dark Side 112
Chapter 6: Private Placements
Federal Securities Laws Applicable to Private
State Securities Laws Applicable to Private
Preparing the Private Placement Memorandum 120
Subscription Materials 124
Compliance Issues 125
Accepting Subscriptions 126
Changing or Updating the PPM Before
Completion of the Offering 126
After the Closing 127
The Rise of Secondary-Market Private
Placements and the Story of SecondMarket 127
Practical Tips for Ensuring a Successful PPM
Chapter 7: Commercial Lending
The Basics of Commercial Lending 134
Preparing for Debt Financing 136
Understanding the Legal Documents 146
Periodic Assessment of Banking Relationships 148
Chapter 8: Leasing, Factoring, and Government Programs
SBA Programs 164
Chapter 9: Venture Capital
Venture Capital Investing Trends 178
Primary Types of Venture Capitalists 180
Preparing to Meet with Venture Capitalists 182
Central Components of the Venture Capitalist’s
Investment Decision 189
Due Diligence Is a Two-Way Street 192
Balancing Your Needs and the Venture
Capitalist’s Wants 193
Understanding the Venture Capitalist’s Decision
Chapter 10: Anatomy of a Venture Capital Transaction
Evolution of Venture Capital Deal Terms 198
Negotiating and Structuring the Deal 198
Aligning Business-Plan Analysis and Investor
Concerns with Term Sheet Provisions 201
Understanding the Legal Documents 203
Getting Ready for the Next Round 207
2002 and 2003: The “Down-Round” Dilemma 207
The Pre- and Post-2010 Market: The Big Chill
and the Slow Thaw 209
Chapter 11: Preparing for an Initial Public Offering
Recent History 212
The Present and Future 212
Advantages and Disadvantages of an IPO 215
The Hidden Legal Costs 220
Preparing for the Underwriter’s Due Diligence 222
Selecting an Underwriter 226
Selecting an Exchange 231
Alternatives to Using a Traditional IPO 236
Chapter 12: The Mechanics of an Initial Public Offering
An Overview of the Registration Process 242
The Registration Statement 248
The Road Show 256
The Waiting Period 257
Valuation and Pricing 258
The Closing and Beyond 259
Ongoing Reporting and Disclosure Requirements 259
Resources on IPOs and the Public Securities
Chapter 13: Franchising, Joint Ventures, Co-Branding and
Business-Format Franchising 270
Joint Ventures 281
Chapter 14: Mergers and Acquisitions
Current Trends Affecting Mergers and Acquisitions
in a Turbulent Environment 301
Develop an Acquisition Plan 303
Analyzing Target Companies 307
Selecting the Target Company 308
Conducting Due Diligence 310
Valuation, Pricing, and Sources of Acquisition
Financing the Acquisition 314
Structuring the Deal 315
Preparing the Defi nitive Legal Documents 317
Postclosing Matters 320
Chapter 15 Capital-Formation and Business Growth Resources
Federal Agencies 332
Business Growth Resources on the Web 334
Internet Resources to Learn More About Private
Placements, Angel Investors, Venture Capital
Networks, Accelerator Programs, and Other
Alternative Sources of Funding 337
International Finance Institutions on the Web 340
Guidebooks, Publications, and Networks
(Including Computer Software) 341
High-Tech Exporting Assistance 342
Raising Capital At Any Stage of a company's growth is challenging and requires creativity and tenacity, but these hurdles are especially difficult to conquer at the earliest stages of an enterprise's development. In this chapter, we'll take a look at where and how to raise capital at the seed level - when you're first organizing your business, or when it is at its earliest stages of growth.
In the chapters that follow, we'll look at funding strategies that are commonly used after a business gets past the start-up phase and establishes a steady flow of customers and a reliable revenue stream, even if the company is not yet profitable. These include: alternatives for raising capital at the early stages; private placements (a more organized and expanded method of angel financing for moderate- growth companies); commercial debt financing (once the business has assets in place to serve as collateral for the loan); and ways to acquire resources that you would otherwise purchase if you had raised capital. Later in the book, we'll explore growth -financing strategies such as seeking institutional venture capital (for rapidly growing companies that offer exceptional potential returns on investment) or raising capital by taking your company public with an initial public offering (IPO). Then we'll offer some creative alternatives to traditional financing as ways to grow your business. The main thing to understand is that no one plan fits all: The strategies available- and useful- for a particular company depend mainly on its stage of development and the nature of its business. What works for a start-up retailer may not work for a ten-year-old manufacturer, and neither of those strategies may work for an early-stage technology or life sciences business!
At the seed level, you are looking for capital to acquire the initial resources that you need to launch the enterprise, attract and hire employees, conduct research and development, acquire computer systems, and build initial inventory. (These expenditures are commonly referred to as the allocation of proceeds.) The sources and uses of capital are described in the business plan as discussed in Chapter 3.
I'm devoting the rest of this chapter to the likely sources of seed and early-stage capital described in Figure 4-1. Although this time in your business is characterized by frustration, struggles, setbacks, and delays, there are many sources of cost-effective seed capital available if you are creative and aggressive in your search and still maintain control and majority ownership of the business.
Financing the Business with Your Own Resources
The combination of your own financial investment and time investment ("sweat equity") is a prerequisite to obtaining capital from third-party sources. The capital markets expect you to put your own funds at risk before asking others to risk investing in your business. This is often called the "straight-face test" because you are able to look a venture investor in the eye and demonstrate your own commitment and belief in the potential of the new enterprise. If you have cofounders, all of you are expected to make this type of commitment. This is true even if the level of personal investment varies due to differences in the partners' financial circumstances or the degree to which a particular individual contributes a particular skill, recipe, knowledge, or relationship - the intangible, nonfinancial aspect of contribution.
Your initial capital may come from savings, 401(k) plan loans (where permitted) or withdrawals, home-equity loans, credit cards, or other sources as set forth below. Of course, this also violates the OPM (Other People's Money) rule: Wherever possible, use other people's money to invest in a risk enterprise. But in the world of new-venture financing, the OPM rule usually goes out the window unless you're a veteran entrepreneur with an established track record and can demand that others risk their capital without investing your own funds in the enterprise.
So where do some of America's most successful entrepreneurs raise seed and early-stage capital? Each year Inc. magazine selects the 500 fastest-growing companies and conducts various surveys of the companies selected, including their capital formation strategies.
According to the 2003 Inc. 500 survey, seed capital came from:
Personal Savings 78.5% Bank Loans 14.3% Family 12.9% Employees / Partners 12.4% Friends 9.0% Venture Capita 16.3% Mortgaged Property 4.0% Government Guaranteed Loans 0.1% Other 3.4%
Note: Percentages do not equal 100% because many companies use multiple sources.
If I Don't Have a Rich Uncle, Where Can I Get the Initial Seed Capital?
Traditionally, entrepreneurs have used their own savings and credit (credit cards, home-equity lines of credit, and so on) to finance the prelaunch expenses and initial seed investment for their companies. If you don't have liquidity in your personal or retirement savings, you may be able to borrow against your 401(k) account, pension, or life insurance policies.
Only you can dictate what portion of your life savings you're willing to risk, and prudence should dictate some level of conservatism, which may vary depending on your immediate cash needs as well as your short- to medium-term goals and needs. An indi-vidual with limited savings and two children nearing college age should be very careful with his or her savings and may want to reconsider whether this is the right time to launch a business venture at all. Conversely, a young couple with toddlers and one working spouse may decide that this is a perfect time to use their savings to launch a business. They know that they have a steady source of income from the working spouse and plenty of time to replenish their savings if the business venture is unsuccessful.
Family, Friends, and Fools
After exhausting that portion of your life savings and available credit lines to finance the start of your business, the next most likely source of capital usually comes from those who love and trust you, or the three "Fs"-family, friends, and fools. Whether it's an equity investment or a formal or informal loan, entrepreneurs often turn to old friends and family members, who typically provide capital on the basis of a relationship rather than on the basis of financial rewards.
If your family is anything like mine, however, you may want to reconsider this strategy. You would have to be prepared to provide business-plan updates at family dinners and to be reminded weekly of "who helped you get started." The benefits of this inexpensive capital may be outweighed by the costs of the family dynamics and by the complex emotions of guilt, despair, and frustration if the business fails and the family investment is lost.
Turning to old friends for money may also be unwise, particularly when the friend is investing in your new business based on trust and can't really afford to lose the money if things go south. Business loans and investments have ruined a lot of long-standing relationships over the years. The catch-22, of course, is that if things go very well, then your family and friends wind up arguing with you because you didn't give them a chance to participate. Again, you know your friends and family and their tolerance for risk, and only you can decide whether it will be advisable or appropriate to approach them for seed and early-stage capital.
If you decide to solicit friends and family as a source of capital, you must be very open and honest about the risks and rewards of the enterprise-and the risks are likely to be much more significant than the rewards in the early stages of the business. Make sure that they know that this is not like investing in the public stock market where public reporting, a track record, and the availability of liquidity protect against downside risk. You should also put the terms of the investment arrangements into writing to formalize the transaction and to avoid confusion about the rights and responsibilities of the parties.
Heaven on Earth - Finding an Angel Investor
Once you've demonstrated that your own funds are at risk and that you have exhausted your "emotional investors" (family, friends, co-workers, and others who love and trust you), it's time to begin your quest for an angel. If flying with angels isn't your cup of tea, then pay close attention to the other likely sources of seed and early-stage capital, discussed later in the chapter.
The term "angel" originated on Broadway, where wealthy investors provided funds to aspiring directors to finance the production of a new musical or drama. The motivation for the investment included financial reward but was mainly driven by the love for the theater and the chance to develop friendships with aspiring actors, playwrights, and producers. The point was that these investors provided high-risk capital and were motivated by some-thing more than money. Even today, playwrights, artists, producers, and musicians often rely on the altruism of others to advance their projects or careers; likewise, an aspiring entrepreneur must rely on something other than financial reward as an impetus for the investment. Your focus in meeting and presenting to angels must be on what makes this person motivated to invest more than what Internal Rate of Return (IRR) will be attractive to their wallet.
Beyond Broadway, angel investing has become a critical source of financing for seed and early-stage companies. From Arthur Rock in the early 1960s, whose angel dollars and capital-formation efforts helped launch companies such as Intel and Apple Computer, to cashed-out entrepreneurs such as Lotus founder Mitch Kapor, whose angel investments include RealNetworks and UUNet, to new-economy multimillionaires and Internet pioneers like Ted Leonsis of America Online, and the early-stage investors in Google, thousands of modern-day angels have played a key role in the launch, development, and financing of scores of early-stage companies, as well as the mentoring and assistance to thousands of entrepreneurs.
Angels come in different shapes and sizes and often invest for very different reasons. Some are motivated by something much larger than financial return - a good thing, since it is hard to convince someone with a net worth of $125 million that your deal will make them rich. There are "checkbook angels," usually friends, neighbors, and others who typically invest $5,000 to $25,000 on a passive basis hoping to get in early on the next Yahoo!. Then there are "capital-X" angels who typically invest $50,000 to $250,000 on a more active basis and who may insist on some advisory or mentoring role as a condition to their commitment. Finally, there are the "superangels," the cashed-out multimillionaires and even billionaires who have the capacity and the guts to invest $500,000 to $2 million in an early-stage enterprise in a deal that may look more like a venture-capital transaction (from a legal paperwork and control perspective) than like a deal made in heaven!
The Importance of Angels
Although the business media tends to focus on the activities of the institutional venture-capital firms, the amount of money that is invested annually by angels or private investors in growing businesses is much, much greater. Researchers at the Center for Venture Research at the University of New Hampshire estimate that 250,000 active angel investors are investing some $20 billion annually in 30,000 ventures, which represents over 80 percent of the total start-up and seed capital investments in the United States. Angel investors have become a critical source of seed capital at a time when venture capital funds are leaning toward latter-stage investments. The amount of money managed by venture-capital (VC) firms has grown dramatically, from $2.3 billion in 1986 to more than $60 billion in over 800 VC firms in 2003, according to a recent Venture One study. But the number of ventures under management remains small because it takes as much time to research and manage a small investment as a large one. Thus, the minimum first-round investment by a venture-capital firm is now about $4 million, eliminating many entrepreneurs who are looking for investments of as little as $50,000. The enormous success of the venture-capital industry has opened a window of opportunity for angels or private investors looking for start-ups in which to invest.
Angels Versus Venture Capitalists
Before the second half of the twentieth century, American private-equity investing was dominated by families and individual placements in emerging-growth opportunities. Wealthy families and individual investors provided start-up capital for companies such as Xerox and Eastern Airlines. The birth of the venture-capital industry is generally attributed to the formation in 1946 of the first pooled and professionally managed fund, American Research & Development (ARD). As a limited partnership, ARD and other early funds offered a passive, diversified approach for investors in earlier-stage private companies.
Over the last forty years, the VC fund model has become a centerpiece of the alternative-asset arena. Venture firms have grown larger, with more funds coming from large institutions, pension funds (which were permitted to make a limited amount of venture-capital investments when the "prudent man" rules were revised in the 1980s), corporations, and endowments. Today only 20 percent of institutional venture capital is derived from individuals and families. Paid professionals-general partners of these limited-partnership vehicles-have taken over responsibility for searching, researching, negotiating, closing, monitoring, and developing exits for these types of investments.
Angel investing has grown significantly in recent years as baby-boomers near retirement with significant wealth. Angels also include cashed-out entrepreneurs who may have feathered their nests by selling their business or taking it public. Some angels provide capital to entrepreneurs as a type of "quasi-philanthropy:" a way to give something back to their communities in the spirit of fostering local economic growth. Others are savvy private investors who also are helping an entrepreneur launch a new business along the way. It is critical for an entrepreneur seeking angel investment to understand the angel's need and motivations then take steps to meet these needs. Maybe you're the son or daughter these angels never had; maybe you remind them of themselves when they were younger; or perhaps they just want someone to coach.
Excerpted from Raising Capital by Andrew J. Sherman Copyright © 2005 by Andrew J. Sherman. Excerpted by permission.
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