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Raising Capital
By Andrew J. Sherman AMACOM BOOKS
Copyright © 2005 Andrew J. Sherman
All right reserved. ISBN: 0-8144-0856-7
Chapter One
Start-Up Financing 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.
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Excerpted from Raising Capital by Andrew J. Sherman Copyright © 2005 by Andrew J. Sherman. Excerpted by permission.
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