“Friends and family are still the largest source of capital for companies in the early stages of development, but the current funding market presents several additional options for young companies. Be open-minded and investigate numerous sources of capital,” says Thomas C. Armstrong, corporate attorney at Berliner Cohen and a FINRA registered investment banker.
Smart Business spoke with Armstrong about the financing options available to startups and emerging enterprises.
What are the choices when it comes to raising equity capital?
- Friends and family. When starting a company, many times they are the primary source for capital. That’s true even in Silicon Valley, where you read about all of the angel investors and venture capitalists.
- Angel investors. These are wealthy individuals who provide financing, advice and connections. The investment is usually in the form of equity or possibly a convertible note that converts to equity when the company obtains a larger round of financing. There also are angel groups that will analyze the company and make a determination whether to invest. The process tends to be somewhat more formal and can take longer than what the entrepreneur may anticipate.
- Venture capitalists. Conventional wisdom is that they are looking for 10 times return on investment, so it’s for high-growth companies. Quite honestly, there are many companies that don’t fit that model. It doesn’t mean that they’re bad companies; it is just that they don’t fit the criteria for venture capital funds.
No matter what type of investor you’re making a pitch to, it’s important to present them with a credible exit plan or strategy. A lot of companies talk about how they’re going to grow and be the next big thing, but never clearly explain how the investor is going to get liquid on their investment and exit the company. If you’re taking outside financing, investors want a clear and credible exit strategy.
Why should debt financing be considered?
Often overlooked as a financing option, debt may be an option or part of an overall financing package. Banks are trying to be more creative and there’s been renewed interest in so-called revenue loans. Of course, for revenue loans the company has to have revenue — so it’s not for pure startups — but it can be a relatively modest amount of revenue. Revenue lenders will lend a certain percentage of your gross revenue, and a percentage of your monthly gross revenue goes to pay the loan. That payment amount goes up or down as your gross revenues go up or down. The good news is that they’re not asking for personal guarantees with these loans.
The downside is the interest rate is higher than for traditional bank loans. Your cost of capital, however, may ultimately be less than if you raised equity from angel or investor groups because you’re not giving up any ownership in the company. Of course, don’t forget about grant money if that is something the company may be able to apply for.
What problems can companies encounter if they don’t choose the financing route that’s best for them?
If they go to the wrong places for capital, they risk giving up too much of the company with a bad valuation or losing valuable time in their search for capital.
Another consideration is the expectations of investors. What is their time horizon? Are they patient or impatient money? Do they want to see distributions or just capital appreciation?
Entrepreneurs also need to think about whether these investors are going to be involved in the business. Some business owners may want that, while others don’t want to deal with people that are too meddlesome.
There also are legal ramifications to consider. Any time you are issuing securities in the company you have to comply with federal and state securities laws.
That’s a broad topic, but essentially you have to ensure that investors understand their investment and have been given sufficient disclosure about the company and the risks associated with investing in it. In particular, there are rules and regulations regarding who can invest and how much.
Under the recently passed Jobs Act, the government has tried to make it easier for companies to raise capital and the emergence of crowdfunding and the internet are opening up new avenues for raising capital. But again, you still need to comply with securities laws. The important thing for entrepreneurs is to look into all sorts of capital sources. ●
Thomas C. Armstrong is of counsel at Berliner Cohen. Reach him at (408) 286-5800 or [email protected].
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