Proper Funding: One Size Does Not Fit All
Few aspects of a start-up or early-stage company are as critical to future success as access to capital. While the money is green regardless where it comes from, the type of investor you ultimately connect with can drastically alter the manner in which your organization grows and the culture it exudes.
Through this narrative, our hope is to alleviate some of the confusion that seems omnipresent within the realm of investment finance, and analyze at high level some of the options available. While not an exhaustive list, these funding sources are amongst the most recognizable and frequently employed by small business.
In the Resources section of this website we have listed a number of institutions focused on capital formation. They are broken down into the chief constituents we see in the marketplace today: Crowd Funding, Angel Investing, Venture Capital, and Private Equity.
Friends & Family
The Friends & Family round is the one utilized most often by enterprising start-ups in an effort to commence operations. With respect to timing, it is often the most expedient with assets being made available in a matter of weeks and months rather than months and years. Unfortunately, the pitfalls of gathering funds from Friends & Family can be many.
A common misunderstanding among entrepreneurs is that a Friends & Family round is somehow exempt from U.S. securities registration. This could not be further from the truth. Business owners raising capital without the proper legal counsel and procuring the necessary registration requirements are, in fact, violating securities laws.
We can state emphatically that there is no Friends & Family exemption from U.S. securities registration requirements. Both federal and state law requires that any entity selling securities (whether it be debt or equity) must have them registered with the Securities and Exchange Commission (SEC), as well as the state securities commissioner of each state where potential investors reside. The consequences of not adhering strictly to these regulations can be severe. Violation of securities laws can result in criminal prosecution of the company’s owners and principals.
Many business owners do, however, make an effort to comply with securities laws. Most often they seek exemptions from the registration requirements under the Securities Act of 1933. Start-ups and early-stage companies frequently utilize Regulation D and Rule 506 as the exemption to some of the registration guidelines.
Under Rule 506 of Regulation D, there are two distinct routes from which an issuer can claim exemption. To avoid any confusion, the following text is from the SEC website.
“Under Rule 506(b), a company can be assured it is within the Section 4(a)(2) exemption by satisfying the following standards:
- the company cannot use general solicitation or advertising to market the securities;
- the company may sell its securities to an unlimited number of “accredited investors” and up to 35 other purchases;
- Companies must decide what information to give to accredited investors, so long as it does not violate the antifraud prohibitions of the federal securities laws. But companies must give non-accredited investors disclosure documents that are generally the same as those used in registered offerings. If a company provides information to accredited investors, it must make this information available to non-accredited investors as well;
- the company must be available to answer questions by prospective purchasers; and
- financial statement requirements are the same as for Rule 505.
Under Rule 506(c), a company can broadly solicit and generally advertise the offering, but still be deemed to be undertaking a private offering within Section 4(a)(2) if:
- The investors in the offering are all accredited investors; and
- The company has taken reasonable steps to verify that its investors are accredited investors, which could include reviewing documentation, such as W-2s, tax returns, bank and brokerage statements, credit reports and the like.
Purchasers of securities offered pursuant to Rule 506 receive restricted securities, meaning that the securities cannot be sold for at least a year without registering them.”
By definition, an accredited investor is someone who satisfies either of the following:
- an individual net worth (excluding value of the primary residence) exceeding $1,000,000, or
- individual income in excess of $200,000 ($300,000 married) in each of the two most recent years and has a reasonable expectation of reaching the same income level in the current year.
If that is not enough, non-exempt, non-registered offerings can disrupt future transactions, bring about government investigations, and lead to an expensive rescission offering. Moreover, we can assure you that additional funding rounds will take on a different complexion once any prior non-registered offerings are discovered.
Beyond the legal ramifications, which admittedly extend well beyond this narrative, business concepts are the most overvalued at the Friends & Family level primarily due to a lack of sophistication by the investors. Lenders fall into the trap of taking most financial projections and strategic intentions as fact and have a difficult time deciphering certainty from risk. In other words, they buy into the hype surrounding the business concept because they want to seem supportive of their family member or friend.
Our advice is simple and direct with respect to any form of funding, but particularly with the Friends & Family round: do your homework, hire a securities lawyer, and get proper federal and state registration. The stakes are simply too high and the consequences too severe.
Lenders and Business Loans
Perhaps the most basic form of funding is a loan. Whether collateralized or uncollateralized, the concept is as straightforward as start-up finance can be. The sources for business loans are varied and historically have been the domain of local, regional, and national banks, as well as government agencies.
The U.S. Small Business Administration (SBA) offers numerous loan programs to assist aspiring entrepreneurs in their quest to get funding. A misconception of this form of funding is the SBA does not make or source loans to small companies or start-ups. Rather, they establish the guidelines for lending and the funds are provided by traditional lenders (banks), community development organizations, and commercial lending institutions. What the SBA does provide is a guarantee of the loans underwritten, effectively eliminating some of the risk to the lending partners.
A lesser known government program comes in the form of the Small Business Investment Company (SBIC). Founded in 1958, the SBIC was designed to facilitate the availability of longer-term capital. Through this program, the SBA licenses private entities to operate and capitalize investment funds that then facilitate the lending to small business. The sources of private capital are pension funds, university endowments, insurance companies, banks, and high-net-worth individuals (accredited investors). Operating in this manner the SBIC program draws many parallels to traditional Venture Capital funding (discussed later), while providing small businesses with low-cost, government-guaranteed debt or equity.
As the financial world has evolved, so too have the avenues for small businesses and start-ups to acquire funding. Social media-driven programs such as Crowd Lending have opened a new paradigm for financing nascent projects and business concepts (we discuss the rapidly evolving domain of Crowd Funding and Crowd Lending below).
Crowd Funding is a relatively new approach in the world of private investing. While initial funding efforts date back to the late-90s, it was not until 2003 and the launch of ArtistShare that the modern-day revolution of Crowd Funding and Crowd Lending began to proliferate. Since this pioneering endeavor, a multitude of web and social media sites such as IndieGoGo, Kickstarter, Lending Club, and MicroVentures have sprung up and taken the domain of alternative finance by storm. As a testament to how prolific this funding mechanism has become, more than $5 billion in capital was raised in 2013.
A typical Crowd Funding model involves three primary constituents:
- the project initiator [or subject(s)] who proposes the idea/project to be funded;
- individuals or groups who support the idea; and
- a fulfillment organization (typically a social media platform) that organizes the transaction by bringing the relevant parties together.
The most obvious benefit to this next generation financing method is the ability to fund an idea/project outside of the realm of traditional finance. The ability to do so provides the project initiator with reputational benefits, an indication of interest from a mass audience, and a feedback loop for project backers through the pre-release of informational content or beta-testing.
Another benefit of Crowd Funding has its roots tied to the world of behavioral finance. The process of financing a project through mass participation offers a degree of validation (also known as the wisdom of a crowd). Whereas certain channels of traditional capital tend to be very binary (i.e., one person or small committee provides a go/no-go decision), Crowd Funding outcomes reflect a declaration regarding the potential success of an idea or concept.
Outside of the traditional financial system, Crowd Funding is not without its own set of unique risks. In a world of constant innovation and rapid product cycles, Intellectual Property (IP) theft becomes a real concern once the details of a project are formally announced. Further, without a proper regulatory framework, the risk of fraud or inappropriate use of funds is relatively high.
Beyond these more tangible risks, there are underlying hazards in the form of “donor exhaustion” due to the sure magnitude of available deals. In addition, reputational damage is a strong possibility for those project owners that fail to meet their campaign goals or are unable to complete a venture with the capital raised.
Given the popularity of Crowd Funding and the relatively low barriers to entry, we expect the Securities and Exchange Commission (SEC) and other regulatory bodies to issue new rules and guidelines to govern the conduct of these funding systems. To this end, the SEC in 2015 began regulating equity Crowd Funding efforts to businesses larger than 500 investors and more than $25 million in funding, requiring them to file reports like a public company. Given this financing cap, we expect Crowd Funding to persist in the sphere of small, early-stage companies and start-ups and for the regulatory bodies to legislate the process as necessary.
By definition, Angels are accredited investors – high net worth individuals (net worth excluding home of $1 million) with annual income of $200,000 ($300,000 married) over the past two years and the expectation that this income will continue into the future.
With typical investments between $10k and $150k, Angels are regarded as the next round of funding after Friends & Family. They are frequently involved in the final stage(s) of product/service development and the subsequent launch. Angels can form a syndicate (Angel Group) in which more than one Angel may combine to fund larger deals ($500,000 to $1 million or more). Angel Groups typically have more leverage than individuals and can realize slightly better terms.
Due to their early market entry, Angels are exposed to slightly more risk than VCs who consider deals of greater size and business maturity. Further, companies at the Angel investor level typically have not formed a Board of Directors. However, a small advisory panel may be necessary and Angels are often a part of that construct.
Owing to the relatively nascent stage of evolution and the eclectic nature of business ventures, valuations tend to be less structured and more flexible. In exchange for this flexibility and added risk, Angel investors require on average 20% to 40% equity positions. The primary focus of Angel-backed companies is cash conservation (reducing cash burn), revenue growth, expense management, brand creation, and product development and roll-out/launch.
Angels fill an important role in the chain of early-stage capital. As sole proprietors, they are more nimble in performing due diligence and arriving at an investment decision. Unlike their larger counterparts, VCs and PE, Angels do not have committees to review deal and transaction flow. As a result, they have shorter due diligence timeframes, invest less capital, and realize shorter time horizons to liquidity (typically 2 to 5 years).
Venture Capital (VC)
Venture Capital (VC) is often viewed as an older brother to Angel investing and a close cousin or sub-sector of Private Equity (PE). Unlike Angel investors who are accredited individuals, VC funding is performed at the firm level. VCs raise a large amount of capital from institutional investors who are looking to diversify returns by gaining access to early-stage investments, but do not have the time and/or possess the necessary due diligence capabilities.
As analyzed in our narrative, A Closer Look at the Differences between Private Equity and Venture Capital, the roles, objectives, and characteristics of a VC fund are vastly different to those of PE. For that reason, entrepreneurs should view VC as a completely separate and distinct investment class.
VC funds earn returns by acquiring an equity stake (typically a minority position) in a target company. VCs have lower capital investments relative to PE ($2 million to $50 million), but much higher than Angel investors. VC funds consist of a portfolio of start-up, early-stage high-growth companies; 20 or more is typical.
Owing to the greater uncertainty of early-stage investing, it is not surprising that several VC-backed companies fail to gain traction and ultimately go bankrupt. For this reason, VCs manage portfolio risk by diversifying their investments across multiple high-growth, emerging industries.
While a handful of investments may go bankrupt, the expectation is for one or more ventures to significantly outperform and make the underlying fund profitable. Of course, every VC fund hopes that one of their investment companies will evolve into a bellwether like eBay, Sun, Google, and Apple (all VC funded start-ups).
VC funds have a number of similarities to Angels. First, VCs tend to be more intimately involved in the operations of a target company. This advisory function is usually tied to industry-related expertise as opposed to the core investment banking knowledge evident at PE firms.
Second, valuations are less defined within the VC environment. This is attributable to the early-stage nature of the investments, as well as the more eclectic nature of the companies.
Finally, the financial and business focus resides with cash conservation (reducing cash burn), revenue growth, expense management, brand evolution, and capturing mind/market share.
At the VC level, we frequently observe the creation of a more formalized corporate structure, complete with a Board of Directors. In addition to their advisory services, VCs often require a board seat that may subsist through a liquidation event and into the next round of funding.
Private Equity (PE)
PE firms acquire companies to support a number of stimulative measures: promote expansion, provide working capital, advance product development, and/or restructure the capital composition. PE deals are treated as outright purchases with deal sizes ranging from $100 million to tens of billions. Investments can either be cash, equity, debt [leveraged buyout (LBO)], or some hybrid structure.
Valuations within the PE landscape are relatively more defined than their VC counterparts. Target companies are frequently known quantities within established industries and are evaluated based on public market multiples such as price-to-sales, earnings, cash flow, and enterprise value-to-EBITDA.
Given these requirements, it is not surprising that a vast majority of a PE firms’ headcount comes from the investment banking ranks. Outside of replacing the management of a target company, most PE firms prefer to keep out of the way as long as tangible progress towards stated objectives can be readily observed. As such, PE investors have less involvement with daily operations.
Bankruptcies are less common in PE owing to the maturity of target companies. However, severely distressed turnarounds do fail occasionally and the result can be catastrophic to the funding PE firm.
PE investments have a more geometric growth pattern that can be hastened by the introduction of a new product line, an altered marketing or distribution strategy, targeted operational cost savings, or some combination thereof.
Exit strategies typically involve an initial public offering (IPO) in which investors realize some return on invested capital (ROIC). Due to the larger scope involved, it is not uncommon for the investment horizon to extend anywhere from 6 to 12 years, or longer, depending on risk appetite and the underlying conditions of the public markets.