Week 5 assignment
bemp1130
chp9.docxChapter 9 Raising Capital
Learning Objectives
· To understand the difference between debt and equity funding
· To identify the different financing stages of a venture
· To understand the various sources of capital, including debt and equity financing
· To develop a general understanding of the laws and regulations governing raising private capital
The director, Steve Taylor, was about to give up on his upcoming film, an adaptation of Donald Miller's novel Blue Like Jazz, the day before its preproduction as he received the news that two investors backed out of their $500,000 commitment to the project. With no financing, the project seemed doomed. Donald Miller posted the news on his blog, and immediately two fans responded by proposing to start a fundraising campaign to finance the film via Kickstarter.com . While the Blue Like Jazz campaign hoped to raise $125,000, it ended up raising $345,992 toward the project (Boudway, 2012; Busch, 2012). The money and awareness of the campaign also lured back the original investors and allowed the film production to go forward. On April 13, 2012, the film was released nationally.
Kickstarter is a website where the general public can contribute financially toward the realization of certain projects ranging from music to complex electronics. In exchange, contributors to the project receive some kind of reward defined in each project. Kickstarter is part of a global trend known as “crowdfunding,” where projects are funded through pledges made from people through the Internet. As lending from such typical sources as banks or investors has become more difficult, crowdfunding presents an innovative opportunity for entrepreneurs to obtain the cash they need to start and/or grow their venture.
Raising capital is one of the major challenges facing entrepreneurs worldwide. From “bootstrapping” to venture capital funding, this chapter explores the various sources of funding available to entrepreneurs. Also covered is crowdsourcing and how it can disrupt the traditional sources of financing. Chart 9.1 presents a schematic representation of the material covered in this chapter.
Chart 9.1 Schematic of Chapter 9
Types of Capital
Capital is basically one of two types: debt or equity.
Debt occurs when an entrepreneur obtains financing in exchange for regular interest payments and paying back the amount borrowed within a certain time frame. Debt can take many forms. It can be structured to be convertible into common stock, to have a floating interest rate, to be accompanied by warrants for the firm's common stock, or to have payments to a sinking fund. Debt may be secured by assets of the firm, guaranteed by the firm's principals, or backed by letters of credit or some other default protection. The permutations are almost endless. Some form of secured or unsecured debt is usually one of the first forms of capital investment raised by the entrepreneurial firm.
The other alternative type of capital is equity, which is defined as giving an ownership percentage in the company in return for financing. Like debt, equity may be flexible in its structure. Equity may be structured to have different places in the venture's liquidation preference vis-à-vis other equity owners, be super-voting or have no vote, or have many other permutations.
Each type of capital has its advantages and disadvantages. While debt financing usually only provides cash, equity financing may bring more than just the needed capital. In addition to cash, equity investors may provide mentorship, marketing assistance, or valuable contacts. This is what happened when Facebook received its first angel investment in 2004 from Peter Thiel, co-founder of PayPal. Thiel did not just provide the cash needed for the venture to grow; he also brought his expertise and a network that guided the company in its early stage.
While the press frequently emphasizes the role of venture capital firms in the economy, their investment is in very few companies compared to the total number of ventures financed by private individuals/angel investors. According to the 2011 industry report from PricewaterhouseCoopers, the National Venture Capital Association, and MoneyTree, 3,761 venture capital deals were made in the United States in 2011 compared to 66,230 entrepreneurial ventures financed by angel investors, nearly 18 times more.
The goal of a venture raising capital is to obtain the necessary capital at the best possible terms. Having several offers to consider is obviously the preferred outcome. This chapter will guide entrepreneurs in the capital-raising journey by describing the steps necessary to securing cash to move their ventures to the next level. It is important to remember that entrepreneurs need to be excellent salespersons when raising capital. The ability to sell and come across as a confident entrepreneur will have a dramatic impact on their success in this respect. While we will not cover the art of selling, we advise entrepreneurs to actively study and attend seminars on selling, as it is vital for the success of a venture.
The Capital-Raising Process
The first step is determining how much money the venture needs to raise. A number of issues affect this amount:
1. What is the time frame being considered?
2. What maximum cash flow deficit will occur during that time horizon?
3. What safety margin should be provided?
4. What price in terms of cost and control must be paid?
Based on the venture's financial projections, entrepreneurs can estimate how much capital the venture will need. Often the financial needs of the company occur at milestones, and the funding is contributed at these key points. For example, capital is injected to allow the venture to bring the first version of the product to market. More capital is then invested when sales reach a target level. Progressively larger injections of capital can be made as new milestones are achieved. With respect to establishing milestones, entrepreneurs should underpromise and overdeliver.
Raising the right amount of cash reduces dilution and eases the exit process. If a company raises $2 million on a $6 million premoney valuation for a total $8 million postmoney valuation, investors are typically expecting an exit valued at $32 to $48 million, a four to six multiple of the invested capital. If the company raises $4 million with the same $6 million premoney valuation, the new postmoney valuation is $10 million; the same four to six multiplier would require an exit valuation of $40 to $60 million. While an entrepreneur might be willing to exit at a valuation of $35 million, the investor may not accept anything less than $40 million (or higher). Conflicts between investors and entrepreneurs often arise. While entrepreneurs may consider selling as soon as the opportunity arises, investors, especially venture capitalists (VCs), often want the maximum return possible for their fund. While asking for more money than you need may provide more cushion, it also may lead to pressure from investors.
Financing Stages
Entrepreneurial firms typically have several financing stages ranging from (1) seed or prelaunch, (2) early, to (3) mid and later stage.
Seed stage companies are usually funded through bootstrapping (which will be covered in the next section). Early stage firms have no track record and need capital to create and launch their products/services on the market; this capital usually comes from personal savings, family and friends, or such creative sources as crowdfunding. In very specific cases, angel investors or venture capitalists may be willing to fund seed stage companies. One of the most notable seed funding stories in the history of Silicon Valley is the company Color Labs, Inc. Color Labs raised $41 million prelaunch money in 2011 with no product on the market. The only asset the company had at the time was a very strong founding team composed of renowned personalities such as Bill Nguyen (who sold his company Lala for several million dollars to Apple in 2009), Peter Pham (previously CEO of BillShrink), and D. J. Patil (LinkedIn's chief scientist). However, such cases are rare, even in Silicon Valley.
Early stage companies are already up and running and often have sales. By this stage of their development, the progress is usually material and significant. As a result, firms in this development stage typically request more funding and receive more favorable terms than do seed stage companies. The entrepreneurial team continues to be very important at this stage, however; they must be able to delegate and build an executive team that keeps the company growing.
Mid and later stage companies usually have already achieved significant benchmarks. These benchmarks can range from having significant revenue, having raised previous rounds of investment, having established a market niche, perfecting technology patents or trademarks, and achieving positive cash flow and even profits. At this stage, board pressure, conflict, and voting issues can occur between investors who have provided different levels of funding. All investors require a significant return on their investment, which affects the selling of the firm in terms of timing and amount. If the venture has loyal customers and stable cash flow, bank loans or other forms of conventional debt as well as equity financing may constitute the best forms of financing for the venture.
Sources of Capital
Meeting Capital Formation and Resource Needs
Generally, entrepreneurial firms face more acute problems with respect to raising capital and acquiring resources than do more established performing firms. Entrepreneurial ventures, at least in their early stages, need virtually everything such as capital, office equipment, furniture, computers, legal advice, accounting help, manpower, supply sources, and distribution channels. The entrepreneur needs to arrange for his or her nascent venture to acquire the essential resources needed. There are various ways and methods of accomplishing this task.
Bootstrapping
Bootstrapping is not merely a type of funding but in fact an attitude toward starting a firm. Bootstrapping is defined as the process through which entrepreneurs find creative ways to explore opportunities to launch and get traction for their startup business while having limited resources available (Cornwall, 2009). Bootstrapping is thus a mind-set that the entrepreneur needs to have to obtain the necessary capital and services to advance his or her venture's interests. Included in this mind-set is the willingness to use not only the cash flow and credit of the venture but also the entrepreneur's own resources, the resources of his or her friends and family, barter, and paying performance and stock bonuses for service providers and the founding employees. In short, the “bootstrapping” entrepreneur is creative and will do what is necessary to get the venture through the first critical months or years until more traditional financing is possible.
Bootstrapping is used by more than just entrepreneurs seeking to launch their business when no alternative sources of funding are available. It can be used as a first step to delay external funding and retain equity, minimize risk, increase efficiency within the business, or simply create a company culture where resources are maximized and waste minimized. While aspects of bootstrapping may be viewed negatively under certain circumstances (i.e., delaying payments excessively to employees or suppliers), most entrepreneurs engage in the practice to some degree or other at the start of their entrepreneurial journey. Dissatisfied employees will underperform, and unhappy suppliers will result in shorter terms of payments and a bad reputation that will hurt the company in the long term.
Savings. Most startup companies are funded at the beginning with the entrepreneur's personal savings. Entrepreneurs considering starting their own company often need to be willing to compromise their lifestyle for a period of time to fund their upcoming venture. Depending on the type of business and its cash requirements, the amount of savings necessary for supporting a startup firm will vary. Having savings will allow entrepreneurs to start the venture and finance their own labor when revenue is little or nonexistent. If possible, entrepreneurs should have at least 6 months’ worth of expenses saved at the outset of the venture and adapt their standard of living to face a period where they personally will have no income. Entrepreneurs often need to go through a long period of time without a paycheck as the business may take a while to reach a point where they can finally draw a salary.
Some businesses require little capital to get started. That was the case for Chad Mureta. Chad suffered a horrible car accident in 2009 and was heading toward severe financial difficulties as his insurance coverage was limited. With thousands of dollars in debt and his bank account empty, he had little chance of obtaining funding for any entrepreneurial activities. He borrowed $1,800 from his stepfather to create a mobile software application called Fingerprint Security Pro. The software application was distributed through the Apple app store and became an overnight success. The money generated allowed him to build more mobile software applications. Today, Chad is the owner and founder of three companies: Empire Apps, T3 Apps, and Best Apps.
Side Business. Another option that can be used in conjunction with saving is for entrepreneurs to keep their present job. As a result, entrepreneurs are able to have a source of income while they work on building and growing their entrepreneurial venture in their nonwork hours. It is hoped that by the time the entrepreneurial venture requires full-time dedication, it will be generating enough income to provide a salary.
Creative Ways to Bootstrap
There are several creative ways for entrepreneurs to launch and grow their venture. Several ideas that will allow entrepreneurs to bootstrap their way into business are discussed below.
Rent. Apple and Hewlett-Packard are two of the many companies that started in their founder's garage. In fact, more than 50% of the entrepreneurial ventures in the Unites States actually start at home (Kasperkevic, 2013). With the advent of the Internet, having an online presence is easier than ever. Websites such as www.weebly.com or www.wix.com allow entrepreneurs to build an online presence by themselves in hours for less than $10 per month. For certain types of companies, an online presence and a phone number are enough. If large corporations such as Amazon are able to manage their sales from a website, why shouldn't the same be true for startup companies? Meetings can be arranged at local restaurants, hotel lobbies, or, even better, the client's premises.
While an online presence may be enough for certain types of business, others may require a physical space to credibly deal with potential clients. Many free or inexpensive spaces can be used instead of the traditional office. For example, office suite companies now offer workstations or access to a room within a large office suite for rent at a fraction of the price of a traditional office. By using such “corporate identity” programs, entrepreneurs can give a postal address and phone number. In addition, most universities and cities today have incubator centers where young startups can launch and grow their ventures for free or at a lower cost. Some incubators offer rent, utilities, and associated services for free in exchange for equity in the venture. This represents a great way for entrepreneurs to bootstrap their way to success.
There are also more creative ideas, such as occurred in the case of a young Eastern European pianist. She negotiated with a hotel to play 2 nights a week for free in exchange for use of their concert hall during the mornings for both practice and giving private lessons to students. She not only gained credibility for being a great pianist, as she was playing at a renowned hotel, but also used the hotel to advertise her piano classes to people who attended her shows.
Furnishings and Equipment. Furnishings and equipment can represent a large initial cost for a startup venture. Entrepreneurs will have to determine what they really need and if, for example, a new MacBook Air is really necessary at this stage. Always forgo brand-new furnishings and equipment and rent or buy used. Often companies going out of business or upgrading their process or furnishings will sell these at a bargain price. Similarly, good deals can be found online, in local media, and at auctions. The Internet and websites make it easier than ever to find such deals.
In addition, certain types of equipment may be rented instead of purchased. For example, photographers do not need to purchase equipment for specific types of shootings (such as underwater). They can simply rent it for a day or week when needed, thus paying a fraction of the cost of buying it.
Staffing. Some businesses may require manpower beyond the entrepreneurial team to be operational. Employing people is very costly nearly everywhere in the world. It is much more cost-effective to outsource services. If a business needs administrative assistance to take care of paperwork and respond to e-mail, why not outsource it online? Companies such as AskSunday.com provide this type of service at a marginal cost of having to employ someone full-time to do the job. If an entrepreneur requires more technical skills, why not use a website like elance.com where professionals from all over the world offer their services at very competitive rates? Reviews and grading allow entrepreneurs to choose which freelancer they want to hire for the task. An escrow account can be established, and the funds are released when the freelancer delivers a job the employer deems satisfactory.
If a physical presence is required, entrepreneurs may contact placement firms that specialize in recruiting and placing temporary employees (from delivery staff to CEOs). This allows entrepreneurs to bypass full-time employment and the fringe benefits and for a short period of time have the human resources necessary to start their venture.
Another alternative is the recruitment of student interns. Local universities are a great place to find students looking for opportunities to earn school credit and gain professional experience. Interns are usually highly motivated and willing to work for a low salary. Many entrepreneurs value student interns highly given their cost, flexibility, and motivation to perform. Internship programs can be found at university employment or career services offices as well as online through such links as the following:
Bootstrapping has the following key characteristics:
1. Has little or no equity give-up
2. Is faster than waiting for banks or investors to make funding decisions
3. Shows commitment to future investors
4. Creates positive pressure to succeed as entrepreneurs’ own money is invested
5. Makes the venture more lean because entrepreneurs purchase and finance only what is strictly needed
6. Forces entrepreneurs to focus on revenue early on
7. Offers total control and flexibility, allowing decisions to be made quickly
While “bootstrapping” is a good way to start a venture, a number of sources of capital are important for entrepreneurs. These are discussed below.
Equity Capital
Equity financing is money offered by investors in exchange for an ownership share in the business. Such funds may be provided by friends and family members as well as private (angel) investors or venture capital firms. Equity investors want to realize a substantial return on their investment out of future profits of the venture and ultimately exit, usually through a successful sale of the business. Some equity investors, such as angels or venture capitalists, can also bring more than just cash to the investments, as they usually have a strong network and valuable experience. A discussion of the different types of equity investor follows.
Private (Angel) Investors
Private investors, frequently called angel investors (the term used historically to describe the backers of Broadway shows), are high-net-worth individuals who in the United States are certified to be accredited investors under the Securities and Exchange Commission (SEC) rule. In practice, angels are a key resource for entrepreneurs seeking early stage or seed capital. They are known for investing their personal funds (in the form of either debt or equity) in ventures started and managed by other individuals who are neither a friend nor a family member. Normally, angels invest between $25,000 and $500,000. Angels often band together to form angel networks or clubs, which act as clearinghouses for deals and where members of the network can invest together in interesting ventures.
Interestingly enough, the motivation of angels is normally not exclusively financial. While making a return is important, angel investors usually look also for a “qualitative return” that goes beyond money. Typically, angel investors have money, motivation, and time to diversify their investment portfolio with active investments. What this means is that they usually want to be high-worth partners by not only supplying the needed capital but also contributing with their knowledge and network. Angel investors can contribute in several ways. For example, they can leverage their network by opening doors to new clients, distributors, partners, and further sources of financing. They can also have a more involved role by helping entrepreneurs with operational and strategic tasks depending on their experience. Finally, an angel investor's reputation and track record may even result in his or her being a mentor who in times of turbulence brings confidence and calm to the business. They are generally comfortable with 5- to 7-year investments as it usually takes several years for an entrepreneurial venture to show a return. Sometimes, returns can be phenomenal, as was the case of Peter Thiel with his investment in Facebook.
In 2004, former Napster employee Sean Parker was looking for a potential investor in the company; he was now president of Facebook. Parker reached out to Reid Hoffman, known Silicon Valley serial entrepreneur and co-founder of PayPal, who at the time held the position of CEO at LinkedIn. Hoffman found potential in the idea but declined the opportunity. He revealed that conflicts could emerge from his actual role at LinkedIn. He recommended Peter Thiel, whom he knew from his time at PayPal. Peter Thiel liked the idea and concept after meeting Sean Parker and the creator, Mark Zuckerberg.
In August 2004, only 5 months after the launch of the venture, Peter Thiel made a $500,000 angel investment in Facebook. In exchange, he was granted a 10.2% equity stake and joined the company's board. This represented the first outside investment in Facebook.
Due to subsequent rounds of funding and movements in Facebook shares under private sales and dilution over the years, Thiel's investment by the time of the initial public offering (IPO) was about 3%. A 3% share of the $100+ billion IPO—Peter Thiel had generated a tremendous return on his investment through angel investing.
Angel investors know that the only way to be part of something big is by investing in the early stage of a venture. When angels begin investing other people's money in deals they believe worth the investment, they become what are known as super angels. They usually make more investments than regular angels and invest not only their own money but also their friends’ and other private investors’. When operating in this capacity, they often work as a miniature venture capital firm, and sometimes they are referred to as “micro VCs.” Once a super angel raises money, he or she has fiduciary responsibilities similar to those of venture capitalists.
Venture Capital Firms
Venture capital (VC) firms are in the “business of building businesses” and exchange their investment for an equity part of the venture. From a historical perspective, VC investments are far from new. In the 15th century, Christopher Columbus traveled from Portugal to Spain seeking the investment to journey on new ventures that would bring fortune and fame to its sponsors. Venture capital has since evolved into a sophisticated industry, known for its unique structure, which combines risk capital with management and with labor and material to accomplish a common goal—return on investment.
At venture capital firms, the most senior partners in the firm are the managing directors (MDs) or founding partners (if they are the ones who founded the firm). They are the ones responsible for the investment decisions and serve on the board of directors of the companies they invest in—called portfolio companies.
The second layer within a VC firm is the principals or directors. While they typically have some influence on a deal, they still require the consent and support from the managing director(s) in the final investment decision.
Associates represent the third layer of a VC firm. They are often composed of recently graduated students who focus on basic research tasks. They generally have no decision-making ability and do not act as principals within the firm.
Some VC firms may also have advisers on a part-time basis who are venture partners, operating partners, or entrepreneurs in residence (EIRs). Such individuals typically have considerable experience in certain fields and bring high added value to the VC firm both during the due diligence process and during the management of the investments. They may also connect the VC firms to interesting deals through their personal networks.
Entrepreneurs should be aware of the structure of the VC firm they are targeting. While they need to work with all members of the firm, entrepreneurs must remember that only managing directors make the final decision. In addition, managing directors are usually with the same firm for many years, while lower-level individuals in a VC firm are often looking for an opportunity for promotion either internally or externally. As a result, entrepreneurs should make sure they have a good relationship not only with the principals but also with the managing directors of the firm.
Differences Between VCs and Angels. A typical venture capital firm usually receives more inquiries for financing than does an angel investor since its contact details are listed publicly in directories. Angel investors usually prefer to remain private and use angel networks as their point of contact where the head of the angel network is the contact for the deals and a screening committee determines the ones to present. Angels themselves receive less deal flow and often take longer to make an investment decision. While VCs expect a percentage of their investments will not be successful, angels like to think all of their investment decisions will generate a positive return, which of course does not happen. Angels do not have any pressure to invest as they are not managing a fund with investor money. VCs have to invest and generate a return to satisfy their fund's investors or limited partners.
Angel investors seem to be more concerned with a firm's success in terms of both financials and sustainability, while venture capitalists appear to give more relevance to fast growth and exit strategies. Angel investors are using their own money; venture capitalists are using other people's money as well as their own. Angel investors usually work part-time on their investments, while VCs are full-time and focused on maximizing their return on investment. A large number of angel investors were in the past entrepreneurs themselves, but that is not as common in the VC industry. While angels focus on a wider variety of enterprises, VCs focus on fewer industries with high growth potential.
Both angel investors and venture capitalists are seeking a high return on their investment. If they do not believe they will make a high return on their capital, they will typically ignore the opportunity no matter how exciting the project is.
Crowdfunding
Crowdfunding is a relatively new way for entrepreneurs to raise financing. While it is just being established and widely used, it allows firms to raise money over the Internet from numerous investors investing small amounts of capital. Typically, an idea for a product or service is posted onto a crowdfunding platform along with a fundraising target. People all over the world can review it and decide if they want to contribute to its development. Donations can be as low as $5 to $10, although some contributions have reached as high as thousands of dollars. In return, “backers” receive a gift such as a copy of the end product.
Globally, crowdfunding platforms raised $1.5 billion in 2011 for one million campaigns, with most of the total raised in North America (Crowdsourcing Org, 2010). Due to its growing popularity and its ability to help firms access capital and increase jobs, crowdfunding received attention from policy makers in the United States. The Jumpstart Our Business Startups Act (JOBS Act) of 2012 opened the door for equity crowdfunding, although the precise details of how this market will develop depend on the SEC. Under the new legislation, a company can raise up to $1 million per year in equity crowdfunding. It is projected that the total market for equity crowdfunding could be $4 billion (Prive, 2012).
What we know is that crowdfunding is premised on large numbers of investors investing small amounts of money. As a result, managing hundreds or even thousands of investors might present a challenge for busy entrepreneurs (Emmanuel, 2013). Furthermore, at a later stage, some sophisticated investors (angels or venture capital firms) may be reluctant to invest in a crowdfunded venture. One way to solve this problem is to have anyone participating in the crowdfunding agree to become one voting block if required for later stage financing.
The Pebble Smartwatch is an example of a firm that used crowdfunding for raising capital. In April 2012, after multiple failed attempts to get funding from venture capital firms, Eric Migicovsky posted his idea of an app-supported Smartwatch that connects to an iPhone or Android smartphone on Kickstarter, one of the most popular crowdfunding platforms. He set his fundraising target at $100,000. Within 24 hours, he had raised $1 million. By the end of the funding period, the project had raised over $10 million from nearly 69,000 backers (Gobble, 2012). Pebble entered mass production in January 2013, with planned production of 15,000 watches per week, with backers who contributed $99 or more getting the first orders filled first (Simonite, 2013).
There are essentially three main types of crowdfunding:
1. Prize-Based Crowdfunding. In exchange for their investment, investors receive a tangible item or service (e.g., Kickstrater.com and IndieGogo.com are known for this).
2. Equity-Based Crowdfunding. In exchange for their investment, investors receive an ownership position in the company.
3. Lending-Based Crowdfunding. Investors lend money, which is repaid over a set period of time.
Prize-Based Crowdfunding. Prize-based crowdfunding allows entrepreneurs to bypass typical investors and pitch their ideas directly to Internet users who may be willing to provide financial support. Using websites such as Kickstarter and IndieGogo, entrepreneurs post online their ideas and products with pictures, text, and videos. Internet users are then offered special rewards such as exclusive merchandise, samples of the product, or even an opportunity to meet the founders of the project in exchange for a monetary donation. In the case of a CD recording, for example, donating $15 will guarantee a copy of the CD, $30 an autographed CD, and $50 an autographed CD and poster. Donations above $500 provide the opportunity to meet the singer and sing part of the album itself.
Gustin Jeans used a prize-based crowdfunding project. The founders of Gustin, a company that provides premium menswear handcrafted in San Francisco, launched a Kickstarter project with the goal of raising $20,000 in exchange for their own products, jeans (Tarnoff, 2013). Within a week, the company had raised $100,000 from more than a thousand different people around the globe. In total, 4,010 people contributed to Gustin Jeans’ project, and the crowdfunding campaign raised nearly half a million dollars in less than 35 days!
A significant advantage of prize-based crowdfunding is that entrepreneurs do not give away any ownership or equity stake in their venture, or give up any kind of control. Other sources of cash (i.e., equity-based crowdfunding, venture capital firms, and angel investors) usually require ownership or interest repayment of principle in exchange for capital.
Some of the advantages of prize-based crowdfunding include the following:
1. Ideas can be tested and funded easily.
2. No equity is given up.
3. No control is given up.
4. Investors become your word-of-mouth marketing team on social media and among their friends.
5. Entrepreneurs sell their products before they actually exist, providing a good proof of concept.
Lending-Based Crowdfunding. Lending-based crowdfunding occurs when people as a “crowd” lend money expecting that the loan will be repaid with interest. Sites that focus on this approach are SoMoLend.com , LendingClub.com , Microplace.com , Buildingsociety.com , and Prosper.com . This approach is particularly beneficial for companies that do not want to give up equity stakes in the company.
Some advantages of lending-based crowdfunding include the following:
1. No equity is given up.
2. No control is given up.
3. Interest rate charged is usually competitive and allows debt to be available in regions of the world where access to credit is limited.
Equity-Based Crowdfunding. Equity-based crowdfunding allows individuals to invest in startup companies and small businesses in smaller amounts of money for ownership in the venture. Previously in the United States, only accredited investors were able to invest in privately held companies. Several online platforms focus on this: Fundable.com , WeFunder (United States), CrowdCube.com (United Kingdom), and FundedByMe.com (Sweden, Norway, and Finland).
These three types of crowdfunding provide not only a way to fund entrepreneurial ideas but also “proof of concept” by gauging public interest and having real customers invest their own money in the project. Entrepreneurs in their early stage can benefit from crowdfunding, as it can serve as a cheaper and potentially more reliable alternative to more expensive marketing research studies.
Debt Capital
Debt capital may take many forms. It can be secured or unsecured, bear interest at a variable rate or a fixed rate, be convertible into equity or not, or be structured to have warrants or common stock attached. Debt is a very flexible form of capital.
Today debt is still one of the main sources of capital for entrepreneurs. Debt capital has both advantages and disadvantages. Its advantages include the following:
1. It is usually faster and cheaper than securing equity.
2. The cost of capital is more easily determined.
3. It provides tax benefits.
4. The entrepreneur does not give up ownership in the company.
5. Debt usually is the lowest-cost capital component.
Its disadvantages include the following:
1. Loans can be difficult to obtain.
2. A personal guarantee is often required to secure the loan.
3. Collateral is required on an asset higher than the amount of the loan.
4. The company has to pay back the money borrowed, and the payments must be made in a timely manner.
5. If debt is not paid back, debt can force a company into bankruptcy.
6. Debt appears on the balance sheet as a liability, which makes equity investment less attractive for investors.
The sources of debt capital covered in this section are consumer credit, bank loans, government, and grants.
Consumer Credit. The vast majority of new businesses use consumer credit to provide financing, whether in the form of personal or business credit cards or other short-term borrowing programs. As of the end of 2009, 83% of small businesses reported using credit cards to finance their operations (Board of Governors, 2010). Many small businesses use credit cards as a convenient method of paying for goods and services and of tracking expenses. Some small businesses also use credit cards for borrowing purposes, carrying a balance on the card from month to month.
Small business credit cards differ from consumer cards in that they are issued to firms, rather than individual consumers, and are intended to be used for business purposes. Small business credit cards are also distinct from other types of credit card products designed for businesses, such as corporate cards, procurement cards, and fleet cards, which are usually issued to larger businesses. Small business credit cards are very similar to personal credit cards. Personal and small business credit cards have similar features such as rewards programs, balance transfer programs, and introductory rate promotions. The fees and pricing structures, as well as other terms such as grace periods, can also be similar across the two products.
Examples of business credit cards include American Express Business Platinum Card, Chase Ink, and the CitiBusiness Thank You Card. While all three cards provide financing to small businesses, their fees and rewards vary. The American Express Business Platinum Card, for example, has a $450 annual fee, and the balance needs to be paid in full each month. The card caters more to business travelers, with rewards on major airlines, hotels, and car rentals. The Chase Ink and the CitiBusiness Thank You cards do not charge an annual fee and do allow for balances to roll over month to month. Business owners earn reward points that can be converted to cash or discounts at office supply stores, restaurants, or gas stations, as well as travel benefits.
Bank Loans. Often a bank's primary business is to loan money at an interest rate for profit. Interest rates will vary from bank to bank and the perceived credit risk of the borrower. In general, banks are not receptive to financing startup companies with limited or no revenues and/or assets. When they do, it is often as a personal loan to the entrepreneur disguised as a collateralized business loan. If the business does not have assets or receivables, the bank will usually require the entrepreneur to pledge his or her property as a guarantee for the loan. Entrepreneurs without personal assets to pledge as collateral have little chance of securing a bank loan for their startup.
An alternative to larger commercial or regional banks is the community bank. Community banks are usually friendlier to entrepreneurs than larger, not geographically focused banks. Typically, a community bank is a smaller bank that specializes in more local lending. A complete list of community banks can be found at www.icba.org .
Overall, entrepreneurs seeking any type of bank loan will need to pass a credit analysis in order for the bank to determine their ability to repay both principal and interest. Usually, there will need to be collateral to secure the loan as well as a solid business plan.
The major issue with obtaining a loan from a bank is the required collateral. It is estimated that 90% of first-time business owners pledge their home as collateral for a business loan. While it can be scary for entrepreneurs, this action demonstrates credibility and commitment to the business idea. If the entrepreneur defaults, banks indeed have the right to sell his or her home to recover their loan amount.
Entrepreneurs should be aware that the success of their venture depends mostly on their ability and effort. They should seek the following in any debt obtained:
1. Being able to refinance the terms of the loan at a later stage with no prepayment penalty
2. Being able to improve the terms or extend or add to the amount of the loan if payments are made on time and the firm achieves certain milestones
3. Having a fixed interest rate
4. Having a specified grace period and cure period for noncompliance
Government Guaranteed Loans. Many governments provide some kind of guaranteed or subsidized loans for entrepreneurs. These programs are usually locally focused at increasing or retaining employment in the area. These loans often come with such benefits as a lower interest rate or lower qualification standards than regular banks. The only problem is the bureaucratic process associated with the loan and the reporting system.
In the United States, the Small Business Administration (SBA) has several loan programs for small companies ( www.sba.gov ). SBA loans have the unique characteristic of being available to entrepreneurs who do not qualify for regular bank loans. To be eligible for an SBA loan, the company must qualify as a small business, have a for-profit goal, and have no internal resources of financing. Further details on which types of companies can and cannot apply to this program can be found at the www.sba.gov site.
While these loans are processed by regular banks, the SBA guarantees up to 85% of the loan principal. The maximum loan under this program is $2 million, of which 75% (1.5 million) is guaranteed by the SBA to the lender. In this case, if the recipient defaults on the loan, the bank lending the money has only a 25% risk because the SBA guarantees 75% of the amount borrowed. While the loan is secured, entrepreneurs should be aware that the amount borrowed is first personally guaranteed and that lenders will request SBA for a refund only after they have assiduously pursued the payment of as much of the loan as possible.
Four of the SBA's main programs are the 7(a) Loan Guaranty, Microloan, 504 (CDC) Loan Programs, and Small Business Investment Company (SBIC), which are discussed below.
The 7(a) Loan Guaranty program is the most popular of all the programs offered. It provides bank loans where the SBA guarantees 85% of the loans up to $150,000 and 75% for loans between $150,000 and $2 million. Further details can be found at http://www.sba.gov/category/navigation-structure/loans-grants/small-business-loans/sba-loan-programs/7a-loan-program .
The Microloan program is available through nonprofit community-based organizations and offers small and short-term loans (up to 6 years) to small businesses. The maximum loan amount is $50,000 with an average of $13,000 per microloan, and the interest rate charged is usually between 8% and 13%. The purpose of these loans is usually for working capital, purchase of inventory, supplies, furniture, fixtures, machinery, or equipment. Microloans cannot be used to pay down existing debts or purchase real estate. More information can be found at http://www.sba.gov/content/microloan-program .
The 504 (CDC) Loan program offers long-term and fixed-rate financing to small businesses to acquire fixed assets such land, buildings, or equipment. This loan cannot be used for working capital, inventory, or to consolidate or repay debt. The loans are delivered through certified development companies (CDC). CDCs are private nonprofit corporations created to promote economic development in their local communities. The 504 loans are usually structured as follows: The SBA provides 40%, a participating lender provides 50% of the total project costs (typically a bank), and the borrower contributes with the remaining 10%. Under specific circumstances, a borrower may be asked to increase its contribution up to 20%. The maximum loan amount in this program is limited to $5 million but may be increased to $5.5 million under specific circumstances. There are more than 260 CDCs in the United States, each covering a specific geographic area. By 2012, the 504 loan program had provided over $50 billion worth of loans. More information about the 504 (CDC) loan program can be found at http://www.sba.gov/content/cdc504-loan-program .
The Small Business Investment Company (SBIC) program represents a partnership between the public and private sectors. SBICs are private equity funds that invest in small businesses that meet specific criteria set by the federal government. While licensed and regulated by the U.S. Small Business Administration (SBA), the organization is privately managed. The SBIC program is available only to companies with a net worth below $18 million and after-tax net income for the prior 2 years below $6.0 million. The SBIC program offers both debt and equity capital. Usually, the debt has a 10-year maturity.
Along with the debt capital, the SBIC provides strategic management help. The advantages of this program are that companies get not only cash but also experts willing to assist them. SBIC represents a long-term loan or equity investment but differs from traditional VC funds as SBICs are not allowed to take control of the portfolio companies funded. More information about this program can be found at http://www.sba.gov/content/sbic-program-0 .
Community Development Financial Institutions (CDFIs). CDFI programs serve low-income individuals and communities that usually do not qualify for other financing options. The CDFIs’ purpose is pursuing a specific goal such as create jobs, promote economic development, or develop affordable housing. CDFI organization makes sense for certain types of businesses where financing from banks and private investors is not an option. Since 1994, the CDFI Fund has provided more than $1 billion worth of financing. For more information, visit the website at http://www.cdfifund.gov .
Foundations and Grants. One source of financing for young companies and entrepreneurs is through grants, which are nonrepayable funds “granted” to businesses by another organization, usually a government department, charitable foundation, or trust. Grants do not require the funds to be paid back. Typically, the grant-giving institution has a mission statement or vision and will provide financing for firms that further the purpose of the organization. While grants do not require the funds to be repaid, many do require a return on their investment in the form of community impact or the fulfillment of a specific social or community benchmark.
An example of a private grant-giving organization is The Kauffman Foundation, based in Kansas City, Missouri. The late entrepreneur and philanthropist Ewing Kauffman established the foundation in the 1960s as a vehicle for providing financing for entrepreneurial companies, advising his associates to “invest in people and be willing to take risks to accelerate entrepreneurship in America” ( Kauffman.org ). In general, the Kauffman Foundation grants are limited to programs and/or initiatives that have significant potential to demonstrate innovative service delivery in support of education and entrepreneurship. A list of some of the foundation resources is indicated in Table 9.1 .
The foundation encourages grant seekers applying for funding to review its founding priorities to see if there is strong congruence between the goals of the foundation and the applicant firm. A letter of inquiry is then submitted detailing a description of the applicant, the purpose for the funds, a proposed time frame, and an estimate of the costs. If approved, the foundation distributes the grant money to the organization with the expectation of receiving a “return on their investment” by creating jobs and furthering the organization's specific mission ( Kauffman.org ). According to its website, the Kauffman Foundation currently has an asset base of approximately $2 billion.
Securities Law and Regulations
In the United States, various state and federal securities laws and regulations must be complied with to raise any kind of capital. Since the interpretation and application of these laws and regulations is very complex, it will not be discussed in detail. In the following section, the U.S. regulatory framework is briefly presented that applies when one raises capital for an entrepreneurial firm. It is incumbent upon the entrepreneur to understand all state and federal regulations that apply to his or her situation. The best way to do this is to engage a competent attorney to deal with these issues.
Basic Securities Laws of the United States
Section 5 of the 1933 Act. Section 5 of the 1933 Securities Act requires securities that are not exempt to be registered with the SEC prior to any sale or distribution. Section 2(a)(3) of the 1933 act defines “sale” as including “every contract of sales or disposition of a security or interest in a security, for value” (Hazen, 2006). It also requires any sale of a security to be accompanied by a prospectus that meets the requirements set forth in the Securities Act. This information enables investors to make informed decisions about whether to purchase a company's securities. The registration documents that a company files with the SEC provide essential facts, including a description of the company's business, a description of the security to be offered for sale, information about the management of the company, disclosure of the risks inherent in the venture, and financial statements certified by independent accountants ( SEC.gov ).
All securities sold in the United States must be registered or exempt from registration. Certain securities that are issued by certain institutional investors or that have been granted specific exemptions under the Securities Act may not be required to be registered.
Regulation D: The Private Placement of Restricted Securities Offered by Small Firms. Securities issued under the exemption referred to as Regulation D are not required to be registered for sale to the public. Regulation D is the most common exemption from registration that is used by entrepreneurs raising private funds for their ventures.
Regulation D (or Reg D) contains rules providing exemptions from the registration requirements. This exemption from registration allows small issuers to offer and sell their securities without having to register the securities with the SEC. Reg D consists of three separate but interrelated exemptions.
1. Rule 504 provides exemption for certain offerings not exceeding $1 million within a 12-month period.
2. Rule 505 exempts certain offerings not exceeding $5 million within a 12-month period.
3. Rule 506 permits nonpublic offerings to qualified purchasers without any limitation on dollar amount (Hazen, 2006).
A Reg D offering is intended to make access to the capital markets possible for small companies that could not otherwise bear the costs (in both time and money) of a normal SEC registration.
Rules 144 and 144A: The Resale of Restricted or Control Securities. Rule 144 allows public resale of restricted and control securities if a number of conditions are met. Restricted securities are securities acquired in unregistered, private sales from the issuing company or from an affiliate of the issuer. Investors typically receive restricted securities through private placement offerings, Regulation D offerings, or employee stock benefit plans as compensation for professional services or in exchange for providing “seed money” or startup capital to the company (Hazen, 2006). Control securities are those held by an affiliate of the issuing company. An affiliate is a person, such as an executive officer, a director, or a large shareholder, in a relationship of control with the issuer and therefore has the ability to influence, directly or indirectly, management decisions. Five conditions must be met for these securities to be sold:
1. The prescribed holding period must be met.
2. An adequate amount of current information is available to the public regarding the historical performance of the security.
3. The amount to be sold is less than 1% of the shares outstanding and accounts for less than 1% of the average of the previous 4 weeks’ trading volume.
4. All of the normal trading conditions that apply to any trade are met.
5. If wishing to sell more than 500 shares or an amount worth more than $10,000, the seller must file a form with the SEC before the sale.
Even if all the conditions of Rule 144 have been met, investors still cannot sell their restricted securities to the public until they have gotten the legend removed from the certificate. Once the sale is approved by the SEC, a transfer agent can remove a restrictive legend, and the sale may proceed.
Rule 144A provides a safe harbor exemption from the registration requirements of the Securities Act of 1933 for resale of restricted securities to qualified institutional buyers (QIBs), as defined in the rule. In general, a qualified institutional buyer is an institutional investor that in the aggregate owns and invests on a discretionary basis at least $100 million in securities of issuers that are not affiliated with the buyer. The SEC's objective in adopting Rule 144A is to achieve “a more liquid and efficient institutional resale market for unregistered securities” ( SEC.gov ). The rule also permits QIBs to buy and sell securities among themselves. Companies issuing unregistered securities may raise enough capital in the 144A market to remain private. They may also use a 144A offering as an intermediary step toward an initial public offering (IPO).
Selling Securities to the Public Market for the First Time Is Referred to as an Initial Public Offering (IPO). Securities sold in the public market need to go through a more complex issuing process than securities sold through one of the private placement exemptions (Reg. D, Rule 144, and Rule 144A). The procedure is called an underwriting. Below is a summary of this underwriting process.
Step 1: Contract with a securities broker/dealer to complete the underwriting process. There are several types of commitments that the broker/dealer may offer.
1. Strict Underwriting. The issuer uses an “insuring house,” which will advertise and receive subscriptions and applications for shares from the public. The underwriter guarantees to purchase the unsold portion of the allotment.
2. Firm Commitment. The underwriter agrees to purchase all the securities from the issuer. The principal underwriter will contact other broker-dealers to become members of the underwriting group (syndicate), who act as wholesalers of the securities to the public.
3. Best Efforts. The underwriter does not commit to purchase the entire allotment being offered to the public. Rather than buying the securities from the issuer for resale to the public, the underwriter sells them merely as an agent. This is the most usual type of commitment.
Step 2: Complying with relevant securities law. Section 5 of the Securities Act prohibits all selling efforts by making it unlawful to offer a security for sale unless a registration statement has been filed and has become effective. Section 5 divides the registration process into three time periods: the prefiling, waiting, and posteffective periods.
1. Prefiling a Registration Statement. Once the public offering is contemplated, the time prior to the completion of the initial registration statement and filing is known as the prefiling period.
2. Waiting. After the registration statement has been filed with the SEC, there is a statutory 20-day waiting period prior to the effective date of registration statement, at which time sales of securities can take place. Although no sales can be made during this period, anyone is free to make an offer to buy or sell the security. The prospectus that meets the requirements of Section 10 of the act can be disseminated during this time.
3. Posteffective. Once the registration statement becomes effective, Section 5's prohibitions cease to apply. Market participants are free to buy and sell the registered securities provided they have been given the proper disclosures.
The key to a successful IPO is to engage a reliable, effective underwriting and a competent and reasonably priced law firm. Most IPOs can be done in 3 to 6 months.
Summary
There are many sources of capital available for entrepreneurs, but the competition for this capital is very intense. Identifying potential sources of capital is necessary, difficult, and time-consuming, but being a successful entrepreneur requires being successful at attracting capital.
Most entrepreneurs start by investing their own savings; they then move on to friends and family, angel investors, consumer credit sources, and then banks or venture funds. If they are motivated, capable, and organized, they may be able to do an IPO in the public securities markets.
If the entrepreneur solicits any form of investment capital from third parties, then the process is regulated by federal or local laws, particularly the solicitation process. No matter where the firm is domiciled (whether in the United States or some other country), compliance with securities law and regulation is expensive and requires professional assistance. In addition, the process is almost always very time-consuming. The results of an IPO are never predictable, and occasionally they can be disastrous in that they generate little or disappointing amounts of new funds at a high cost in terms of time and money.
Overall, the process of fundraising is difficult, time-consuming, and definitely not without risk and frustration. Yet it is an essential part of successfully starting and growing a new venture.
