1 Raising Money for a Start-Up Company Jason Nazar Exam #: 1729 2 Overview .................................................................................................... 3 The Funding Lifecycle.................................................................................. 4 Business Planning....................................................................................... 6 Bootstrapping .............................................................................................. 7 Raising Money from Friends and Family.................................................. 11 Legal Issues with Raising Capital ............................................................. 12 Federal Security Laws..........................................................................................12 State Security Laws ..............................................................................................12 SEC.gov Resources................................................................................................13 Requirement for Private Placement Memorandum................................... 14 C Corporation vs. LLC................................................................................ 15 Advantages and Disadvantages of an LLC .....................................................15 Advantages and Disadvantages of a C Corporation....................................16 Incorporating in Delaware vs. California .........................................................17 Angel Investors vs. Venture Capital ......................................................... 18 California Angel Investor Groups ............................................................. 20 Trends in Angel Investment ...................................................................... 20 Typical Term Sheet Clauses....................................................................... 21 VC Trends .................................................................................................. 22 Valuation Methods.................................................................................... 23 Appendix................................................................................................... 26 3 Overview Entrepreneurs face a great deal of challenges in building a successful venture. They have to identify a good opportunity, in a thriving industry, organize a competent management team, out pace the competition, and build a product and/or provide a service that is worthwhile to others. However, in spite of all these obstacles, raising money to seed or grow a company is often the largest challenge of all. The following paper will discuss the business and legal process of raising capital. There are various stages in the lifecycle of a business, and each has their own unique funding requirements. Our discussion will primarily concern scalable businesses that are headed towards professional or venture investment. The vast majority of businesses will never get any professional investment. The entrepreneur may fund the business themselves, take out loans, or raise some money from friends and family. The primary distinction is the end goal. A lifestyle business is one that provides its owners, shareholders, or members with revenues and profits sufficient to sustain their needs (even extravagant ones). These businesses may or may not have resale value, but typically would not provide outside investors with a substantial return. In contrast a venture business, while much riskier, typically will provide outside investors with a liquidity event that has the potential to provide very large returns. Idea Phase o Entrepreneur has the idea for a product or service o Writes a business plan to identify the critical business and financial issues o Bootstraps the initial product or service Seed Phase o Entrepreneur seeks to validate their concept o Additional capital is required to buy more product or offer the service o A combination of Bootstrapping and raising money from Friends and Family Round A o The concept has been validated or the market opportunity is large and the business is very scalable o Entrepreneur needs more access to capital to stay competitive in the marketplace and grow their business o Entrepreneur seeks our Angel Investment Venture Round o The business has a viable opportunity for a large exit either through an acquisition or an Initial Public Offering o Management team needs access to a large amount of capital to make it to profitability, exponentially grow the business, and/or position the company for an acquisition. 4 The Funding Lifecycle 5 6 Business Planning The following questions should be considered when starting a new business; they also make up the primary content of a business plan. 1.) What is the Product/Service? 2.) What is its Unique Value Proposition? a) What makes it different or better 3.) What is the Market Opportunity? a) What problem do you solve b) How large is the market c) How fast is the market growing d) Who is the competition 4.) How do you Make Money? a) What is the revenue model 5.) Who is the Management Team? a) How are they uniquely qualified 6.) What is the Strategy? a) What is the long term goal b) What are the 3, 6, 9, & 12 month milestones 7.) How do you Sale or Market your Product/Service? 8.) How Much Capital Do You Need/Intend to Raise? a) What are the Primary Start-Up Costs? 9.) What are the Projected Financials for the Company? a) What is the projected income statement 10.) What is the Preliminary Valuation of the Company? a) How much would you sell a percentage of your company for? 7 Bootstrapping The process of bootstrapping most simply means “pulling one self up by their bootstraps” – an entrepreneur that funds his/her own business and continues to grow it from the revenue and profits generated. But what happens when the capital isn’t there to being with? Bootstrapping has also come to include a variety of strategies to grow the company in those earliest of stages when capital is a scarce resource. Here, we will review some of these alternatives. Leverage Equity – in lieu of cash, equity (stock or a membership interest) can be used by founders to help grow their business. Often when entrepreneurs are first getting started all they have is an idea and their own investment of time and skill. These resources should not be undervalued. Equity in one’s venture can be leveraged to 1) entice partners, 2) buy services or employees, or 3) to receive goods from vendors. Often entrepreneurs are hesitant to give away an interest in their business, this is understandable. However, a smaller portion of a successful business is ultimately more valuable than the entire portion of a business that has no value. Certainly, equity should only be distributed where absolutely necessary and only to individuals or organizations which the entrepreneur trusts and feels comfortable partnering with for potentially the life of the business. Sharing equity in the venture is perhaps the most viable way to provide a new company with services and/or goods that it might not otherwise be able to afford. The type of equity provided will depend on the type of business. Lifestyle business will likely have to provide a share of future profits, since the business is not set up to be sold and the stock may not have any resale value. Venture business, may not make a profit for some years to come (if ever), and the equity grantee is likely looking to share in the potential upside of an acquisition or an IPO. Partner -Single founder businesses can be much more challenging to make succeed. Primarily, because they’re single founder businesses….one person has to do everything, as well as have enough capital to get the business off the ground. In addition to partnering to have more resources to run the business and to incorporate additional skill sets, additional partners will reduce the amount of financial risk that any one entrepreneur would normally have to take. 8 Ask For Deferred Payment – Partners, employees, and vendors may sometimes be willing to provide services or good for deferred payment. Namely, the entrepreneur can make the payments owed at a later date. Typically two conditions have to be met. First, there is usually a risk factor built into the delayed payment. This risk factor adds a premium to the overall amount of money the party providing the goods/services receives on top of the fair market value. For example, lets take a web developer that agrees to provide his/her services for deferred payment with a risk factor of x2. Normally the value of their services would be worth $10,000. But here, the service provider would typically agree to 1) get paid at a later date to be specified or 2) get paid when the company has the required funds to do so. At that time, the company would owe the service provider $20,000 instead of $10,000. The service provider takes a premium on the market value of their services for the associated risk. Secondly, the typically must be a relationship of trust. The party providing the good/services typically either has 1) a prior working relationship with the entrepreneur or 2) some credible means or references to evaluate their reliability. This is a key factor, as the grantor will want to ensure the value of the time, services, or resources provided. Depending on the nature of the relationship, and the extent of the trust, the grantor may ask to secure their deferred payment investment with a personal note. Find Free Help – often the most coveted resource that entrepreneurs need is human capital. The skill sets that entrepreneurs need are often found by going no further than their family, friends, educational and professional contacts. Simply asking for help is often the best way to get valuable services that an entrepreneur might otherwise not be able to pay for. It’s also often the most neglected aspect of bootstrapping, perhaps because it’s so obvious. In addition to the contacts that can be found within the entrepreneur’s network, there are also additional resources available. Ultimately there has to be an exchange of value, but that exchange does not always have to be paid for by the business owner in cash. Providing experience to work in an industry or on a specific task can often be all the value a service provider may require. In these cases, employing interns can be an important strategy to bootstrapping any business. While some cash considerations may be required, here the primary value sought is experience. This isn’t always the most ideal situation, and the entrepreneur can find him/herself spending more time helping the interns than they help the company. But with the right individuals, this can be an invaluable strategy for any business owner to employ human capital to growing a business without the cash typically required to do so. 9 Pre-Sale – Established businesses purchase their inventory with cash or credit and then resale that inventory to their customers. The dilemma for new entrepreneurs is that they may not have the cash or credit to purchase that inventory. In these cases many business owners rely on pre-selling their goods or services to generate the cash to purchase those goods or provide those services. Take Shelly for example. Shelly had an idea to make trendy laptop covers that protect computers from scratches and spills. She had enough money to make a dozen prototypes, but her manufacturer wants $10,000 do produce a skew of 2000 items. Shelly had planned to sale the covers directly to consumers over an internet store that she recently had designed. She spent all of her last savings and maxed out her credit cards to produce the prototypes and get up her website. Here, Shelly could possible take her designs to an established distributor or to a chain of computer accessory stores and sell a large order. By requiring payment in advance, she could use the funds to produce the items required for the supplier and would perhaps have inventory left over to sale to the public. Access to Credit – Entrepreneurs often have more access to credit than they often realize. At the simplest level, individual business owners have their own personal credit lines in the form of credit cards. Entrepreneurs can always take out additional lines of credit and can consolidate multiple lines of credit into temporary interest free accounts. In addition small business (SBA) loans are available for new business owners, where entrepreneurs can often get more access to capital or better terms as a business owner, than they would as an individual. In addition, larger lines of credit can always be secured against personal or real property. Banks and other lending institutions will collateralize real estate, stock portfolios, and other liquid assets and lend capital to entrepreneurs. These loans are often in the form of a line of credit, which is similar to a credit card, but often with much great access to funds. In lieu of these assets, an entrepreneur can use the assets of their friends and family to secure the loan, and in some cases can even secure the loan against their receivables or through letters of intent to purchase their product. In addition, entrepreneurs can often get equipment leasing for general office necessities or for hard assets required in the product of their product. In these cases, the supplier may provide credit terms for the lease agreement. Barter – In the world of start ups, talent is often a more bountiful commodity than cash. Fortunately most entrepreneurs need cash to buy talent. Where cash is not available, entrepreneurs can always rely on bartering their skill set to get work done that is needed. 10 For example lets say Mike and Janet are web developers working on the latest and greatest web 2.0 site. They need to get their corporation set up and require the help of attorney in drafting their bylaws. Richard is a hard working, and perhaps less creative, attorney who wants to get a new website up to promote his legal practice defending the rights of K9s. Here, Mike and Janet can offer their web services to Richard in exchange for his legal services. While this process certainly takes longer than simply paying cash, it is an extremely important alternative when cash may not be an option. 11 Raising Money from Friends and Family Raising capital from close personal contacts often sustains the life of an early stage business. There are many advantages as well as risks to this strategy. In addition there are a variety of legal implications and procedures that must be considered. Easier to Raise Capital – the money that an entrepreneur raises from their friends and family is often the easiest round of financing to close. The trust factor has already been established and the financers are typically lending more based on that relationship of trust, rather than a thorough analysis of the business opportunity. Faster Time to Close – One of the more challenging parts of raising capital is the time aspect. For the most part, no matter how long an entrepreneur expects its going to take, it will take longer, often much longer. Investors take a great deal of time on due diligence and will sometime delay the funding process to have more leverage in the negotiations. By contrast, the friends and family round is typically the fasted round of financing for the entrepreneur to close. Best Terms – an integral part of any round of financing is the term sheet. Investors will negotiate the valuation of the company as well as the right and privileges of their stock. At times the interests of the entrepreneur and the investors may not be aligned and there may be a stalemate in the fundraising process. Issues relating to the terms typically are less prevalent in the friends and family round. The entrepreneur can keep a larger percentage of his/her company and they don’t usually have to make as many concessions. Leverage for Future Rounds – subsequent investors (angel and VC) often want to see that the entrepreneur has some “skin in the game”. Namely, that they have risked their own resources of time and capital into the venture. Investors are more secure in putting capital into a company where the entrepreneur as co-invested a substantial amount. Other ways entrepreneurs demonstrate this is by raising capital from their friends and family. Outside investors may be more likely to invest in a business where the entrepreneur has raised money from those sources first, because they know the entrepreneurs won’t want to loose the money of all their closet relatives. Pressure & Harm – along with the benefits there are some unique risks. Raising money from friends and family usually has more pressure associated with it than outside investors. Whereas, professional investors understand the risks and perhaps have the capital to spare, entrepreneurs have a much heavier weight associated with taking capital from their loved ones. Sometimes this is an important variable that drives the founders towards success. But the pressure to keep the capital investment secure can often cause harm to personal relationships. In addition, to protecting the investment, arguments can also rise when money is made and it was unclear how the profits or windfalls were supposed to be spilt. 12 Legal Issues with Raising Capital Federal Security Laws The Federal Security and Exchange Commission (the SEC) regulates the sale of securities. The Securities Exchange Act of 1933 (§5) makes it unlawful to solicit or sell securities unless a registration statement is filed with the SEC. However, certain exemptions may apply. Regulation D of the Code of Federal Regulations governs the limited offering and sale of securities without registration; rules 501-506 set forth those exemptions. Rule 506 of Regulation D is considered a safe harbor because it does not place any limitations on the amount of investment than can be solicited. The rule does require the following: (1) an exclusion of any general solicitation or advertising; (2) an offering to no more than 35 non-accredited, but sophisticated, investors who have knowledge and experience in business matters; and (3) access to disclosure documents and the opportunity to investigate the offering. Furthermore, Rule 506 allows for an offering to an unlimited number of accredited investors. An accredited investor is defined, in part, as “Any natural person whose individual net worth at the time of his purchase exceeds $1,000,000 or any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years”1. In addition institutional investors such as a bank, broker or dealer, insurance company, investment company, SBA-licensed Small Business Investment Company, or other investment funds are considered the same.2 If the offering qualifies under one of the private placement exceptions under rule D, then to obtain a valid exemption from registration, Form D must be filed with the SEC no later than 15 days after the sale of the private securities. State Security Laws The California Corporations Code §25110 sets forth the requirements for qualification for a transaction of securities. It states that it is unlawful for any person to offer or sell any security in an issuer transaction unless such a sale has been qualified or unless such security or transaction is exempted or not subject to qualification and that any offering to the contrary shall be considered an unqualified offer or sale. 1 CFR Regulation D Rule 501(a)5-6 2 CFR Regulation D Rule 501(a)1-2 13 A variety of exemptions are included in the California Corporations Code3. Most similar to the federal exemptions are those include in §25102(f)(1-4) which include provisions to the following: (1) sales of the security are not made to more than 35 persons, including persons not in the state; (2) all purchasers must either have a preexisting personal or business relationship with the offeror or any of its partners, officers, directors, or controlling persons, or managers; (3) or if not affiliated with the offeror must be reasonably assumed to have financial experience and the capacity to protect their own interest in connection with the transaction; (4) each purchaser represents that they are purchasing for their own account and not with a view to or for sale in connection with any distribution of the security; and (5) the offer and sale of the security is not accomplished by the publication of any advertisement. SEC.gov Resources The Security Exchange Commission provides a variety of online resources for investor and entrepreneurs to navigate their way through the morass of legal issues related to offering securities. Listed below are key excerpts from the site with links to additional resources and forms. Regulation D Offerings: http://www.sec.gov/answers/regd.htm Under the Securities Act of 1933, any offer to sell securities must either be registered with the SEC or meet an exemption. Regulation D (or Reg D) provides three exemptions from the registration requirements, allowing some smaller companies to offer and sell their securities without having to register the securities with the SEC. For more information about these exemptions, read our publications on Rules 504, 505, and 506 of Regulation D. While companies using a Reg D exemption do not have to register their securities and usually do not have to file reports with the SEC, they must file what’s known as a "Form D" after they first sell their securities. Form D is a brief notice that includes the names and addresses of the company’s owners and stock promoters, but contains little other information about the company. 3 A comprehensive list of exemptions can be found in the CCC §25111, 25112, 25113, 25140, and 25143 14 Accredited Investors: http://www.sec.gov/answers/accred.htm Under the Securities Act of 1933, a company that offers or sells its securities must register the securities with the SEC or find an exemption from the registration requirements. The Act provides companies with a number of exemptions. For some of the exemptions, such as rules 505 and 506 of Regulation D, a company may sell its securities to what are known as "accredited investors." The federal securities laws define the term accredited investor in Rule 501 of Regulation D as: 1. a bank, insurance company, registered investment company, business development company, or small business investment company; 2. an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million; 3. a charitable organization, corporation, or partnership with assets exceeding $5 million; 4. a director, executive officer, or general partner of the company selling the securities; 5. a business in which all the equity owners are accredited investors; 6. a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase; 7. a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or 8. a trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes. Requirement for Private Placement Memorandum A Private Placement Memorandum (PPM) is a standardized legal document that contains the relevant background and financial information typically required to transfer private securities. As noted above, investors must reasonably be able to protect their own interests, and must have accessible to them all available information about an investment. The PPM includes an executive summary, risk factors, use of proceeds, shares of the company, shareholders agreement, stock incentive plan, principal shareholders, management and management compensation, method subscribing and how to subscribe, and additional relevant information. Perhaps most important, a PPM also includes the subscription agreement which is the actual sales contract for purchasing the securities. This document includes the signature of the potential investor and thereby commits them to the purchase of the securities. In this way a PPM is differentiated from a business plan which is 15 typically not considered an offering of securities. Business plans typically include an executive summary, business concept, description of the business industry and venture, marketing plan, corporate structure, risk assessment, action plan, financial plan and statements, financing and capitalization, and references. PPMs and business plans have many similar components and often business plans either make up a substantial portion of a PPM or are attached in their entirety as an appendix. However, a PPM contains more relevant information for potential investors. A private placement memorandum should typically always be sought if a company plans on offering private securities. A sample table of contents for a Private Placement Memorandum Includes: C Corporation vs. LLC Advantages and Disadvantages of an LLC A limited liability company ( LLC ) provides shareholders with many of the same protections at a C Corporation and safeguards their actions from personal liability. Indeed, an LLC may even provide extra protection at times because its structure is less formalized and requires less reporting. Therefore, there are not as many causes for action to pierce the corporate veil or treat the company like an individual. Overall there is much less paperwork to file and technical procedures that have to be followed to maintain an LLC. A LLC is considered a pass through entity for tax purposes, which means that shareholders in an LLC only have to pay taxes on their personal gain and nothing in corporate tax. Shareholders are taxed in proportion to their ownership percentage. This is a tremendous advantage for start-up companies who can avoid 16 business and sometimes personal taxes when the company is growing and before it begins to show a profit. In addition, a LLC uses an Operating Agreement instead of By-Laws, which are typically easier to amend. In addition, an LLC may be an advantageous vehicle for start up entrepreneurs if their company is going to show a loss. Here the members of the LLC may be able to take the losses associated with the business and use them to reduce their tax liability on their ordinary income. They can typically do so to the extent of their basis. In contracts, the losses accrued under a C Corporation can not be passed on to the shareholders. Rather they can be carried back 2 years or carried forward 20 years to reduce the gains to at the corporate level. There are some drawbacks to using a LLC. Most states cap the number of members a LLC can have. For this reason, and others, LLCs are not the preferred method of incorporation for public companies or companies that intend to eventually have an IPO. LLCs are a relatively recent corporate invention, and as such, the courts are still analyzing their benefits versus potential drawbacks. While the benefits to the business owners are clear, courts may begin to take a more hard-line approach to the freedoms extended to LLCs. In addition an LLC is a more difficult vehicle to use in a venture business. Where there are numerous investors and equity stakeholders, the ability to offer shares and stock options is very advantageous. An LLC is much more limited in its ability to provide for the division of equity amongst many different parties. In addition, venture capital firms are hesitant to invest in companies that are structured as an LLC. Typically they will require that the LLC be converted to a Delaware Corporation before the investment is made. When this conversion is anticipated early on, the process of turning an LLC into a C Corporation can be a relatively hassle free process. Advantages and Disadvantages of a C Corporation A Common Law Corporation (C Corp) is the most recognized and common entity for large corporations and public companies. Both the public and the courts are familiar with the structure of the C Corp and there is a general sense of security that accompanies dealing with this type of entity. Like a LLC, a C Corp affords its shareholders limited liability. However, unlike a LLC, a C Corp can have an unlimited amount of shareholders and is the preferred type of vehicle when taking a company public. A C Corp has disadvantages, especially for start-up companies. Most notably, it is the only corporate entity that is taxed twice, both on its corporate profits and on the profits to its shareholders. In addition, the filing and reporting procedures for a 17 C Corp can be complicated and cumbersome. However, C Corporations are the preferred entity for most investors. Incorporating in Delaware vs. California Delaware is widely regarded by the business community as the friendliest state to corporations and is typically where many public companies incorporate. Foremost, directors and officers are usually afforded the most protection by the Delaware courts. The courts are considered very knowledgeable about business affairs, and due to their case load, stay current with modern business trends. However, to incorporate in the state businesses have to pay the Delaware Franchise Tax, which is determined based on the capitalization of a company, which can be a significant cost. By contrast, California courts can be uncommonly tough on management, but there are advantages to incorporating in California. If the company is primarily based in state, there may be cost savings associated with remaining. In addition, if litigation is brought against the company, shareholders would not necessarily have to travel to a different state to try the case. The most important reason for incorporating in California may be §2115 of the California Corporations Code, which mandates that California rules apply to corporations incorporated in another state if the corporation is primarily based in California. Under this rule, a company would be responsible for both CA laws and the laws of the state they incorporate in, as long as it can be established that the company is principally based in CA. 18 Angel Investors vs. Venture Capital Angels Investors and Venture Capital firms may ultimately end up investing in the same deals, but they typically enter during different stages in the lifecycle of a business. There are some important distinctions to note. Angel Investors -Individual, accredited investors -Got coined “angel” from financers of theater productions in the early 1900’s -Typically have industry expertise in the area they are investing -Provide early-stage investment -Serve as a bridge between Friends and Family and Venture Round -Can tolerate loss of entire investment -Typically invest 25K -1.5M dollars -May invest individually or with groups of other angels -Offer guidance and advice to management team Venture Capitalists -Typically general partners investing 3rd party money -Do not typically provide early stage investment -Diversified portfolio expecting a large home run on approximately 1 out of 10 deals -Need to generate a specific return on investment (usually around a 25-30% internal rate of return annually across the entire portfolio) -Will remain active in the management of the business -Typically will required a board seat and may seek majority control -Investment size typically ranges between 1.5M and 10M -Some venture firms are set up to invest in early stage companies and make investments more similar in scope to those of an angel or angel group 19 20 California Angel Investor Groups http://www.gaebler.com/angel-investor-networks.htm • Angel Capital Network • AngelsCorner • Aztec Venture Network • Band of Angels • California Investment Network • Idealflow Angel Fund • Maverick Angels • North Bay Angels • Pasadena Angels • Sacramento Angels • Sand Hill Angels LLC • Silicom Ventures • TechCoast Angels • TENEX Medical Investors • The Angels' Forum LLC Trends in Angel Investment According to the Center for Venture Research at the University of New Hampshire: • 2006 – invested 25.6 billion (51,000 deals) • 2006 – approximately 240,000 individual investors • 2005 – invested $23.1 billion (49,500 deals) – Increase of 2.7% in $’s over 2004 – Increase of 3.1% in deals over 2004 • 2004 – invested $22.5 billion (48,000 deals) • 2003 – invested $18.1 billion • 227,000 active angels – 20% Healthcare/medical devices and equipment – 18% Software • 55% in seed/start-up • 43% in post-seed/start-up (10% increase over 2004) Sector Healthcare Software Biotech Retail Financial/Bus Prod Industrial/Energy Deals 21% 18% 18% 8% 6% 6% 21 Typical Term Sheet Clauses 22 VC Trends • 2005 – invested $21.7 billion (2,939 deals) • 2004 – invested $20.9 billion (2,876 deals) • 2003 – invested $18.9 billion • Increase due largely to late stage investments: $9.7 billion in 2005 $7.2 billion in 2004 $4.9 billion in 2003 Less than 2% in early/seed stage Investment Criteria 23 Valuation Methods 24 25 26 Appendix I. List of Venture Capital Firms in California (excel spreadsheet) II. Financial Projections Template (income statement, balance sheet, cash flow statement) III. Sample Finders Fee Agreement IV. Sample Non Disclosure Agreement V. Sample Private Placement Memorandum VI. Rules Related to Regulation D VII. Form D (to offer securities) VIII. Angel Investment vs. Venture Capital (Foster Center for Private Equity) IX. Angel Investing (Foster Center for Private Equity) X. Private Placement Memorandum Subscription Agreement (Greenberg Traurig LLP) XI. Sample PowerPoint Presentations used to Raised Capital (early stage and late stage)