Why Raise Capital?

Most new businesses are built without raising substantial amounts of outside capital. They are founded with small infusions of cash from the founders, perhaps augmented by support from relatives or wealthy individuals. In doing so, the founders avoid the effort and dilution of raising capital from institutional investors. The vast majority of small businesses remain small, and their founders are happy maintaining family control and pursuing modest growth.

However, most business owners and management teams eventually reach a crossroads. Should they take on outside financing to fund future growth? Should the shareholders diversify their personal net worth by selling stock in their business to provide personal liquidity and enhance their financial security? If they do, will they have to give up the operating control that made their companies successful in the first place? These are very good questions to consider.

Once the decision is made to seek outside capital, entrepreneurs and management teams can use equity and/or debt capital to achieve a variety of business objectives.

Reasons to Raise Capital

Shareholder Liquidity allows founders and other shareholders to diversify their financial holdings while retaining some control of their businesses.

Recapitalizations provide liquidity for shareholders seeking to sell the majority of their business, while allowing them to retain more operational leadership or to work with the financial partner to bring in a new management team.

Growth Capital allows businesses to expand more rapidly or take advantage of opportunities requiring immediate capital. It may require relinquishing some ownership.

Acquisition Financing allows businesses to expand through strategic acquisitions.

Leveraged Buyouts enable management teams to take control and receive ownership stakes in companies acquired from founders, corporate parents, inactive founders, or other significant shareholders.

How Much Capital Should You Raise?

Since a company grows in value as it progresses, the founders can minimize their dilution by raising only as much money as necessary at each stage of growth. Ideally, you would raise money just as you need it, but that would require precise vision, constant fundraising and preoccupy management with selling stock as opposed to building and selling a product or service. Because investors tie the growth in the value of the business to the achievement of demonstrable milestones, increases in the business’ valuation can only be realized in a stepwise fashion.

So the answer to the question, "How much capital should we raise?", becomes apparent. You should raise as much capital as is necessary to get to the next major milestone that will justify a substantive increase in the company's valuation. When it comes to cash, the cost of under funding vastly exceeds the cost of over funding. It is therefore prudent to add a cushion to the estimate of how much capital is required to get to the next milestone - 50% is customary.

Prudent CEOs raise more capital than they think they'll need and rarely turn away capital in an oversubscribed round. There are two reasons why taking too little cash and running out is so costly. First, it puts the company in a very weak position when negotiating price with a new investor. More importantly, it reveals a lack of ability to forecast the future and therefore undermines new investors' confidence in management's plans.

If it is available, Take The Money!

Alternative Financing Sources

Friends and Relatives. Many companies have financed their development stages through the help of friends and relatives. Points to consider include: (1) how much equity to give to these early investors; (2) how to keep family relation-ships intact if the venture fails; and (3) involvement of family members in the daily operation of the business. Be sure to consult an attorney specializing in venture-backed deals for guidance on proper structuring to avoid possible hang-ups later.

Angels. Angels are investors in small companies using their own money. Many of today's more active angel investors created their own wealth in successful entrepreneurial companies. Angels provide funding and a varying range and depth of value-added assistance to the entrepreneur. Many of the new breed of angel investors have organized into formal and informal groups, many of which have staff to screen and do initial evaluation work on business plans submitted by entrepreneurs seeking funding. These groups are far more organized and active than the "investment clubs" of the early 1990's.
There is no organized registry or listing of angel investors or groups.

The best way to contact these financing sources is through local chambers of commerce, economic development authorities, business incubators and local universities.

Debt Instruments. If the business opportunity you are pursuing is the purchase or expansion of an existing business, you may want to consider various debt instruments. Advantages include retaining equity, fixed interest payments and flexible payment or payback terms. Bank financing is the most familiar form of debt to most company owners. The advantages to bank financing are lower interest costs and no equity requirements from the lender. Bank financing is generally available to companies with higher levels of revenue and cash flow. For smaller and mid-sized businesses, especially businesses in service industries where little to no assets exists, bank financing becomes increasingly difficult. Owners of smaller to mid-sized business looking to secure bank financing will almost always have to grant personal guarantees and put up collateral outside the business as well.

Convertible and subordinated debt is useful for companies that have a high degree of risk but do not want to give up a large portion of equity. The conversion feature of convertible debt or warrants associated with subordinated debt are attractive to investors or banks that typically make loans but require equity participation for their added risk.

Joint Ventures. These have become increasingly popular for medical/biotechnology companies in the past few years, but any company can benefit from having a strong corporate partner. Joint venture agreements must be carefully structured to avoid relinquishing major shares of royalties or marketing rights to the partner. Expectations for both sides should be carefully documented and enforceable.

Private Equity / Venture Capital. Venture capital organizations are generally privately held partnerships or corporations that invest alongside management in young, rapidly growing or rapidly changing companies. They invest large quantities of long-term risk capital, usually seeking capital appreciation rather than cash repayment. Unlike other financial intermediaries, venture capital professionals add value to their investments by actively participating in the oversight of their portfolio companies. They function in a dual capacity as financial partner and strategic advisor, providing the entrepreneur risk capital to fund the venture’s growth and expert business counsel to ensure the enterprise’s survival and competitive positioning in the marketplace.

Corporate Partners. Corporate investors represent a double-edged sword to small companies. They can bring great resources to bear. They can also impose ponderous decision-making processes on fragile small companies. Venture capitalists only have one agenda in their investing, the maximization of stock value. That happens to be the same agenda as the company's founders. Corporate investors usually have a more complex and less compatible agenda in mind. The people making initial investment frequently change jobs and the relationship with the company can fall hostage to corporate politics. Finally, a corporation focuses primarily on their own success. If that company's core business takes a sudden downturn, the relationship can suffer through no failure of performance on the part of the funded company. In our view, business relationships with large corporations (such as marketing or technology agreements) should stand on their own feet without the complication of an equity investment.

Revenues. The least dilutive way to finance a company is with its own cash flow. The obvious benefit to growing with internally generated cash is the avoidance of dilution to the owners. The reality for most small businesses however, is that this method can rarely provide enough capital to achieve a high level of growth.

Once the decision is made to raise outside capital it is critical that the effort is organized and well thought out. No matter which avenue is pursued a solid business plan with projections, a concise presentation and well organized data to back up your plan are critical to successfully securing capital. Business owners truly only get one chance to make the right impression when presenting to investors so take the time to carefully prepare.

Karl Buettner (610-560-4700 x 101) is a partner and Christopher Jansen (610-560-4700 x112) is a Managing Director at Gatehouse Ventures, LP.

Gatehouse Ventures, LP, is a private equity firm specializing in leveraged buyouts and leveraged buildups in partnership with qualified management teams. Gatehouse focuses on companies with market values between $5 - $20 million and where our principals can leverage their expertise to drive value for our partners.

www.gatehouseventures.com

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