Raising Operating Capital Part 3 Chapter 6
Jun 28, 2010
The theme of my Blogs for this year is what I would include in a book about small business finance and accounting. This month is the last of several articles on raising funds for the Small Business.
Remember, Never! Ever! Run Out of Cash, NO MATTER WHAT! But that is often easier said than done, so this month we will continue our discussion on why a good business plan is required to source funds as we look at sourcing outside investment capital. It should be noted that the cost of capital models generally show that equity investments are the most expensive forms of capital. I won’t bore you with the math at this time, but it has to do with a number of factors including the risk premium associated with ownership investment Vs other types of capital investments.
We will discuss three sources of outside capital. They are used at different stages of the enterprises development. Early investors invest in management. Later stage investors invest in potential synergies, market expansion, processes and systems. All look for the exit strategy and anticipated ROI for the funds invested over the time horizon leading up to that exit.
Accordingly, following are sources of outside financing for various applications and stages of developments:
1) Angel Investors (Early Stage)
2) Venture Capital Investors (Development Stage)
3) Mezzanine Financing and other hybrid financing vehicles (Various Stages)
4) Private Equity Groups (Later Stages)
Each of these groups has planning horizons and expected returns on investments during that time frame. Again, the business plan must clearly articulate the information they need to initially assess the investment. Part of the goal is to answer the questions they may ask in the document. This is particularly true of the planned exit and timing. Let’s look at these areas separately.
This is a group that can source funds for early stage development. Typically they fund transactions with capital of up to approximately $1 million. These early stage investors are looking for companies with potential to significantly increase in value. They look for their seed capital to fuel the initial growth of the company.
Venture Capitalists typically look to invest $5 million or more. They are medium term investors that look for an exit generally in three to five years. This could be through a sale, public offering or other exit that yields an acceptable return on their investment.
No Man’s Land
In between Angels and Venture Capital is “No Man’s Land”. Capital needs in this range almost always come from either lenders or internally generated funds. The company needs to grow through this segment to reach the next level of financing. That is where an alternative to pure debt or equity to grow the company can be considered, mezzanine financing.
Mezzanine & other Hybrid Investment Financing
Mezzanine financing may also be referred to as subordinated debt and is used as bridge financing. Typically it has an interest rate significantly higher than market (often 400 – 600 basis points), warrants for shares at a discounted strike price and/or other debt to equity convertibility features allowing conversion to common shares of stock. Also there may be terms that ratchet ownership in the event of default. The advantage to the lender is that they are ahead of all equity holders in the event of bankruptcy liquidation.
Another hybrid investment is the use of Preferred Stock with convertibility features allowing conversion to common stock. This stock typically, but not always, has no voting rights. Again they are preferred above the rights of the common shareholders in the event of default or bankruptcy liquidation.
Private Equity Groups
Private Equity Groups (PEGs) can be used in a number of way to provide growth capital. They can take out dissident shareholders, create a new platform investment in their portfolio of companies for a particular industry or add to an existing platform investment for a specific industry. They can assist in an Mergers & Acquisitions campaign and can also be used as an exit strategy for the current ownership. Typically these are financial investors focused primarily on investment returns, though occasionally a synergistic valuation may be used for platform additions.
So regardless of where you plan to source capital, internal, external, debt, or equity, a solid business plan with associated projections is essential to clearly articulate why you need the funds and how they will be used to achieve the goals of the investor/lender, including repayment and return on investment.