GPSolo Magazine - April/May 2004
When Clients Venture Among the Capitalists
Ask a few people about their definition of the term venture capital and you’re likely to hear a host of descriptions, from “financing for new businesses” to “capital that’s subject to more than the normal degree of risk” to a knowledgeable “independently managed, dedicated pools of capital that focus on equity or equity-linked investments in privately held, high-growth companies.”
All the replies are accurate to some degree. Venture capital is a catchall term that describes an illiquid equity investment in a privately held company. The company may need seed, development, or early or later-stage capital; but in all cases, to secure an investment, your client will need to convince potential investors of its ability to execute a high-growth strategy.
Venture capital funds typically are run by investment professionals who have a fiduciary responsibility to their investors and thus pay strict attention to corporate housekeeping, business planning, management team building, internal projections, document preparation, and due diligence of the companies they invest in. How this information is presented in the proposal can be critical to a successful capital raise.
Business owners often turn to a lawyer after having met with several different investor groups and having been unable to obtain funding. Nine times out of ten, the client was introduced to a few investor groups as a “favor” to a friend of the owner, CEO, CFO, etc. This a highly ineffective way to raise funds; moreover, after several months of talking with investor groups and getting nowhere, you and the client’s deal will appear tired and shopworn—as much as one tries to be discreet, eventually the street has a way of knowing who’s out there knocking on doors.
Finding the Right Fit
Raising capital is an extremely time-consuming and labor-intensive process. Selecting, engaging, and working with well-respected and experienced outside advisers, other counsel, bankers, and auditors early in the process can be crucial to a successful raise. Remember, an investor group of venture capitalists (VCs) probably looks at 300-plus companies a year; your client has got to stand out.
Do as much research as necessary to ensure both you and your client understand the VCs’focus and their investment objectives. VC funds produce exceptional internal rates of return for their investors; this is how they stay in business and raise capital for future funds. A successful venture must be able to meet or exceed the group’s internal objectives—as a guideline, typically a 30 percent or higher annual return.
The next most important point is to know what the proposal is worth. The business owner who creates a company often acts like a parent whose child wasn’t chosen for the lead in the school play—parents just don’t believe they have an ugly baby—but not understanding how a company is valued by potential investors is probably the single biggest deal killer there is. The value of the company must be based on solid financial information. The client must know how comparable publicly traded companies are valued, what mergers and acquisitions have been going on in the industry, how to value the client’s future cash flows through discount cash flow (DCF) analysis, and the historical growth rate of the industry as well as the project rate. In each of these areas, the most compelling details will be those that make investing in the client’s company too good to pass up.
Industry focus is another important investment criterion. Funds often are focused on a certain market sector—consumer products, technology, biotechnology, media. Your client’s investment opportunity must fit within the fund’s industry focus. Also essential is knowing in advance the size of the fund as it relates to the amount of investment your client wants. A fund with $250 million to invest will have a hard time justifying a $5 million venture because doing the due diligence and working with that company take the same amount of time and effort as a $20 million investment. It’s simply not prudent for the fund to work with $5 million at a time and then stay on top of 50 companies’ activities.
Additional factors that should be investigatedbefore presenting to an investor group are stage of development (is the company looking for seed capital or is it in a later stage of development?), funding round (is this the company’s first round or a later round of capital?), and geographic location (many investors insist that their funds cover only specific areas of the country).
Nuts and Bolts
In my experience, business owners often forget that wealth creation is best achieved by focusing on executing the plan to build a successful company rather than by having lawyers puff up owners’ egos while nitpicking valuation issues and ownership interests. From the VC perspective, nothing is higher on the priority list than management, management, and management. Management with a strong, proven track record and relevant skill set is the most important factor in evaluating an investment. How your client’s management views the business and the individuals’ experience, industriousness, and commitment and willingness to work with new partners are all factors that can further a positive result.
In preparing for the meeting, always keep in mind that the business plan or confidential information memorandum you and your client create, as with all forms of communication to potential investors, must present the company in the best light. Be sure all documents are credible and accurate and that they cover every aspect of the company the potential investors may query: the opportunity and market size and segments; all variables including customers, technology, distribution, and competition; management skills and experience; marketing strategy and sales plans; strategic relationships; and current and projected financials. This information must be clear and must be able to stand up to the strictest due diligence examination—and be able to help you and your client present the business opportunity in an enticing and compelling manner.
Depending on the size and developmental stage of a company, several other types of funding options may be available. But be sure your client is clear about the distinction between debt and equity. Debt is some form of a loan to the company, while equity represents an ownership stake. Growth capital typically is some form of equity.
• Banks and other commercial lenders are not in the business of providing growth capital. Senior debt commonly includes funds that are borrowed from banks, insurance companies, investment banks, or financial institutions, as well as notes, bonds, or debentures not defined as junior or subordinated. (“Junior” and “subordinated” refer to the order of repayment behind a “senior” credit facility.)
• In the lending category are companies looking to expand or acquire business or other assets, to repay debt, and to repurchase equity, and companies with working capital needs. Lenders review a number of factors in determining ability to repay debt. Commonly, inventory and/or accounts receivable, operating profits, or potential asset sales are taken into consideration.
• Commercial financing comes in a variety of forms, with lines of credit, revolving loans, and term loans the most frequently used. Commercial loans and letters of credit also are common debt structures for closely held businesses. Lease financing and factoring can help to reduce working capital needs as a business grows.
• Mezzanine capital became the “hot” funding vehicle as banks and other lending institutions tightened their criteria after the bubble burst in 2000. Mezzanine capital occupies the place in between the high-risk VCs and security-oriented commercial vendors. It fills gaps in the company’s capital structure between equity and senior secured debt.
Mezzanine investors typically have a medium-risk tolerance, look for current financial results (i.e., that the company is currently performing), want positive operating income, will accept a junior collateral position, and work within a flexible structure (usually subordinated debt with warrants or some other equity feature, or preferred stock). Funding may be used for buyouts, recapitalizations, acquisitions, and growth past a point at which a senior lender would feel comfortable but below the level an equity investor would be willing to provide.
Mezzanine lenders can be viewed either as cheap equity or expensive debt. The debt will carry a current coupon of 10 percent to 14 percent, with an equity component that will yield the investor an internal rate of return between 15 percent and 30 percent. As with VC funds and commercial lenders, a well-articulated plan will give your client the best chance of attracting mezzanine funds.
As with all financial transactions, you and your client must weigh the pros and cons of all options. Cases that involve existing debt may require additional information or explanation: The client must be able to clearly explain the purpose of the financing, the amount of money needed, time period the funding will be necessary, possible collateral, and whether the client will personally guarantee the repayment. A business plan including information on the client’s industry and an overview of the company’s history and future should accompany applications to any of these sources.
Navigating the Process
Many companies seeking funding never obtain it. One of the reasons for this is what I call the “entrepreneur’s curse”: They like to do it themselves, their way! But seeking outside advice is nowhere more critical than in bringing outside investors into a company.
The multitude of corporate governance issues that need to be addressed in any financial venture fairly demand the assistance of a skilled attorney, and the same principle may be true in terms of a lawyer’s knowledge of business capitalization. Don’t be hesitant to secure outside guidance that might benefit you and your client. Engage an experienced and objective investment banker to help determine valuation and structure and to review—or even present—the company financials if this will help. Raising capital signals an exciting time in a company’s development; the trick is all in increasing the odds.
Julie A. Garella is the managing partner of McColl Garella, LLC, an investment banking firm in Charlotte, North Carolina, that focuses on middle-market companies. She can be reached at firstname.lastname@example.org.