Notices
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While Graham Segal trading as Chiron! the business doctor.™ has made every effort to ensure that this work is free from error or omissions, he expressly disclaims all responsibility for injury, loss or damage occasioned to any person acting or refraining from action as a result of material in this work whether or not such injury, loss or damage is in any way due to any negligent act or omission, breach of duty or default on the part of Graham Segal trading as Chiron! the business doctor.™. Graham Segal trading as Chiron! the business doctor.™ shall not therefore be liable for any damages whatsoever arising from or attributed to this work.
This work is sold or distributed with the understanding that Graham Segal trading as Chiron! the business doctor.™ is not engaged in rendering legal, financial, accounting, securities, investments, taxation or other professional services. If professional assistance is required by any person following reference to this work, such person should seek the services of a competent professional.
The fact that an organisation or web site is referred to in this work as a citation and/or a potential source of further information does not mean that Graham Segal trading as Chiron! the business doctor.™ endorses the information that the organisation or the web site may provide or recommendations the organisation or the web site may make. Further, readers should be aware that internet web sites listed in this work might change or disappear between the publication date of this work and when it is read.
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PLEASE READ THIS IMPORTANT NOTICE
Please do not distribute this eBook to others. It is for your personal use only. Unauthorised distribution of my eBook constitutes theft of my intellectual property. If you want to send a copy of my eBook to one or more friends, colleagues or even employees, please email the publisher who has additional copies ready for downloading at very substantial discounts of up to 90% on the initial selling price. Cheap as chips, really.
Production and Publication
The Venture Capital MasterClass: everything you always wanted to know about raising equity capital ... but, until now, you had no one to ask
Publisher:
Graham Segal trading as Chiron Proprietary Publications™
23 Rex Street, Eastern Heights 4305 Queensland, Australia
Telephone: 61 (0) 405 702 644
Web: http://chironthebusinessdoctor.com
Email: chiron@chiron.itsonline.com.au
© Graham Segal, Author. December 2012
First published 2013
This book is copyright. Apart from any fair dealing for the purpose of private study, research, criticism or review, as permitted under the Australian Government’s Copyright Act 1968 as amended, no part may be reproduced by any process without written permission of Graham Segal trading as Chiron! the business doctor.™. Inquiries about this work should be addressed to the publisher.
Library Cataloguing-in-Publication entry:
Segal, Graham. 1941– .
‘The Venture Capital MasterClass: Everything you always wanted to know about raising equity capital ... but, until now, you had no one to ask’
1. Venture Capital.
2. Islamic Finance.
3. Islamic Finance Venture Capital.
4. Small Scale Investments.
5. Small Scale Public Offerings.
6. Entrepreneurship.
7. Business Introduction & Matching Services.
8. Business Management.
Cover design: Damien Segal, Consultant Web Designer (chiron@chiron.itsonline.com.au)
Logo design: Damien Segal, Consultant Web Designer(chiron@chiron.itsonline.com.au)
In equity raising, winning isn’t everything, it’s the only thing
Paraphrased from a quote from Vince Lombardi, the very famous coach of
the Green Bay ‘Packers’, the renowned American football (grid iron) team
Foreword
FOREWORD
By
Nick May
Founding Director of EcoHydra Technologies Ltd.
A company registered in the United Kingdom
When I was in the process of launching a healthcare products business back in the early Noughties, my associates and I were fortunate enough to be introduced to Graham Segal. When I learned that his firm was called “Chiron! the business doctor.™”, my first thought was that my business wasn’t sick, so it shouldn’t need a doctor. However as our discussions with Graham progressed, I realised that what I thought I knew about setting up a dynamic entrepreneurial company was just the tip of the iceberg.
I was in an interesting position, in that I had originally been an investor in the company as a startup. As the company had progressed, my role had morphed into being more entrepreneurial, and I was now an active director of the company. I could see that Graham clearly understood investment and management issues, and he was able to clearly articulate them.
Over the course of the next couple of years, Graham helped steer our company through a veritable minefield of issues, any one of which could have spelt disaster for the company if not handled correctly. With Graham’s guidance, our company transformed itself from being an aspiration into a thriving business with an international investor and customer base. Along the way, Graham’s dedication and good humour kept our management’s nerves steady.
When Graham told me that he was writing this book, I was delighted that his knowledge and experience would soon be reaching a much wider audience. Reading the book brought back fond memories of working with Graham. More importantly, I was impressed at the wealth of new and valuable information that I learned. This book both entertains and educates, and will no doubt become a must-read for anyone contemplating growing their business.
Nick May
December 2012
Chapter 1. Equity Capital: the friend of small business
This eBook explains how the equity raising process works and how Chiron! the business doctor.™ helps business owners and entrepreneurs like you to access the venture capital market and raise funds for the exponential expansion of your company. In particular, this eBook is extremely important to you if you are
a business owner requiring substantial funds to rapidly expand your production facilities, or undertake other significant capital expenditures, or develop and market new products or new services, or enter new markets such as international export markets, or
an entrepreneur seeking funds to commercialise a new product or new service and take that new product or new service to the market.
If you wear either of those hats, then your requirement for development or expansion funds is quite normal. If you wear either of those hats, then you are in a dilemma. On the one hand, you want to start your venture as quickly as is possible but you don’t have the funds you need. On the other hand, you may or may not be able to access loan funds, but in any event, you do not want to take out a very large loan thus saddling yourself with a substantial debt and a hefty payback commitment in terms of both money and time. Moreover, since banks and lending institutions generally require collateral and personal guarantees to underpin any loan funds advanced to you, you may also be placing substantial personal assets such as your home at risk.
That is a very limiting framework boxing you in. It leaves you no wriggle room to manoeuvre forward. Two points therefore arise from your situation. The first is that I fully understand how important it is to your future growth activities that you can tap into a source of funds so that your venture can start. The second point is that you must have assurance that the source of funds to be tapped will provide the funds you require in accordance with an agreed drawdown schedule. You don’t want to be caught high and dry with no money at a critical development point in your venture.
Equity Capital: the way to go
The most beneficial and helpful way for you to raise the necessary expansion funds you need is through the use of equity capital. Indeed, it is next to impossible to expand your business exponentially without equity capital. But, I hear you ask: ‘What actually do you mean when you refer to the term equity capital? What exactly is equity capital?’
Equity capital is money you receive from one or more investors in exchange for a share in your company. That is, you sell securities (Ordinary Shares or other types of shares) in your company that are purchased by investors who think that your company is a good bet to provide them with a satisfactory financial return on their decision to invest in your company.
‘I understand that’, you continue with your questions, ‘but just who are these investors? Are they individuals or companies? Do they have a heart? Will they be sympathetic to me? Will they like me?’ Well, investors generally fall into one of six categories of investment:
private investors
angel investors
professional investors
sophisticated investors
venture capital firms
private equity firms
Investors: who are they?
Private investors. Private investors are ordinary persons seeking to invest smaller amounts in growth companies.
Angel investors. Angel investors traditionally fund ventures that are not yet mature enough or have enough growth potential to attract the interest of venture capital firms. Angels typically invest in seed, startup or very early stage ventures.
Professional investors. Professional investors are persons covered by the definition of professional investor in Section 9 of the Australian Corporations Act 2001 (except a person mentioned in paragraph (e) of that definition); or a person who has or controls gross assets of at least $10 million (including any assets held by an associate or under a trust that the person manages).
Sophisticated investors. Sophisticated investors are persons who have the ability to invest at least $500,000 into one particular investment proposal or who own or control a defined level of capital assets as set out in Section 708 (8) of the Corporations Act 2001.
Venture capital firms. Venture capital firms are companies with investment funds contributed by external contributors that are primarily invested in early stage investments that have an expectation of high growth.
Private equity firms. Private equity firms are companies with investment funds contributed by external contributors that are primarily invested in later stage large scale investments including management buy-outs and leveraged buy-outs that often lead to initial public offerings for a listing on a stock exchange. These are the ‘big boys and girls’ of the investment industry.
Investors, whatever their category, are canny, smart, cautious, prudent, intuitive, frugal and in some cases, even parsimonious. Where their business is concerned, don’t expect them to be generous, benevolent or charitable. They will neither like you nor dislike you, they will be neither approving nor disapproving of you; but you should be in no doubt that they will examine your equity proposal on its merits.
Let’s return to the point that equity capital is funds you receive from one or more investors in exchange for a share in your company. In effect, you are bringing new shareholders into your company (one or more of whom may wish to be appointed as a director of your company) and that raises some very daunting managerial issues that you must consider in some detail before you make the commitment to pursue an equity raising program.
In turn, that brings up the important point as to whether or not you have yet considered the pros and cons of using equity capital. While equity capital is valuable to you because it does not require repayment and does not attract interest payments, there are nevertheless both advantages and disadvantages with the use of equity capital. You need to be aware of these advantages and disadvantages because although the advantages are, well, advantageous, the disadvantages have the ability to derail your business plans. I discuss the advantages and disadvantages in Chapter 4.
After you have carefully considered the advantages and disadvantages of using equity capital, and have decided to pursue an equity raising program, the next step is to consider the legal technicalities involved in raising equity capital from the public, compliance with which is a very difficult and expensive task.
Raising Equity Capital: legal technicalities
The most important of these legal technicalities is that, with one exception outlined below, the Australian Corporations Act 2001 makes it illegal for individuals or companies to raise equity capital funds directly from the public without the issue of an expensive prospectus or product disclosure statement that must be first registered with the Australian Securities and Investments Commission (ASIC). In preparing a prospectus or product disclosure statement, don’t expect much change from a cost of at least $100,000. I personally have seen prospectuses that have cost over $1 million to prepare. Such an expense to raise equity capital is clearly beyond the means of most small and mid-size business enterprises.
However, if you think $100,000 is the total cost of raising your equity capital, be prepared for another shock. The $100,000 that you spend on your prospectus is only half the bill. You next have to cover the cost of listing on a small stock exchange; for example the Bendigo Stock Exchange or the National Stock Exchange. If your venture is big enough, you could even aim for a listing on the Australian Stock Exchange. The activities associated with listing on a small stock exchange will set you back at least another $100,000!
There is another point of concern here about which you need to be aware. Prospectuses and product disclosure statements also have an in-built time-delay factor that militates against quick action. This is a consequence of the lengthy preparation and review requirements associated with prospectuses or product disclosure statements and the ASIC registration process.
A couple of paragraphs earlier I made the point that it is illegal for individuals or companies to raise equity capital funds directly from the public without the issue of an expensive prospectus or product disclosure statement that has been first registered with ASIC. There is a qualification to that in that S.708 (1) of the Corporations Act permits an individual person to make offers of not more than $2 million to be subscribed by not more than 20 investors in any rolling twelve month period that firstly, the offer may only be accepted by the specific person to whom the offer is made, and secondly, is made to a person who is likely to be interested in the offer, having regard to:
previous contact between the person making the offer and that specific person; or
some professional or other connection between the person making the offer and that specific person; or
statements or actions by that specific person that indicates that the person is interested in offers of that kind.
Clearly, that does not permit a person such as you to make equity offers to the public at large, the situation necessary to increase your chances for a successful equity raising.
Here is where I come in and provide you with the circuit breaker.
Under the terms of Class Order 02/273 issued by ASIC, I have a personal exemption from the Corporations Act requirement that makes it illegal for individuals or companies to directly raise equity capital funds from the public without the issue of an expensive prospectus or product disclosure statement that has been first registered with ASIC. A Class Order is a set of official government regulations. This personal exemption permits me to issue (that means publish and circulate) a formal Offer Information Statement (called a Class Order Compliant Document, or COCOD for short) on your behalf as a small-scale public offer to help you to raise equity capital funds.
Importantly therefore, I provide you with three crucial imperatives:
the ability to raise equity capital funds by selling securities (viz., shares) in your company,
the appropriate framework for doing so without breaking the law, and
the opportunity to raise the equity capital funds at modest cost.
So you can clearly see that I come into the equity raising equation completely on your side.
Raising Equity Capital: my exemption - your benefit
The importance of my exemption under the terms of ASIC Class Order 02/273 is that it permits you and your company to use my services to raise equity capital from the public without breaking the law. Under the law, and without my personal exemption, your ability to raise money from the public is so constrained as to be almost non-existent. The message therefore is this: don’t even try. Courts have imposed hefty fines on persons who have breached the Corporations Act fund raising laws and forced the winding-up of their companies.
Of course, to get the full benefits of my exemption, you have to formally appoint me as your equity-raising consultant to help you raise the equity capital you need. This is a necessary legal requirement that I will explain in more detail shortly. For now, let’s just review the principal benefits to you of my formal appointment as your equity raising consultant.
Firstly, I help you to raise the equity capital needed from the public through a sale of securities (shares) in your company without breaking any laws. Secondly, you will be raising the equity capital you need without having to face the high cost of the prospectus/stock exchange process that can easily exceed $200,000. Thirdly, I can help you raise the equity capital much more quickly that is generally possible through the prospectus/stock exchange process.
The Equity Raising Process: ensuring compliance with the law
Let’s look now at how the equity raising process works, and how you and I will be working together in the implementation of the process. The process of raising equity capital must be conducted in a prescribed way to conform to the law. Within that context, raising equity capital is and for success must be a collaborative effort between us. The process initially hinges on your company becoming ‘investment ready’ and ‘investor friendly’. This will be the initial priority task.
Investment readiness. Being investment ready broadly means that your company will be acceptable to investors in terms of your business plan and your Class Order Compliant Document. In turn, that simply means that your venture can be seen by investors to provide an acceptable rate of return on their investment in your company provided that you can produce the results forecast in your business plan. It doesn’t mean that investors will invest in your company, it just means that they are willing to have discussions with you about your proposals. When we get you to that stage, the conclusion of an investment agreement will be heavily influenced by two factors.
The first is your ability to develop a good rapport with investors that will portend a close, mutually beneficial working relationship (it is axiomatic that you and the investors have to be able to work harmoniously together). The second is that you personally must convince the investors that you and your management team have the capacity, capability and competence to implement your business plan successfully.
Investor friendliness. Being investor friendly broadly means that your corporate structure and business plan will give investors confidence that, to the highest degree possible, you will protect the funds invested in your company and ensure that the funds will only be used for purposes set out in the Shareholders’ Agreement. There are other important issues involved of course, and they are discussed below and elsewhere in this ebook, but confidence and protection are probably the two most critical issues from the investors’ point of view.
To get at the heart of the process, it is probably most useful if I first advise you of the key points that investors will take into account in evaluating whether or not your company or venture is a viable investment opportunity. By mentioning what investors want and how they will look at your venture or business proposition however, I do not wish to convey the impression in advance that I would be unduly critical of your venture or business proposition in any way. I simply wish to emphasise the point that the equity capital market place really is very tough and often unforgiving.
If your investment proposal and business plan is not right the first time you submit it to potential investors, it will probably be ignored. In those circumstances, there is very little likelihood that you will get a second opportunity to submit your investment proposal to the same investors. That is the importance of being investment ready and investor friendly. As I said earlier, it will be a priority task to work closely with you to bring your company or venture to the highest possible level of investment readiness and investor friendliness status.
The Categorisation of Stages for Raising Equity Capital
Equity capital from investors tends to be categorised by the status of the specific venture requiring the capital investment at the point of investment. This categorisation therefore reflects the venture’s stage of development. Investors, by dint of their own corporate investment policies and the level of funds they have available for investment, make a determination as to the nature of the projects that they will be most interested to explore, and the industries that they will invest in. Investors therefore will usually only invest across one or two of these stages and industries. The categories of investment, which are largely self-explanatory by name, are:
seed funding for research & development, and proving feasibility or viability,
startup funding to kick the venture off,
first stage funding,
early expansion funding,
development funding,
second stage funding
late expansion funding,
leveraged buy-out/leveraged buy-in funding (LBO/LBI) funding for large-scale investment & ownership change by external investors,
management buy-out/management buy-in funding (MBO/MBI funding) for ownership change by an internal management group,
mezzanine debt funding, often used to fund building and construction projects,
pre-listing or IPO (initial public offering) funding to prepare for a stock exchange listing,
business turnaround funding,
international expansion funding, and
generational transfer funding.
I must stress a most important constraint here. There are no guarantees that investors will participate in your venture. Investors, as I have pointed out earlier, by the nature of their profession are canny, smart, cautious, prudent and intuitive. Your success therefore will depend almost entirely upon your ability to justify you and your management team’s expertise and ability to be able to manage your venture to a successful conclusion, and provide investors with full details about your venture’s financial, marketing and sales forecasts.
Investor Reactions to an Equity Capital Investment Proposal
The following broad brush review of the investment process is necessarily brief. I will be going into the mechanics of the process in much more detail later, but for now, here is an outline of what goes on. You can expect that an investor favourably considering your investment proposal for the first time will initially ask you to respond personally to some questions along the following lines as a very minimum. At that stage, the investor will have already perused your COCOD and consequently will be aware of the essential broad details of your venture plus details of your equity offer. That is because a COCOD is an expanded Executive Summary of your business plan along with information about your equity offer. At this point, the investor may or may not have yet read your full business plan:
How do you verify or justify to an investor how much money will be needed to get your venture started, and sustain it through the establishment phase, at least until a cash flow is consolidated through regular sales?
Why should the investor accept your venture’s net profit projections for the first three years after startup as realistic and achievable?
What practical knowledge and expertise in the industry in which the venture will operate do you and your colleagues or management team have?
Can you present a practical, achievable and cost-effective marketing strategy to generate sales?
Can you demonstrate that your target sales are realistic, achievable and will result in cash sales?
Can you show that your venture will generate adequate and continuing levels of profitability and shareholder value?
Most importantly, can you confirm that your venture has a pro-active and experienced management team across all the fundamental business disciplines necessary for your venture, and that the team includes at least one person who has proven business management experience at a senior level?
This latter point is a particularly critical point of concern to investors.
Needless to say, in my work with you to prepare your business plan, we will address these points in detail so that they do not create a barrier to an investor’s interest. If the investor likes your responses to these initial questions and wishes to examine your investment proposal in more detail (Hooray! you have just jumped over the first hurdle), the investor will ask for your business plan, if he or she has not already read it, and perhaps ask to meet you and your colleagues in a formal meeting.
At such a meeting, the investor will normally ask you many further questions that will be much more comprehensive and pervasive that the initial few questions set out above. If the meeting goes well, the investor will normally submit a written questionnaire for you to complete. (Hooray, again! you have just jumped over the second hurdle).
This questionnaire, popularly referred to as a ‘venture appraisal questionnaire’ contains very detailed personal and business-related questions that many business owners and entrepreneurs feel are an unacceptable invasion of their privacy. This is the wrong attitude to adopt. It is wrong for the simple reason that you are asking the investors to commit substantial funds to your venture (which can be in the millions of dollars), so it is not unreasonable for the investor to want to know a great deal about you personally, the members of your team and your venture.
From a pragmatic point of view, investors only want to confirm for themselves that you are a suitable person to do business with and that you will protect their financial investment in your company to the highest degree possible in accordance with a Shareholders’ Agreement. Venture appraisal questionnaires therefore contribute greatly in building confidence between investors and you.
OK, let’s take stock. At this point, you and I will have developed your business plan to present a comprehensive, investment ready, investor friendly proposal. At this point, you will have to use all your sales skills to present your venture to investors in the most favourable light possible; this is therefore the point of make or break. That is because investors expect venture Principals like you to personally present their proposals with authority, knowledge and confidence. Investors will simply not support ventures where, for whatever reason, venture Principals do not represent themselves in the discussions or negotiations with investors.
At this time, my help is from the sidelines as your team coach, and it is you as team captain, with your team in support, that has to play the game to win the money. In these discussions or negotiations with investors (and I mentioned this earlier), it is vital that you develop a good rapport with the investors. Investors generally will only invest in your company where they can establish a good personal and open working relationship with you and your team during the venture investment negotiation stage.
A Few Words of Warning about Discussions and Negotiations with Investors
When talking with investors, here are some important words of warning about the influence of the law. Where an investor indicates interest in your investment proposal and direct discussions commence, it is very important that you use a great deal of discretion in how you promote your investment offer. You must be careful not to use any words, either spoken or written, that may be considered as deceptive or misleading or cannot be supported by reasonable forecasts or projections in your business plan.
In particular, you must be careful not to give or imply guarantees or assurances that specific business objectives can or will be achieved, or that the investment is ‘risk free’, or is ‘low risk’, or has ‘high returns’, or has ‘high yields’. Additionally, you must be careful not to give the impression that you are soliciting for money, share hawking, dealing or trading in securities, exerting sales pressure on the investor, or offering securities advice or investment advice.
Most importantly (and this is critical), you must not give any impression or imply that the investment is endorsed or approved by the Australian Securities and Investments Commission or Graham Segal trading as Chiron! the business doctor™. The regulations under which ASIC permits me to work in the venture capital market specifically prevents me from making any judgments on or providing any recommendations about the commercial viability of any particular venture.
That is because, under Class Order 02/273, ASIC classifies me formally as a Business Introduction & Matching Service. In effect, ASIC categorises me as a ‘business matchmaker’ bringing companies with growth potential into contact with investors who wish to participate in investment opportunities with growth companies. Under these governing regulations, neither I, nor any of my officers, employees, advisers, agents, affiliates or representatives, are securities dealers, financial advisers, finance brokers, share brokers, remisiers or an intermediary to any established stock market, and we cannot buy or sell securities as a broker or buy or sell securities on behalf of a third party.
A quick word about money: be sure you know what you need; the cardinal sin is to under-estimate the amount of equity capital required
Business owners and entrepreneurs are historically notorious for under-estimating the amount of funds required to get their ventures started, and sustain them through the establishment phase until regular sales can consolidate the cash flow. This is probably a natural reaction to the philosophical rationale that it is probably easier to raise a lesser rather than a greater amount through an equity funding program. However, nothing turns off investors more quickly than a venture running out of money – after all, the investors contributed the disappearing money!
Such a situation shows a serious lack of professionalism and business competence on the part of the business owners and entrepreneurs concerned, because the venture’s sales and cash flow forecasts must obviously be way off target. This situation places the investors in a difficult position. For example, do the investors put in more money, which they haven’t budgeted for, or do they let the venture fail, and lose their investment? The imperative here is this: the investors may not be in a position to be able to commit more funds to the venture at that particular time.
Investors, by and large, do not have large dollops of money sitting around in bank accounts or hidden under their mattresses doing nothing. Their funds are always working in various ventures. An investor may have to juggle his or her investment funds to commit more money to a venture in trouble, but that may not be possible in the timeframe available to save the troubled venture. The business owners and entrepreneurs will also lose their investment in this situation.
An additional point of concern to investors is that if a new investor is brought in to save the venture, the original investors’ shareholdings will be diluted. This will adversely affect the original shareholders and lead to a possible less cordial relationship between the original shareholders and the management team. That would be a most undesirable outcome.
As a matter of general principle, it is better to over-estimate the funds required, rather than under-estimate the funds required. Of course, whatever the level of funds estimated as the base for the equity offer, the figure has to be justified through the business plan.
Raising Equity Capital: no guarantees
I have already said this, but I must stress it again. There are no guarantees in any capital raising program that investors will contribute funds to a particular venture. As a sidebar issue, there is also an element of luck involved in business owners and entrepreneurs being in the right place at the right time. This is because investors do not always have investment funds available at the specific time that a business owner or entrepreneur submits a funding proposal.
Investors who may be keen on a particular venture but do not have investment funds immediately on hand have been known to reach agreement with a business owner or entrepreneur to commit investment funds at some pre-determined or agreed point in the future.
Chapter 2. Equity Capital: raising equity requires dedication, inspiration and perspiration!
Through my exemption from the fundraising provisions of the Corporations Act 2001 (explained earlier in Chapter 1), I can process your need for equity funding relatively quickly through the issue of a small scale public offer, a much quicker process than preparing and registering an expensive prospectus and pursuing a small stock exchange listing. In place of the expensive prospectus, I personally prepare a Class Order Compliant Document that sets out details of your company, your business objectives and how you will achieve them, the anticipated financial returns from your venture and details of your equity offer to investors. It further identifies for investors your company’s corporate structure and commercial governance, and includes other important information such as Board representation, senior management experience and financial performance.
The Equity Capital Raising Process
The process is this: Based on detailed discussions with you about your broad longer-term commercial objectives, I initially help you to identify the key elements necessary to enhance an equity raising program designed to achieve those longer-term commercial business objectives. These key elements will include, but not be limited to:
the amount of equity capital to be raised,
the type of shares to be issued,
the number of shares to be allocated to investors,
the number of shares to be retained by the foundation shareholders, and
the offer price to be asked for the sale and purchase of these shares.
Obviously, these key elements cannot be determined with any credibility until we first finalise your business plan and the associated financial forecasts and projections.
Let us look at an example here. Say we determine after completing your venture’s business plan that your company needs to raise equity capital of $2,000,000. This will be an amount justified in your business plan as the actual amount needed, for example, to purchase capital equipment or real property, to commercialise and produce sufficient product for distribution to wholesalers/retailers and to support your company until you have a regular cash flow. So it is a genuinely justifiable figure and not a figure plucked out of the air that seems like a good idea at the time.
You can raise the funds through the sale of 2 million Ordinary Shares at an issue price of $1.00 per share. You can just as easily raise the funds through the sale of 20 million Ordinary Shares at a sale price of $0.10 cents per share. The decision concerning the initial share price offer however has important managerial implications that you need to consider carefully. I will come back to this point shortly.
Having determined the number and sale price of shares to be sold to raise the equity funds needed, you will then have to decide how much equity in your company you will need to give to the investors in return for their financial contribution. This is a very difficult question to answer. In the first place, you cannot definitively answer the question without finalising your business plan’s financial forecasts and projections. In the second place, the higher the percentage of shares that you allocate for investors (which is the equity in your company you are offering investors), the more financially attractive your equity offer will be to investors.
However, there are a couple of caveats here. In Chapter 20, I explain in mathematical terms a process you can use to assess the minimum percentage of shares in your company that you should allocate to investors having regard to the quantum of equity funds under discussion with an investor. Where you can negotiate a deal with a better outcome that that described in Chapter 20, then that is very much to your advantage. But in a startup situation, you may not have a high degree of flexibility in terms of your negotiating position having regard to your options for action.
The second caveat is that you need to be aware that there is a danger to your future expansion through a venture capital firm if you take seed funding in an incorrect way at this startup stage. Here’s the deal you need to be alert to.
Your venture seems to be a good bet, your product development is on track, you have registered your company, but you now need some dollars to establish yourself. Your favourite rich Aunt, Auntie Joan, loves you dearly and because she knows you will naturally be successful in business just like her, she offers you $300,000 to help you out. Because you wouldn’t want to hurt Auntie Joan with a refusal (you love her dearly), you reluctantly accept the $300,000 with both hands and because you love your aunt’s confidence in you, you issue her with a 10% shareholding in your new, hot off the press company.
Uh, oh! There’s a bright red flashing light now sitting on top of your head. What you have just done is create a valuation for your startup of $3 million. This will probably create a problem for you when you later discuss an investment proposal with a venture capital firm. I discuss why this is a serious problem in later chapters. Please note that I am not saying here that you cannot accept Auntie Joan’s money. What I am saying is that there are different ways and means of doing it that will not create a set of difficult circumstances for you later in the development of your venture.
This matter is so serious that I strongly recommend that you obtain some professional advice before you jump in with both feet and simply issues shares for seed funding without any consideration of longer-term consequences.
To return to the question of how much equity in your company you will need to give to the investors in return for their financial contribution, the percentage of shares that you allocate for the professional investors in a formal funding round is heavily influenced by the venture’s forecast profit levels. This is important because you have to keep in mind that most professional investors will want a certain minimum rate of return that will generally lead to their exit from your business (either in part or in full) after anything from three to five years. Some investors of course will stay longer, but for business planning purposes, you should work on the assumption that the investors will want to retire from the investment in your company in three to five years time.
An important point to keep in the forefront of your mind here is that this ebook is written from your point of view. My advice therefore is coloured by the objective that you will probably want your business to continue trading for many years. After all, the business is your baby and I understand that you have both an emotional and a proprietorial commitment to it. But there is a dark cloud on this horizon. Many investors, after your company’s trading record reaches a significant level will want to exit from the investment in your company as I said in the above paragraph.
Unfortunately, the exit strategy for many, if not all, investors centres on what they call a trade sale, which is a polite way of saying that they want to sell your whole company to a larger expansionist or predatory company. By selling your whole company, the investors hope to reap a much larger financial harvest than they could by just selling their shares alone. You and your founders may therefore be forced, perhaps against your will and wishes, to exit stage left. I will have more to say about this in Chapter 6, but for now just note that my advice is based on the objectives that your primary intention is keep your business operating after the investors exit, although I recognise that the trade sale is a perfectly legitimate option for you to pursue also.
The point I am really trying to make is that you will have some serious options to consider at the point that you accept equity capital. Although you do not need to make any decisions concerning this now, I will do my best to help you determine which option is best for you at the time when you will have to make a decision about accepting equity capital.
During this three to five year period when you have the investors as shareholders, you need to build into your business plan an appropriate mechanism that will permit you to pay out the investors at their nominated exit point, if you wish to continue trading. Bear in mind here that there is no ‘best way’ to deal with the exit of investors. It’s just something that you have to deal with in the normal course of events.
The secret of course is to plan for this so that the transition will be as smooth as possible with the least disruption to your normal business operations. The complicating factor is that in the negotiation phase with potential investors about your equity offer, the question of an exit strategy is generally at the centre of the negotiations and investors may not necessarily concede to your wishes. You will just have to cross the bridges when you come to them.
Investors Should Get New Shares
When you come to sell shares to an investor, you will create new shares, so although your own equity percentage in the company will reduce, your number of shares held will remain constant. This does not mean that you will suffer a reduction in your share value. When Bill Gates started Microsoft, he was reputedly a 48.5% shareholder in a startup company operating from his parents’ garage. Over the years, as equity funds were raised to finance Microsoft’s expansion, his equity percentage reduced, but his number of shares owned remained reasonably constant. Today, his percentage equity shareholding is probably miniscule in comparison with the total number of shares issued by Microsoft, yet it makes him one of the richest persons in the world.
Valuing your Venture to Support an Equity Raising Program
Let’s return to the decisions concerning the amount of equity to be raised, the type and number of shares to be issued, and the price to be asked for the sale and purchase of these shares. I said earlier that these decisions have important managerial implications for you that need careful consideration.
The relevance of these decisions is that they reflect a notional valuation of your company that must support the equity raising. This notional value does not purport to be a formal (i.e. accountant’s) valuation of your company or venture as it stands now or in the future. It is simply a process to establish a practical foundation for the determination of the base ‘value’ of the company in terms of the number & value of the shares to be created or issued.
From the decisions concerning the amount of equity to be raised, the type and number of shares to be issued, and the price to be asked for the sale and purchase of these shares, we can notionally value the company by multiplying the number of shares issued (including your own) by the price paid by investors for their shares. The importance of this figure is that it is an influential factor to potential investors. If the notional valuation is set too high in relation to the size of the investment, that will naturally be a turn-off for investors.
While this procedure sets the amount of equity you need to establish and then run the company until you can create a sufficient and regular cash flow, this will not be the company valuation used in negotiations with investors concerning an investment deal. That valuation will be more formal in nature and will take into account the inherent projected values of your ideas, intellectual property, design registrations and the skill set of the founders. In that regard, you may think it somewhat outrageous, absurd even, to value those items collectively at millions of dollars. Your company’s valuation, I can tell you from experience, will be couched well in excess of a million dollars, because investors will not usually invest in a company with a lower valuation.
Perhaps I can put these concepts into a more practical perspective. When someone buys shares in a startup company, that implicitly establishes the company’s value. Take an example: if someone as a first investor pays you $20,000 for a 10% share of your startup company, your company is theoretically worth $200,000. I say theoretically because in early stage investing, valuations are not reflective of reality. That is because there are no comparative benchmarks available to test the valuation.
As an entrepreneur with a startup, you simply have to accept the reality that with startups, no recognised definitions of valuation exists. What does this mean? It means that to all intents and purposes, in a startup venture, your value is in the future. And because your value is in the future, you and the investor will most probably come to different conclusions as to what the prognosis for the value of your start up is.
However, as your company becomes more established and begins producing regular operating statistics such as sales and profits, its valuation will get closer and closer to an actual market value. But in a new startup, the early valuation number is just notional, a figure of convenience that reflects a combination of factors that are based on the contributions of everyone involved (founders and early financiers).
But even when you can establish positive growth rates and you are seeking much higher funding amounts from venture capital firms, the venture capital firms will (I’m speaking off the record here), continue the valuation charade. They will decide how much money you need and how much of the company they want, and those two constraints will yield a valuation for the venture capital firm’s purposes, which of course may not be suitable for your purposes. Having done that, they will then try to dress up their valuation through a reference to some form of mathematical computation. I have more to say about the intricacies of valuation in Chapter 3, so will say no more for now.
To change the focus of discussion somewhat, here is another interesting point that you must bear in mind. Where your venture has a high growth potential that could eventually lead to a takeover of your company by a large predator or even a stock exchange listing (IPO) for your company, in the long run it will be to your financial advantage to keep the sale price of your shares as low as practicable so as to create the maximum number of shares. The larger number of shares will provide you personally and your fellow founders with the opportunity to ’cash-in’ and reap a substantial financial reward for the blood, sweat and tears that you have put into the business. Accordingly, the business options I suggest are generally based on an initial share value of between 5 and 20 cents per share to maximise share numbers.
Of course, a view can validly be put that the number of shares is only an accounting convenience, perhaps to have a share price that won’t sound too big after it has grown. After all, a company with 1 million shares of $1 each has the same equity proportions and valuation as a company with 10m shares of 10c each. However, my recommendation is not concerned with accounting principles or company valuations. It is purely concerned with your flexibility to take action in your own best interest at financial harvest time. The greater the physical number of shares you own, the greater your flexibility to act.
Premium Value Accruing to Foundation Shareholders
Mention of founders’ blood, sweat and tears raises a very important point that has a serious impact upon your hip pocket nerve:
Equity funding is the usual funding mechanism that that permits the foundation shareholders (viz., you and your colleagues who have developed the venture to this point) to be paid a premium for the blood, sweat and tears that you have put into the venture’s evolution to the present day.
Traditional business funding through bank, finance company or private sources borrowing will generally not give foundation shareholders any financial benefits or credit for their business development efforts. Bank or finance company borrowing rests of course on concepts of bricks and mortar collateral. Entrepreneurial companies in their early stages of growth normally do not have much to offer by way of physical assets that can be used as collateral for loans.
Hence, the traditional reliance on equity funding, which from one perspective, provides the mechanism for founders to receive some recompense for their ‘blood, sweat and tears’. Of course, the quid pro quo that the founders must face here is their loss of 100% equity, managerial control and profits in their venture.
From the other perspective, where founders have the ability to accept loan funds, and the business is ultimately successful, the founders will pay back the loan and keep their 100% equity, managerial control and profits intact. Under this scenario, the founders may be much better off.
The route that founders will follow depends on their risk assessment and risk tolerance. Selling equity may or may not be less risky to the founders than if they borrow the same money with personal guarantees
The Exclusive Authority to Act Agreement: ASIC Class Order 02/273
I have earlier mentioned the importance of formally appointing me as your consultant when you commence your equity raising. There are some significant technical reasons for my making that recommendation to you. I explained to you that I work under ASIC Class Order 02/273, which imposes a number of duties and responsibilities on me. Those duties and responsibilities include the fact that I must accept accountability for ensuring that equity raising activities in which I am involved are conducted lawfully. In order to carry out equity raising activities competently therefore, I must have effective control of the process.
This means that we need to conclude an Exclusive Authority to Act Agreement. In formal terms, this Exclusive Authority to Act Agreement appoints me as your consultant to prepare a Class Order Compliant Document (COCOD) for the issue of the securities, and then to undertake the subsequent marketing to investors of your equity offer.
This Exclusive Authority to Act Agreement is essential. Its importance lies in the fact that the document provides me with two crucial dynamics. The first is that it confirms my role as a Business Introduction Service (viz., a business matchmaker) under ASIC Class Order 02/273 and secondly, it provides the basis for my personal exemption from having to comply with certain of the fundraising conditions in the Corporations Act in respect of raising equity capital from the public for your venture. It is the document that I would have to produce to ASIC if there was a challenge to my fund raising activities under ASIC Class Order 02/273 or ASIC conducted an audit of my activities.
Specifically, the Exclusive Authority to Act Agreement is an agreement between you and me that enables me to commence the equity raising program through the issue of a COCOD. It enables me to make offers to the public at large to invest in your business. ASIC has set some parameters for my fundraising activities on behalf of clients, and I will come back to this point later. For now, let me just say that because of the strict rules set by ASIC Class Order 02/273 for corporate fundraising, it is important that I am in a position to retain overall control of the fund raising process.
The strict rules set by ASIC contain built in regulations that are designed to protect both companies seeking equity capital and investors seeking opportunities from the many crooks, cheats, scammers and swindlers who lurk on the outskirts of the venture capital industry and prey on trusting business owners and entrepreneurs. In Chapter 27, I deal with the dark side of the venture capital industry.
If I don’t have control of the fundraising process, and others are involved, breaches of the fundraising regulations may occur without my knowledge. In that circumstance, I would be the one accountable. In a worst-case scenario, I could lose my ability to work in this field if the breaches were serious. This does not mean that you or your friends and colleagues cannot assist in the equity raising process; it just means that we all have to work together under my co-ordination to make sure that all of us follow the fundraising regulations.
Raising Equity Capital: the business plan & the COCOD
To draft the COCOD, I would need access to all relevant documentation and information that will be useful and advantageous in promoting the equity offer. It is important that the COCOD co-ordinates very closely with your venture’s formal business plan, because investors will expect to receive both documents. It is therefore important that your business plan be comprehensive and of a standard expected by investors.
On that point, business plans prepared in-house by business owners and entrepreneurs often do not meet investors’ requirements. It’s not so much that the business plan will be wrong in some way – it’s more a question of ensuring that all information relevant to an investment analysis is included and how that information is presented advantageously so that it reflects investors’ expectations. In-house writers are not always au fait with investors’ investment selection criteria and information requirements, and this factor can be crucial in whether your funding proposal is initially accepted for a detailed review or not.
The comprehensive business plans that I prepare are generally quite substantial documents. This is because the business plan has to pre-empt investors’ queries by answering questions before they even take form in the investor’s mind. If an investor has to ask many questions about a venture after reading the business plan, it suggests to the investor that the business owner or entrepreneur is not across the detail of their own venture and this can have fatal consequences for the funding proposal.
Raising Equity Capital: got my business plan, got my COCOD, what happens next?
When you formally appoint me to help you raise equity capital, you can expect that I will complete the tasks set out below. Of course, these are not the only tasks that I would be performing on your behalf in an equity raising program. There are a number of other functions that I fulfill but they depend to a large extent on the individual nature of specific ventures:
I will evaluate your present business operations and/or business proposals to help you determine achievable and realistic business objectives, so that the quantum of equity funds that you will require is calculated as accurately as possible. This is very important because the quantum of equity funds that you will require has a dominant influence on the scope of the investment proposal offered to potential investors.
I will help you to produce a comprehensive business plan that will identify your commercial business objectives and illustrate your company’s investment readiness, thus showing potential investors how you will achieve your commercial business objectives.
I will help your company to become investor friendly by advising you on the introduction (if necessary) of a corporate structure that will provide a level of investor protection and confidence that will help your company to take full advantage of investor interest in your venture.
I will prepare a Class Order Compliant offer document in conformity with ASIC Class Order 02/273 and Corporations Act requirements. The COCOD is your formal Offer Information Statement and sets out details of your company, your business objectives and how you will achieve them, the anticipated financial returns from your venture and details of your equity offer. It will identify for investors your company’s corporate structure and commercial governance requirements, and will include other important information such as your company’s Board representation, senior management experience and financial performance.
I will develop a marketing plan to promote your equity offer to potential investors. In that regard, I must again stress to you that there are no guarantees in any capital-raising program that investors will contribute funds to a particular venture.
I will help you respond to venture appraisal questionnaires submitted by potential investors seeking detailed information about you personally, your management team, your company, your venture and your investment offer.
I will help you determine appropriate responses to term sheets submitted by potential investors interested in your venture that set out the investors’ requirements and proposals in respect of a possible investment in your venture.
I will assist you in the preparation, negotiation and settlement of Employment Agreements with key staff, Directors’ Deeds of Access, Indemnity and Insurance, Investors’ Subscription Agreements, Shareholders’ Agreements and Intellectual Property Acknowledgment Deeds.
You should expect, depending upon the nature of the venture requiring funding, that all going well, the process will take about eight to ten weeks from the date that you issue me with the Exclusive Authority to Act to the date that your equity offer is published and circulated to investors. You must then add on a further three to five months for the actual fundraising procedure itself.
However, having regard to the old proverb ‘there’s many a slip twixt cup and lip’ don’t be surprised if the fundraising process takes longer, because the unfortunate reality is that once your COCOD is published, primary control of the fundraising process is out of your hands and in the hands of the investors.
The timeframe is also heavily influenced by the combination of the complexity of your venture and the complexity of the funding options being pursued.
OK, OK! I know you’re itching to ask me the $64 question: What’s all this going to cost?
There are fees associated with the preparation of COCODs and business plans (I’m sure you appreciate that I have to make a living too!). Fees are set depending upon the amount of work and complexity involved in the venture. If your business plan is not developed enough for the purposes of an equity raising program I can prepare both documents. Of course, there would be an economy of scale involved if I was to prepare both documents, and my charges are quite reasonable.
Whether you retain me to produce your business plan is of course a matter for your discretion. I simply mention it because while some companies ask me to do the work, others prefer to do it in-house. My experience however, as I said earlier, is that business plans prepared in-house rarely meet investor expectations, usually require substantial re-writing and in the end prove unsuccessful as an equity raising sales document.
I have a once-only fee to clients that covers the preparation of both the business plan and COCOD and the costs associated with my work in approaching potential investors. This process involves me in personally contacting many potential investors on my database and presenting your equity offer as a viable long-term investment opportunity. As well as this personal approach to investors on my database, I also post your equity offer on my website where investors seeking investment opportunities have direct access to your COCOD.
Fees are paid in two equal moieties, with the first moiety being paid at the same time that the Exclusive Authority to Act Agreement is signed. The balance of the fee is paid one month later. A discount of 10% is available to clients who pay the full fee at the time of signing the Exclusive Authority to Act Agreement.
When we consider your venture in detail and we discuss a reasonable fee, there are a couple of things that you need to bear in mind. The first is that whatever fee we agree on, it will be many, many times less that the legal alternative. The alternative is that if you do not wish to rely on my personal exemption from certain of the equity raising provisions of the Corporations Act, you will have to pay for the preparation of a formal prospectus and cover the listing costs to a small stock exchange. This is a very, very substantial cost that can easily exceed $200,000.
The key point here is that unless you work through an exempted person (as I am), then you must be prepared to face these very high costs if you wish to work within the terms of the Corporations Act requirements.
In addition to my fee for the actual physical work I perform for you, there is a 6.5% success fee to be paid based on the funds actually raised. Payment of this success fee only occurs when you physically receive the equity funds in your hands.
There are two technicalities in the equity raising process that can arise from the unpredictable nature of negotiations between you and potential investors and lead into an unpredictable outcome. The first technicality is that the investor may wish to fund the venture through a combination of equity (Ordinary Shares) and debt funds in the form of debt securities such as Convertible Redeemable Preference shares.
I mention this because once active negotiations commence between you and potential investors (who of course have their own investment strategies and financial requirements) the result of the negotiations may be a compromise of equity and/or debt funds. Success fees of course will reflect the total of the funds received, no matter how they are categorised.
The second technicality refers to alternatives to cash-based success fees. These alternatives are required where a client making a public equity offer, after negotiations with a potential investor or joint venture partner, agrees to a joint venture arrangement rather than an investment arrangement. Under the typical joint venture arrangement, the client will license the joint venture partner to manufacture and market the client’s products in return for royalty payments usually based on product sales.
In this circumstance, no equity funds change hands, so I would not receive a success fee, despite the fact that the joint venture arrangement was the result of my work. An alternative to a lump sum cash-based success fee in this situation therefore would be for me to receive a proportion of the royalty payments paid to the client for a defined period.
Raising Equity Capital: two important ‘Please Read Me’ statements
One about Me...
Under ASIC Class Order 02/273 , I cannot raise more than $5 million dollars across more than twenty private investors (i.e. small investors) in any rolling twelve-month period. This reference to twenty private investors however does not include angel, professional or sophisticated investors as defined in Chapter 1, which means in practice that there are no restrictions on the level of investments I can raise from these investors.
… And One about You
I have to advise you that there is a legal responsibility on an issuer of securities (that’s you) or a seller of securities to exercise a general duty of care for a true and fair disclosure to potential purchasers (the investors). What that means in terms of equity raising pursuant to Section 708 of the Corporations Act and ASIC Class Order 02/273 is that you must accept responsibility as the sole source provider of all information, data and business projections in your business plan. In turn, this means that you must warrant that
all reasonable care has been taken to ensure that the information, data and business projections contained in your business plan are as true and accurate in all material respects as is possible to be, and
you are not aware of any other facts, the omission of which would make misleading any statement in the business plan.
Chapter 3. Equity Capital: stage by stage through the investment process
Most investors will follow a disciplined and structured procedure to evaluate equity offers that that they receive through various means. Equity offers may be directly emailed to them by the business owners or entrepreneurs themselves acting on spec. The equity offers may be submitted by a Business Introduction Service such as myself. An investor who cannot deal with an equity offer for some reason may pass it to a colleague investor who may be able to deal with it. Investors may discover the equity offer themselves through searches on appropriate websites such http://chironthebusinessdoctor.com
There is of course an ulterior motive for investors to follow a disciplined and structured procedure. It provides a safety valve in that using a systematic and methodical investigative process, fewer investment mistakes are likely to result with a consequent loss of capital funds. Moreover, if the investor works in concert with others, the structured procedure will provide substantial justification for the investor endorsing a particular investment. From the other perspective, the structured procedure provides the investor with a defense to allegations of poor judgement in relation to an investment that may later fail.
The structured procedure therefore has the ulterior objective of eliminating, at the earliest possible time in the process, those investments that cannot meet the investor’s investment selection criteria, investment guidelines and legal obligations. You must understand here that an investor’s participation in successive stages of the structured procedure involves an increasing level of expenditure on professional services and investigative expense. Moreover, it creates a considerable impost on an investor’s time, and in business, time is money. Consequently, only very few equity offers make it through to the later stages in the process.
How long will this process take? There is no way of knowing that. The duration will vary with the complexity of the venture and the ease with which the investor’s investigations can be satisfactorily completed. It is unlikely that a successful equity offer would be achieved in less than twelve weeks from receipt of the initiating COCOD, with the average of successful equity offers taking closer to six months.
This is a difficult time for business owners or entrepreneurs because the process and timing is largely under the control of the investor. It is particularly galling if you become aware that the investor is indecisive, dithering or vacillating. Throughout the process therefore, you must constantly look for signs of where you stand with the investor. It must be said here that investors in general have a reputation for indecisiveness, dithering and vacillation, so if you discover this in your own case, it’s just that the investors are acting true to form. So it is most important that you keep your focus fixed squarely on your goals and make it a priority objective to collect information that may help you assess the investor’s intentions.
This information should give you insights into important issues such as how likely is the investor to offer you a real deal; what particular aspect of your business does the investor need to be convinced about next and what is the investor’s opinion about your management team?
From the investor’s point of view, it's in their interest to collect the maximum amount of information about you and your venture while making the minimum number of decisions that will bind them while they go through the evaluation process. Your primary defence of course is to recruit some competing investors. However, during this process, there are some ways you can apply force back on the investor. You can do this by focusing discussions on your priorities: ask the investor what specific questions they need answered to make up their minds, and when you get the list, respond expeditiously. If they won’t supply the information you request, then clearly you are wasting your time on them.
If the investor keeps raising hurdles and you keep responding adequately only to find the investor raising more hurdles, it will be clear that the investor’s intentions are questionable. In this situation, you must assume that the investor is simply playing games and probably hasn’t got the guts to tell you straight that your equity offer is rejected. Alternatively, the investor could be just stringing you along to see how your venture develops over a few months. In effect, the investor is hedging the bets by putting you surreptitiously through a test. You need to short circuit this.
As suggested above, if you are confronted with a situation of this nature, give the investor one last chance to advise the specific information they need to make up their minds, and when you get the list, respond quickly. If the investor won’t supply the information requested, you really have no alternative but to give them the flick.
At this point, it may be useful to go through the actual equity raising process with a theoretical but practical example. The example will reflect the scenario where your entrepreneurial company has developed, commercialised and market tested an industrially manufactured consumer product. You and your colleague founders have self financed the venture to date and now need a more substantial investment than is normally provided by seed or angel investors.
Equity Raising Stage 1: the initial contact
The first action taken by the investor upon receipt of your equity offer (your COCOD) will be to read the executive summary quickly to see if the amount of funds required, the stage of investment, the industry and the geographical location are broadly acceptable. Where any of these broad criteria are not acceptable for any reason, the investor will simply give you a polite note saying that the investor cannot further pursue your proposal. The investor will not explain the grounds for the decision.
If the amount of funds required, the stage of investment, the industry and the geographical location are broadly acceptable, the investor will go through your COCOD in detail. Then, if your venture seems on the surface to be a reasonable fit with the investor’s investment selection criteria, investment guidelines and legal obligations, the investor will ask you for a copy of your business plan.
Following the investor’s perusal of your business plan, and where the investor can see some potential in your venture, the investor may invite you and one or two members of your senior management team to come to a meeting to discuss your venture. Receipt of such an invitation means that you have passed the first serious go/kill decision point.
Equity Raising Stage 2: first formal meeting; first information exchange
From the investor’s point of view, there is only one purpose behind the first meeting. That is to enable the investor to check out how you, your fellow founders and your venture measure up. Pragmatically, the investor wants to check out four key issues:
Is your deal favourable?
Are you personally favourable?
Are your fellow founders favourable?
Is the risk favourable?
In the invitation extended to you for the meeting, the investor will normally suggest that you come prepared to answer detailed questions about all aspects of your venture. You may even be asked to do a formal demonstration or presentation about your venture.
You must prepare for this meeting diligently and meticulously. This meeting has make or break consequences. In the worst case scenario, you can be eliminated from future consideration for funding. Where you can respond adequately to investors’ questions, your efforts will get you to the next stage of negotiations. The best case scenario is where the meeting will enable you to plant very favourable impressions of you and your venture in the investor’s mind. Don’t blow the opportunity! Remember the old adage that is as true today as it was hundreds of years ago: first impressions are important; you don’t get a second chance to make a good first impression.
This meeting is a two-way street. While the investor may be giving you the once-over, you and your founders must just as effectively assess the investor. That should be obvious to you, because if the investor commits to financially support your venture, you will have work closely with the investor, who will become intimately involved with your venture’s decision-making processes.
If the initial meeting goes well and you feel that the investor is someone that you can work with on a personal level, and presuming the investor has a similar view about you, then a practical foundation will exist for an ongoing negotiating relationship. At this point, the investor would normally request contact details of your founders and senior managers, the names and contact details of referees who can speak on your behalf, and details of your key customers, suppliers and distributors, if your venture has them.
You are quite within your rights at this early stage of negotiations in refusing to disclose sensitive confidential information. Most investors will understand this and not let your reluctance to disclose sensitive information create dissension. Nevertheless, the reality is that you must provide sufficient information for the investor to decide whether it will be worth it to spend more time and incur financial expenses on a more detailed evaluation of a proposed investment in your venture.
If the investor comes down on your side in the wash-up from the meeting, it means that you have passed the second go/kill decision point. The prize you win for passing that test is that the investor will request you to complete a venture appraisal questionnaire to elicit further information relevant to the investment proposal.
Equity Raising Stage 3: informal due diligence
The investor, at this point, will normally conduct a limited survey into your industry sector, your target market, your company and your business proposition. In this survey, the investor could approach a variety of business contacts with knowledge of the industry sector concerned and the target marketplace. The market analysis would normally include a review of your direct and indirect competitors and some validation of the customer benefits associated with your products or services.
The investor will normally visit your office and meet with key executives and key employees on a one-to-one basis. So spend some valuable time comprehensively briefing these key personnel on all aspects of your venture. Remember, this is not the time to be precious about hiding sensitive issues such as salary packages and cash flow projections, to name but two. It will do you no good if the investor discovers that key personnel have different perceptions or understandings of your company’s goals and how they will be achieved. Everyone must sing from the same song sheet.
If the investor is satisfied with the results of the industry and market survey, the meetings with your key personnel and your responses to the venture appraisal questionnaire, he or she will then seek a further meeting with you and your senior management team. Well done, you have now passed the third go/kill decision point.
Equity Raising Stage 4: investor preliminary terms disclosed
At this meeting, the investor will probably brief you and your senior management team on the results of the industry and market survey and seek confirmation that his or her data, facts and conclusions are consistent with what you and your senior management team believes. The investor will then present a ‘warts and all’ evaluation of your proposal, which will normally lead to an outline of some terms under which an investment may be undertaken.
In effect, the investor is issuing you with a preliminary, non-binding, draft term sheet as an aid to facilitating the investment process. In the normal situation, these terms will be an opening gambit to permit serious negotiations to commence; in effect, these terms can be considered as a form of ambit claim in response to the framework of your equity offer.
During this discussion, the investor may seek your agreement to a valuation of your company or a suitable valuation formula. The valuation of startup and early stage companies and the appropriateness of different valuation methods for such companies are generally highly contentious issues that I will be discussing later. The investor may also discuss costs and fees associated with further processing of your equity offer. Investors will naturally try to limit their operating costs and consequently, you must expect that a large proportion of the venture evaluation processing cost will fall on your shoulders. I will mention this again later, but for now, just prepare yourself for this cost and make sure that you include provision for it in your business plan cost projections.
At this point, the investor may further disclose that he or she is not in a position to provide all the equity capital funds being sought through the equity offer and will advise the actual level of equity that can be taken by the investor. In this situation, you can expect the investor to participate actively in helping to attract additional investors. Naturally, having a committed investor on board is a significant benefit in attracting additional investors.
Equity Raising Stage 5: investor internal review requirements
Usually at this stage in the investment process, the investor will take stock. That is, the investor will review all the information held to date to justify that the ‘in principle’ decision taken to back your venture rests on solid grounds. This review will verify that internal due process checks and balances are all in order and that the industry, market and company survey evaluations were properly carried out. This internal review would without doubt include the construction of a limited financial model of the business over the likely duration of the investment.
Of course, larger more complex deals may require a much more extensive and expert investigation, often involving the use of professional services firms and specialist market analysis consultancies. This is where cost apportionment becomes a more substantial issue.
When the investor is satisfied that the investment is on track and still compliant with its investment selection criteria, investment guidelines and legal obligations, the investor will move to Stage 6 and issue a formal term sheet to your company.
Equity Raising Stage 6: the term sheet
With the initial due diligence satisfying the investor’s doubts and uncertainties, the investor will issue a formal investment offer in the form of a heads of agreement called a term sheet. The term sheet sets out the terms and conditions under which an investment will be made in your venture providing that the venture can satisfy a more formal and more stringent due diligence analysis. The term sheet is not binding on either party at this point.
Moreover, where the investor is offering to provide all the equity funds required, the investor will most probably expect you to deal exclusively with the investor during the detailed due diligence period. This is a reasonable request, which you should accept and honour.
Term sheets can vary considerably in their length and complexity. Most term sheets will contain the following clauses as a bare minimum. Naturally, the form and content of a term sheet will reflect the nature of the venture and the conditions outlined in the equity offer:
The number and price of the shares in your company available for purchase
This opening clause of the term sheet will initially state your company’s present situation in respect of the types and numbers of issued securities, including shares, debentures, promissory notes and the like. It will also state the investor’s assessment of the capitalised value of your company. This value will then provide the basis for calculating the percentage of the issued shares that the investor would own subsequent to the investment.
This may present you with the first two points of serious difference or disagreement with the investor. Be on your guard at this point!
The first point of difference: valuations and valuation methods
The first point is that you may not agree with the methodology used by the investor to calculate the value of your company. Valuations and methods of valuations of an existing business both before and after funding is without doubt the most contentious, sensitive and touchy topic in the venture capital lexicon. That is because they contain the seeds of conflict between business owners and entrepreneurs and investors. As discussion topics, they are:
steeped in emotion because they strike at the heart of each party’s hip pocket nerve,
complicated by misunderstandings about the purpose and objective of the valuation, and
subject to often long-standing and deeply held views by the negotiating parties.
Industry gossip has it that probably half of all fundraising negotiations fall through because of a failure to agree on a valuation or a method of valuation. This is a consequence of the fact that in general, venture capital firms want lower valuations while business owners and entrepreneurs want higher valuations. I have something to say about that latter point shortly.
Back in Chapter 2, I made the point that venture capital firms, off the record, will continue with the fiction or charade of applying objective valuation procedures in startup or early stage investment negotiations. I pointed out that because of their financial power, venture capital firms will decide how much money you need and how much of your company they want, and manipulate those two constraints to deliver the valuation required. That is, they will dress up their valuation through a reference to some form of mathematical computation. Whether you like it or not, you are unfortunately stuck with the charade if you want to present your company as a viable company for an investment. You have no choice therefore but to negotiate around the valuation or valuation process proposed by the venture capital firm.
Within that context, the fact is that valuations must increase proportionally as the size of the investment increases. For example, a company that a sophisticated investor may be prepared to put $50,000 into at a valuation of $1 million clearly can't take $2 million from a venture capital firm at that valuation. Consequently, if valuations change simply because of the investment amount requested, that shows how far removed they are from any kind of true value of the company.
Since valuations are predominantly the subject of convenience, you as a founder shouldn't place too much emphasis on them. Some entrepreneurs will contend that I am a profane heretic for promoting such a dissenting view to the generally-held philosophy. Despite that, my advice to you is that the valuation placed on your company should not be your primary focus at this particular time. Why is that, you may ask? It’s because, having regard to your personal long term outcomes, a high valuation can be detrimental to you.
Let’s take an example: If you take substantial funding at a pre-money valuation of $10 million, there is no way that you could sell the company at some point in the future for $20 million. For the venture capital firm investor to get even five times the investment as a return, which would normally be below its expectation, your company would need to be sold for at least $50 million.
But $50 million would only be enough for the return expected by the venture capital firm, where would your return come from? A $50 million sale would probably be an unacceptable situation for the venture capital firm and it would clearly be an unacceptable situation for you. Accordingly, both you and the venture capital firm become locked together to hold out for a $100 million sale, or some figure in that region.
The reality here is that the necessity to get a high sale price for your company decreases the chance of the company being sold at all. Many acquisitive companies of course would be able buy your company for $20 million, but only a handful could do it for $100 million. Therefore, what you need to optimise in the negotiations with the venture capital firm is your chance of a good financial outcome, not the present valuation (however calculated) or the percentage of the company that you keep.
That raises the query as to why founders want to chase high valuations. My view is that they are unduly influenced by bad advice or misled by an ambition that borders on delusions of grandeur. They feel they have achieved a much higher level of success if they can negotiate a higher valuation, particularly when (in their view) they fought bravely against a venture capital firm, a ‘giant’ in the venture capital industry investor hierarchy. They want to bask in the glory of winning what, in their opinion, was a David and Goliath conflict. Yeah, sure!
Moreover, bragging rights are often an issue in these situations. Founders usually know other founders, and if one achieves a high valuation, he or she can brag ‘I did better than you’. But, as I alluded earlier, valuation and funding is not the real test here. The real test, the test that has a profound effect on your personal future, is this: what will the final outcome be for you following the venture capital firm’s funding. Getting too high a valuation may just make a good outcome less likely.
Perhaps we should look at this a bit more closely; it is after all such an important issue. So let’s go back to the principles behind the funding activity I mentioned in Chapter 2 where I said that you had to be very careful how you accepted seed funding from Auntie Joan because it can be detrimental to future equity raising activities. Taking a more realistic example than that used earlier, let’s assume that you have now become an established company, your sales of product are exceeding targets and your new product development program is ahead of schedule. You need some development capital to fund your expansion.
So, you approach an angel investor and negotiate a first funding round deal for a capital injection of $1.2 million in return for an allocation of 2.2% of your company. This money permits a full implementation of your expansion plans. Your company is now going gangbusters from one benchmark to another.
Eventually, the time arrives when you need to take the plunge and kick your company upstairs into the premier league; you are at the point where you can join the big boys and girls in your industry. This time however, you need a lot more dosh; you need a dollop of at least $10 million. You link up with a venture capital firm and ask for a second funding round of $10 million for which you offer the venture capital firm a 5% equity allocation.
Here’s the reality you face with such an equity offer. If 2.2% of the company was worth $1.2 million at the first funding round, then the company was valued at that time at more than $50 million. If 5% today, in your opinion, is worth $10 million, you must now believe your company is worth $200 million. In the current economic climate, that is probably well outside the range of valuations that most similar-stage companies could extract from venture capital firms.
Faced with your funding proposal, the practical question that the venture capital firm will ask you is this: how can you possibly justify such a valuation? From the venture capital firm’s point of view, that sort of valuation is probably more than twice the venture capital firm’s expectations from funding an IPO, let alone a low-level second round. In normal circumstances, venture capital firms fund companies into an IPO in the expectation of a $100 million valuation within a timeframe of three to five years. Politely, the venture capital firm might put the question to you in a different way: what have you been smoking?
The principles that derive from the above scenario are these:
Firstly, the valuation of a company in early stage rounds can adversely affect a company’s ability to attract follow-up funding.
Secondly, you cannot compute the valuation of the company from prescribed formulas that may or may not have widespread general application; consequently, valuation is a highly subjective process, more an art than a science.
Thirdly, investors, no matter what their position in the venture capital industry hierarchy, probably will never have enough data to arrive at a reasonable or generally acceptable valuation of an early stage company.
Please note that I am not overlooking the one advantage of a high valuation, which is that you get less dilution in a deal settlement. However, there is a much less attractive way to achieve such a result: you could simply accept less investment money.
The second point of difference: protection of invested funds
The second point of difference or disagreement flows from the fact that your equity offer is for the sale and purchase of Ordinary Shares. The investor may seek a higher level of protection for the invested funds by requesting issue of part or all of the shares as Preference Shares with special benefits. Within that context, the investor may also request your agreement that, in the event of the liquidation or sale of the firm, the Preference Shares will have priority for payout over any payment to ordinary shareholders.
Additionally, the investor will probably also request that on exit, the Preference Shares will convert to Ordinary Shares so that the investor can take the full benefit of any capital gain arising from increases in the value of your company’s Ordinary Shares. Beware these requests. For reasons that will become obvious when you read Chapter 6, these requests can lead to your financial disadvantage.
I’m not saying here that the investor is asking too much though; after all, the investor has an obligation to protect his or her assets. Of course, this may just be an ambit claim
Impressum
Verlag: BookRix GmbH & Co. KG
Texte: Graham Segal
Bildmaterialien: Graham Segal
Lektorat: Graham Segal
Tag der Veröffentlichung: 27.05.2013
ISBN: 978-3-7309-2987-2
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