With help from JJ Richa
Can you imagine having 300 shareholders? With recent legislation and new portals on the Web, it’s entirely possible, perhaps for the first time for small businesses.
Simply stated crowd funding or crowdfunding is the raising of capital in small amounts, from a broad base of investors. Usually the investors are non-accredited, and only invest a small amount. It’s similar to microfinance, but for the most part using equity instead of a low-interest loan. The object behind crowdfunding is to open up more opportunities for capital to flow into businesses to help them grow and create new jobs. Participants can raise funds without having to do a public offering, which is a costly undertaking.
Crowdfunding is not for everyone. Entrepreneurs who can raise funds in more traditional ways from knowledgeable investors should still lean toward doing just that. But there are many businesses that just won’t appeal to professional or knowledgeable investors. Are you an artist with a new record, a new movie idea, a new small product to offer? Perhaps you can attract a large number of investors who just want to support your idea, or get discounts for your product. The returns are not as important to them as the joy of participating in your dream. These are the more likely candidate companies and investors.
[Email readers, continue here...] In order to participate, certain exemptions and criteria must be met, some of which are:
- No more than $1 million is raised via crowdfunding in any 12 month period; and
- No single investor invests more than a specified amount in the offering:
- The greater of $2,000 or 5% of the annual income or net worth of the investor, as applicable, if the investor has annual income or net worth of less than $100,000; or
- 10% of the annual income or net worth of the investor, as applicable, if either the annual income or net worth of the investor is equal to more than $100,000, capped at a maximum of $100,000 invested.
- The offering is conducted through a registered broker or “funding portal”; and
- The issuer complies with certain other requirements. Some of the important ones are:
- Public listing of the name, legal status, address, website, directors, officers, 20% stockholders, and more
- Share price and methodology for determining the price
- A description of the ownership and capital structure of the issuer and a host of disclosures including a disclosure of various risks to investors
- Companies looking to raise $100,000 or less via crowdfunding can provide financials that are merely certified as true by the officers of the company. Companies looking to raise between $100,000 and $500,000 must provide “reviewed” financials, which means they have to pay a CPA to check them. Companies looking to raise over $500,000 must provide full-blown audited financial statements, prepared by a CPA. Moreover, every year after a successful crowdfunding offering, issuers must file with the SEC and with investors reports of the results of operations and financial statements of the issuer.
- The issuer must clearly disclose any compensation it pays to any person promoting its offerings through a broker or funding portal.
- Issuers are not allowed to advertise the terms of the offering, except for notices to direct investors or through the approved intermediary. Hence, all general solicitations for crowdfunding must at all times flow through an SEC-registered intermediary.
So, what are the advantages of using crowdfunding as your first effort and then going after professional investors? It does prove your business model is attractive to at least some segments of the population, a fact which would be attractive to the later investors. What are the disadvantages? Either too many crowdfunding investors and / or any non-accredited investors in early rounds will most likely cause professional investors to pass and find companies without the complexities in structure caused by crowdfunding rounds earlier.
With help from JJ Richa
The next logical step in our analysis of financing tools is to analyze asset-based lending, in which you pledge or assign your short term assets, such as accounts receivable or inventory, to the lender. Often, the lender then tracks the pledged assets until money is received or inventory sold, expecting repayment from the proceeds of sale.
Asset-based financing is a specialized method of providing structured working capital and term loans that are secured by accounts receivable, inventory, machinery, equipment and/or real estate. This type of funding is great for startup companies, refinancing existing loans, and financing for growth, mergers and acquisitions.
[Email readers, continue here...] One example of asset-based finance would be purchase order financing. This may be attractive to a company that has stretched its credit limits with vendors and has reached its lending capacity at the bank – or a for possibly a startup company without adequate financing. The inability to finance raw
materials to fill all orders would leave a company operating under capacity. An asset-based lender finances the purchase of the raw material. The purchase orders are then assigned to the lender. After the orders are filled, payment is made directly to the lender by the customer, and the lender then deducts its cost and fees and remits the balance to the company. The disadvantage of this type of financing, however, is the high interest typically charged.
Handling the reporting for such loans often require some amount of dedicated time. Many lenders require that a transaction report be generated along with a batch of purchase orders or invoices pledged as collateral for the loan. The lender has the right to reject any individual pledged item, and then calculates a percentage of the value as the amount to loan. Ranging from 50% to 80%, you can request an “advance” up to your credit limit, beyond which no more is available, and you must rely entirely upon your own devices to finance further transactions.
Each transaction report also contains a list of money received against pledged items, so that the calculation of available credit remains fresh, and based upon remaining invoices that are not yet overdue. Government invoices are usually not accepted, and any new invoices from accounts that have outstanding invoices more than 60 days overdue are usually also exempted, as are invoices to concentrated customers who account for a significant percentage of the company’s business.
Asset-based financing is not cheap. Lenders often tack on charges for management of your account, for a “float” of cash to account for the number of days to clear payments received, and for a periodic audit of the company’ accounts. Adding all of these often adds an additional 3-8% to the stated interest rate of the line of credit, sometimes making it one of the more expensive methods of finance.
Finally, some asset-based lenders are “factors” who actually purchase your invoices, hold back a portion of the proceeds to protect against future bad debts, then deduct their fees before remittance and remit a net amount, with the final amount to be remitted upon collection of the money owed by the customer to the factor. Factors redirect your customer’s payment to the factor’s postal lock box. You never see the cash collected, since the invoice is owned by the factor, no longer by you.
There are many other forms of financing a small business. Let’s explore some of them.
We’ve spoken of financing a young company through friends and family, known as “inside angels.” There are three classes of equity investors for early stage businesses that we have not yet considered. Often grouped into formal organizations, these investors are sophisticated, helpful, and connected.
First, angel investment groups come in all sizes from a few organized angels to large groups of three hundred or more. Each has a process in place to accept applications or recommendations for investment into new companies, and to review these and make decisions based upon their exploration, previous experience in the field, knowledge of the company or industry, or about individual entrepreneurs. Angel groups invest from $250,000 to $1,000,000 or more in qualified investments.
The U.S. Angel Capital Association (ACA) lists over four hundred member groups, located throughout the country. The European Business Angel Network (EBAN), and similar organizations in other countries including Canada, all have web sites with directories of angel groups that are local to you. And even though angel groups syndicate their best deals within their respective associated networks, it is always best to apply to the angel groups nearest your physical location. If you are starting a virtual company with your employees working from home locations, as many startups do, it should be the location of the founder. All angel groups will want to see the founders in person at sometime early in the process. Being located in a distant city greatly reduces the chance of funding success.
[Email readers, continue here...] With angel groups, you should plan of spending months in the process, from application through funding. You will have to hone your story well, down to fifteen minutes and perhaps fifteen slides in your presentation. Your opportunity becomes real when you are invited to present to the entire group at a lunch or dinner meeting, after which time one of the members or a paid group leader begins to seek commitments from the members to invest in your
company. You will be given a “term sheet” during the process, calling out the terms proposed for the investment. These terms have become much more homogenized over the years, with many organizations adopting the same general form and terms offered to new investments. Your principal focus may be on the valuation of the company before the investment is made, which determines the amount of the company you will retain after the investment.
Second, there is a rather new term for those large, individual investors who are usually former entrepreneurs made rich through sale of their previous ventures. These “super angels” act alone or in informal groups, and require that you find your way to them through personal introductions from their trusted associates. The advantage to getting the attention of a super angel is that most operate informally and make quick decisions with little due diligence. This class of investor typically writes checks from $50,000 to $250,000.
The third group, venture capitalists, rarely invests in startups, usually reserving their investments for companies that have star entrepreneurs they have worked with before, or companies brought to them by angel groups or other trusted sources. VCs often invest no less than $2 million in a single deal, finding it difficult to put less money to work and still spend time on boards and coaching entrepreneurs to a successful liquidity event. VCs need much higher exit values to justify their higher amounts of investment, and often want companies they invest in to be worth more than one hundred million dollars at exit, not a riskless task.
The one thing in common with all professional or organized investors is the focus upon the exit, or liquidity event, in which the investors can realize a sale of their interest and a profit from their investments of time and money. For early stage investors, the usual expectation is seven years from investment to expected liquidity. When you take money from any of these sources, you make a pact to build, with their help, a business that can be sold or taken public, hopefully within that time period.
These professional investors look for at least ten times their invested money back upon the liquidity event, knowing that the odds of achieving that are only one in ten, and that half of their investments will probably die before any liquidity event at all. They look for businesses that are in large markets, that can grow fast, and that can achieve revenues in excess of $40 million within five years of founding. Those are difficult goals for most entrepreneurs, making this form of financing unavailable to most, but attractive to those that fit into these criteria.
With help from JJ Richa
There are so many ways to finance a small business. Most of them rely upon some form of debt, often personally guaranteed by the founder(s). So we investigate the most simple of these methods of debt financing first, since most are simple to execute and non-dilutive – that is help you to retain your ownership intact.
Here is a list of common loan types:
- Line of credit – short term working capital
- Term loan –real estate, equipment or other long term capital requirements
- Guarantee based programs:
- Small Business Administration (SBA)
- CalCap – California Capital Access Program
- State loan guarantee
- Economic development programs such as CEDLI
The Small Business Administration (SBA) is a valuable funding resource for many businesses. However, the SBA itself does not actually make loans. Instead, the SBA guarantees bank loans, allowing commercial lenders to make loans that they may not otherwise. The SBA, through its programs, reimburses lenders for a guaranteed portion of the loan (usually up to 85%), making it less risky for them.
In order to be able to obtain a loan, SBA or conventional, you must meet the basic financial institution risk rating, which is known as the “5 Cs of Lending”:
- Character – responsibilities and treatment of employees and customers
- Cash flow – debt handling, repayment record, debt liquidity and ratios
- Collateral – hard assets, real estate, capital equipment, accounts receivable
- Capitalization – skin in the game, business resources, own risk
- Conditions – economic conditions, market sensitivity ,expense management
By David Steakley
If you are a screenplay writer, you are familiar with the dogma of the inciting incident. In a movie, the inciting incident is the event at the beginning of the story which causes the hero’s life to be completely transformed and irrevocably changed, and which makes the whole story unfold. Companies also need an inciting incident, because, more often than not, you often will depend upon selling your story to someone. What is the inciting incident for your company? How can you get to it more quickly and with less capital?
Every good story has an inciting incident. You may not spot it at first. For example, ask yourself: “What is the inciting incident in The Godfather?” This one is tricky, because it doesn’t occur until 45 minutes into the film, when Vito Corleone is gunned down in the street. This event totally changes the life of Michael Corleone and makes the rest of the story happen. Ok, now you’re an expert: quick, what’s the inciting incident in Star Wars?
The terminology is from the movie industry, but the concept applies to all stories. Every good story has an inciting incident. I am father of four kids, tween to teens, and I
sometimes kid them, as a seemingly pointless anecdote trickles to an end, with the capper “…and then you found five dollars?” This is amusing (to me, at least) because it points out that the story lacks an inciting incident.
[Email readers, continue here...] Story seems to be an artifact of the human brain, and soul. It is a key part of what makes us human. Stories are the most important repository of wisdom, experience, knowledge, and learning. Story telling is often a key aspect of a great leader’s talent. For example, while Steve Jobs was abusive, rude, and unappreciative, he had what his colleagues referred to a reality distortion field. He told his team how it was going to be, and even though his story of what was going to happen seemed to be completely unrealistic fantasy, he made his team believe the story, and his teams of believers made it come true.
I found myself explaining all this recently to a company team that was pitching me on its story. The company is building a website to match commercial tenants with commercial landlords. They told me all about why this is such a good idea: hard to manage price discovery in the commercial real estate market; fragmented information about vacancies obtained from landlords and brokers; and the large scale of transactions. They told me about their expertise and their network of contacts, and their early customers, and the promising results so far. They wanted to come to pitch to my angel network.
I told them they lacked an inciting incident. None of the angels in my group is likely to write a check without hearing and believing a story about how something dramatic is about to happen. The very best thing, I told them, would be to come back when the inciting incident has just happened, but the consequences have just begun to unfold. We talked about what this could be: major PR to drive tenants to the site; signing a deal with a major landlord to greatly increase listings; a scheme to source listings at massive scale from public data–there are a lot of possibilities, but they didn’t have that element.
When you’re selling your company to potential investors, you have to work hard on your story, and the story doesn’t really begin until the inciting incident.
Answer: In Star Wars, the inciting incident is Darth Vader’s attack on Princess Leia’s spaceship.
David Steakley, a past President of the Houston Angel Network, is a reformed management consultant. He is an active angel investor, and he manages several angel funds in Texas.
By: Arthur Lipper
In the process of raising funds to create and develop a business, entrepreneurs make many statements to those they seek to attract as investors. In my years of investing, I’ve developed a set of tough questions that are sure to elicit both information and a vibrant dialog – questions not on the usual checklists of angel groups or investors. So here are a number of them. Can you answer these? If not, isn’t it worth the work to prepare for the time you’ll be asked some or many of these? And isn’t it worth the effort for your own good as you build for success?
If you are an investor in an early stage venture, wouldn’t a dialog using these questions help greatly in defining and perhaps reducing your risk?
Revenue projections: What will happen to the company if the revenues and earnings projected on a worst case basis are not achieved as predicted? When will the company run out of money if the development of the enterprise is at a slower rate than expected? How much skin do you and your fellow founders have in the game? In a liquidation, would you have profited at the expense of your investors by taking high salary or draws before breakeven?
Liquidity event: Name at least five companies that might be ready to acquire the enterprise if successful. On the flip side of success, which companies or individuals are most likely to want to buy whatever is left of the company if it is unsuccessful?
[Email readers, continue here...] Metrics and management: What might be the first indication the company will not be able to achieve its goals and objectives? When and under what conditions should the CEO and management of the company be changed?
Valuation and fund-raising: How did you arrive at your proposed pre-money valuation? Has this been tested with investors? Who else has been approached to provide funds? What will the proposed managers of the enterprise do if the project does not proceed?Management experience and skin-in-the-game: What has been the experience of the founders and managers in past ventures? Will you and your managers plan to invest cash on the same terms and conditions as you ask? Would you and your managers invest funds, if loaned to them by the investor or others, in the enterprise on the same terms and conditions as is being proposed to the investor?
Profit potential: What is the proportionate profit potential relative to cash investment between the investor(s) and the managers in the event the business is as successful as is predicted? What is the single most important event you expect to foresee for success, and what will happen if it does not occur when anticipated?
As most human endeavors fail to achieve the results originally hoped for the above questions are fair and reasonable – because your angel investor is being asked to accept your forecasts and event predictions to entice him or her to invest in your enterprise.
Arthur Lipper has been a well-respected member of the international financial community since 1954. He has served as advisor to and member of numerous financial exchanges, and was the founder and CEO of Arthur Lipper Corporation and co-founder and Chairman of New York & Foreign Securities Corporation. Today he serves as Chairman of British Far East Holdings Ltd. He has written numerous books and articles for entrepreneurs and investors, and was the publisher and editor-in-chief of Venture Magazine.
The biggest error in planning may not be spreadsheet calculation error. Or cost estimation. It is most often missed assumptions about the market, the competition, the speed of adoption, or other critical metrics you’ve researched, or selected, or even just guessed at to create your plan.
Where did you get the data to drive your assumptions of market size or market share? Most entrepreneurs quote a resource for market size, but fail to then take the next step to eliminate all parts of that market unreachable by the company or product. For example, if you supply software to the chip design industry, do you segment your market into digital and analog users, into high end or inexpensive buyers, and into which languages or platforms users demand or request?
It’s easy to find someone to quote a size of market estimate. I became something of my industry’s source for such a number when I carefully catalogued the 160 players both domestic and international, estimated revenues from knowing the number of employees or installations for each (which were often public knowledge or stated by those companies.) I then created a gross domestic and gross international annual market size estimate for my industry’s products. No-one challenged this number, and it became an unattributed source of the metric for market size for years. Perhaps there was no other way to project the size of that market. But many decisions were made within my company walls, and surely by competitors, based upon those numbers.
[Email readers, continue here...] Then there is the famous entrepreneur’s statement about market share: “All I need to sell is one percent of the total available market to make this a rampant success.” We call that the “gloves in China” syndrome when analyzing assumptions within business plans. Without a trace of how the business will get that one percent, the entrepreneur confidently shows that this is all it takes to make us all rich. Even if the total number of annual units in a market is known, the leap to a percent of that market without a specific plan is often a fatal one.
And these are just two of the many assumptions that underlie any business plan. At the very least, all assumptions should be driven by numbers separately listed in an “assumptions section” of the planning spreadsheet, allowing the reader to manipulate those assumptions to see the various outcomes, and challenge the numbers for the benefit of all who have to defend them.
You’ve heard the old one – that a banker always seems willing to offer a loan when you don’t need it. For small businesses, there is such truth in that statement that you can trust the story to be based in reality from experience.
There are great exceptions for growing businesses and for businesses that have a track record with a banker. Working capital loans and lines of credit are needed for growth and during times of business stress. If a business were operating above breakeven and revenues and expenses steady, profits would flow to either the shareholders’ pockets or to working capital and taxes. Each cycle gives the CEO a chance to use those profits to some positive advantage, including increasing the marketing budget, paying down loans, building working capital, increasing “sticky cash” balances or paying shareholders.
[Email readers, continue here...] But if a good business finds itself in a bad downturn, there may be a need that did not exist before for temporary cash, even as management reacts and moves to trim fixed overhead.
Approaching a banker during such times tests relationships. If there was no previous relationship, few bankers would rely upon anything but a personal guarantee backed by hard assets before considering a loan. But for those wise executives who included their bankers in occasional update calls, press releases, invitations to company events and an occasional personal visit, the strength of the relationship will often show its benefits during times when lending rules of the bank are near the “can’t do it” point.
For those with existing bank loans, that constant attention is more than just important. As loan covenants become closer to being violated or after such an event, bankers have some latitude in deciding how to handle their accounts. Upon discovery without prior notice or updates, bankers sometimes turn the company over to the bank’s workout group – a place you never want to visit. In the gray area where covenants are broken but barely, covenants can be waived for a period of time as companies rectify the problems, all based upon the quality of the relationship between banker and client.
It is during those challenging times that it is most difficult to tell the story to your banker, but just then the most important of times.
Investors sometimes join into investment rounds that have been pre-negotiated by others, receiving the paperwork already created by attorneys from that negotiation. It is not uncommon for a sharp investor to discover a “stinky” clause or two in such agreements when reading them in preparation for signing. Bill Payne came across just such a stinky clause in a recent deal we both were late in the process of joining.
Changing the deal that late in the game is nearly impossible, after other investors have already completed their documents and the deal supposedly put to bed. So what does the latest tag-along investor do?
You can tell from the title of this insight that the usual result is to passively sign while holding the nose, a trick perfected by experienced investors suffering this malady for not the first time.
What if it is the company attorney or entrepreneur that finds the stinky clause so very late in the game? How do you confront the investors who have already agreed to terms and even perhaps signed their documents? Is it worth risking the deal to negotiate a late change during the equivalent of the ninth inning?
[Email readers, continue here...] The answer is obviously in the importance of the issue to the person discovering it. In most cases, the probability of whatever the clause being triggered sometime in the future is slight, and therefore the risk remote. So it is a bet against the event made with chance on your side.
Then again, it is those improbable future events that end up causing lawsuits years later, often just because a party to an agreement did not understand the implication of a clause or even a document. We hire attorneys precisely to help us prevent future conflict by resolving issues before they happen.
Most of us will let the matter slip and sign while holding our nose, a feat in itself (holding the nose, paper and pen at the same time). Some of us will pass on the deal rather than confront the issue, especially if it is an important one to the late signer. And that often happens when just such an issue has bitten the candidate investor in some past deal, making the likelihood of such negative reaction higher with sophisticated, long time investors.
Maybe there are skunks in the woods that don’t even know they smell. Or maybe there are targets in the woods without the capacity to even catch the odor of a bad negotiation or deal documentation. Either way, there are risks in deals we sometimes never catch – that later catch up to us in the most surprising places and times.
This important variation on “money talks” is an important consideration for entrepreneurs when seeking an investment from professionals such as VC’s. Something like a marriage (and often lasting just as long statistically), your investment partner can be a great cheerleader, coach and resource. But the moment things turn sour, including missed plans, some investors on company boards go into a predictable mode of dictating terms for emergency loans or additional investment.
These include forcing early investors to “pay to play,” or invest their pre-rata amounts to keep their original percentages, or suffer the consequences of being diluted to the extreme and losing preferences in a liquidation.
The reaction to bad news by VC’s controlling the board by virtue of their power to supply additional money, often includes the threat – or reality – of starting the process to find a replacement CEO. So the combination of bad news and VC or professional investors on the Board can be volatile for the founders or management. Angel investors tend to be much more understanding, and usually resort to coaching rather than replacing the CEO during bad times.
[Email readers, continue here...] These are only a few of the considerations that have caused an increasing number of early stage entrepreneurs to draw business plans for companies that can be grown with angel and friends-family capital. It avoids the increased risks and pressure that come with subsequent VC investments.
On the other hand, if a business needs large amounts of capital in order to succeed, the entrepreneur and board should contemplate the advantages gained against the increased risks, making a conscious decision to go for the growth with such funds or to grow organically – or to grow with a smaller round from internal investors.