Photo Photo Photo Photo

Raising Capital on Acceptable Terms

Sources of Capital

Precise practices vary between individual investors or lenders in a given category and change with market conditions. Identifying appropriate sources of capital and developing a fund raising strategy to tap them depends on knowing what kinds of investments investors and lenders are seeking. Doing the appropriate research and/or engaging an investment banker in advance can save months of management resources and cash, while significantly increasing the odds of successfully raising funds on acceptable terms.

Financing Life Cycles

Sources of capital have different preferences and practices, including how much money they will provide, when in a company's life cycle they will invest, and the cost of capital or expected rate of return. The available sources of capital change dramatically for companies at different stages and rates of growth. The graphic below depicts the financing life cycles of firms. It shows the source of capital available over time for different types of firms at different stages of development.

                                                    click image for pdf

Sources of Capital

Angel Investors

Angel investors represent the first outside financing source for many start-up companies. An angel is often a wealthy individual who is willing to take risk and is knowledgeable about a specific industry in that the start-up is competing. Angels often are successful entrepreneurs themselves.

Angels typically demand between 20% and 50% equity ownership in a company, and their involvement helps to establish the first valuation of the company's worth. Many successful angels will only participate in new ventures that offer a return of five to ten times their investment over five years. Angels often serve on a company's Board of Directors and/or on the management team to guide the company's success and to watch over their investment.

Crowdfunding Portals

Crowdfunding is typically conducted via an internet-based funding portal. It involves raising capital by receiving small investments from a large cross-section of accredited investors in an internet community. Crowdfunding in the United States is pursuant to new laws included in the CROWDFUND Act of 2012, part of the JOBS Act. These new laws allow small and emerging businesses to raise up to $1 million by offering equity or debt investments to accredited investors.

An accredited investor is a director, partner of officer of the issuer; an individual with single income of more than $200,000 in two most recent years; an individual with net worth of at least $1 million; or a trust with the purpose of acquiring securities with total assets of more than $5 million.

Venture Capital

Venture capital is provided by private investment funds that specialize in scouting and evaluating promising, early stage companies. Venture capitalists are typically interested in companies that have high growth potential after they have developed attractive products and intellectual property. They may also be attracted to companies with strong management teams and business plans.

A venture capitalist typically takes a long term approach to a portfolio company and does not demand liquidity or dividends in the early years. Many companies go through several rounds of venture capital, with some investors participating in each round to avoid diluting their equity. In a successfully growing company, the price of entry increases with each round.

Although most venture capital is equity based, financing may include some debt. Venture capitalists often request warrants to leverage their potential upside if the business is successful. A warrant is a long term instrument attached to preferred stock that entitles the holder to buy stock at a specified price for a period of time.

The Small Business Association (SBA) Venture Capital Program provides venture capital to new businesses through a Small Business Investment Company (SBIC), a privately-owned investment company that is licensed by the Small Business Administration (SBA). It supplies both equity and debt financing. It may borrow from the federal government to augment its private funds. Investments typically range from $100,000 to $350,000. It is a viable alternative to venture capital for small enterprises seeking startup capital as it tends to be considerably more entrepreneur friendly in terms of cost of capital and terms. To qualify, a company must have a net worth of $18 million or less and its average after-tax net income for the two most recent years may not exceed $6 million.

Private Placements

Private placements involve the non-public sale of equity, debt, preferred, or convertible securities to an unlimited, but relatively small number of accredited investors. The first step is the preparation of a business plan that defines the company's long term capitalization strategy. The company typically hires an investment banker to determine the amount of money to be raised, the evaluation and selection of preferred financing options, and the valuation of the securities. The optimal financial structure is one that minimizes loss of control and dilution.

Convertible debt is another option that can be attractive to both the company and investor. Like debt, it reduces the risk to the investor because it offers a fixed interest payment.  Like equity, it offers greater long-term potential if converted into shares. This is an attractive option for start-ups that prefer to postpone valuation of the company until a later date. The goal is that in the future the track record of sales and profits support a higher company valuation that will result in having to give away less equity to investors that would have been necessary during the initial capital raising.

Mezzanine financing may be structured as straight debt or as a class of preferred stock.  It is often offered at a high interest rate through a private placement when more traditional financing is not available, such as when a distressed company needs access to capital markets. If the company is not able to meet interest payments, mezzanine debt may include a provision for pay-in-kind interest, which increases the debt principal or adds "equity kickers" such as warrants to purchase common stock. It is generally subordinated to debt provided by senior lenders such as banks and venture capital companies. Because mezzanine financing is typically provided to the borrower very quickly with little due diligence and little or no collateral on the part of the borrower, the cost of capital is higher than that from a bank or asset based lender.

The private placement offering is made through a Private Placement Memorandum, a disclosure document that is prepared for circulation to investors.  Like a business plan, it describes the company's current situation and a summary of its plans for the future.

Strategic Alliances & Partnerships

Regardless of the viability of alternative financing, strategic alliances and partnerships can realize cash flow, strategic customer relationships, market intelligence, application know-how and more - often without dilution of equity or loss of control. When strategically integrated into the company’s business model, they can cement competitive advantages that thread through the supply chain and distribution channels - capturing value. They are often, however, a last resort - considered only after burning through many months shopping business plans to angels, venture capitalists and lenders.

Early access agreements can immensely benefit an early stage technology company as well as their strategic partner. Deal structures vary, but fundamentally, in exchange for early and sometimes exclusive access to a company’s products or technology for a specific application or market segment, a strategic partner may agree to purchase prototypes and engineering services, execute a license agreement with upfront payments and royalties, and/or agree to invest its marketing resources to fuel broader adoption. In addition to cash, the company gains access to market intelligence and applications know-how - often a vast chasm for early stage technology companies. The strategic partner, on the other hand, earns a competitive advantage with early access to potentially market disrupting technology without the expense of in-house R&D.  R&D is an avoided expense for established companies with shareholders’ short term profit expectations.

There is also opportunity for early stage to late stage companies to harvest elements of their technology whose commercialization is outside the scope of their business plan with licensing-out agreements. Licensing deal structures vary, but fundamentally, in exchange for rights to a company’s intellectual property for a specific application or market segment, a licensor would execute an agreement with upfront payments, royalties, purchase of technology transfer services, and/or purchase of the platform components.


Banks & Asset Based Lenders

Often, early stage companies look to establish bank financing relationships early in their development, particularly to finance working capital. Banks may be willing to extend a line of credit to a start-up, especially if the owner provides a personal guarantee. If the business has collateral assets, asset backed lending may be viable for a portion of the capital needs, and limit dilution.

The Small Business Administration (SBA) facilitates several programs designed to help start-up businesses access financing through banks and other commercial lenders. The SBA's role is to establish lending guidelines and then guarantee that loans will be repaid, to reduce risk of loss to participating banks and commercial lenders. The SBA 7(a) Loan Program is available to new businesses for the purchase of land or buildings, to acquire equipment or machinery, to refinance existing business indebtedness, for long-term or short-term working capital, and to purchase existing businesses. These loans may or may not be used to refinance existing debt that is likely to default, to reimburse funds owned to the owner, or to pay delinquent taxes.

Employee Stock Option Plans

An Employee Stock Option Plan (ESOP) is a stock bonus plan or contribution stock bonus plan with a money purchase pension plan that purchases employer’s securities with funds from the employer that would have been paid as some other form of compensation. A leveraged ESOP uses borrowed funds from the company and/or third party with company securities as collateral. The ESOP repays the loan from employee/employer contributions with the requirement that the employer's contribution as a percentage of payroll or profits provides for a minimum to pay principle and interest on the loan.

Public Offerings

Initial public offerings (IPO) of stock produces a number of important results. It provides a liquidity event for founders and early investors.  It raises permanent equity capital to fund the company's ongoing needs. A successful IPO can enable a promising company to grow more rapidly because capital becomes more plentiful and perhaps less expensive.  It also creates liquid stock that can be used to tie executives and employees to the company through option grants, employee stock ownership plans, and other means.

Follow-on offerings are a public offerings of company stock after the IPO. They are useful in raising new permanent capital, refinancing debt, and cashing-out shares of founders, promoters, angels, and venture capital investors.


Precise practices vary between individual investors or lenders in a given category and change with market conditions. Identifying appropriate sources of capital and developing a fund raising strategy to tap them depends on knowing what kinds of investments investors and lenders are seeking. Doing the appropriate research and/or engaging an investment banker in advance can save months of wild-goose chases and cash, while significantly increasing the odds of successfully raising funds on acceptable terms.