Chapter 2: Raising Capital in the United States
Capitalizing on the Winds of Change
When referring to raising capital, we mean raising substantial amounts of capital for the traditional working capital needs of "for-profit" organizations. Unless you have really wealthy relatives who really like you a lot, for all practical purposes, there are only two ways to legally raise capital in the United States. Although it is nice if you can get it, we do not consider grant money available from governmental or other organizations a form of working capital for a start-up, early-stage, or even seasoned companies because the availability and the amount of funds is always shifting, the probability of attainment is very low, and it generally comes with strings attached. However, we do encourage the attainment of such funds, under the right circumstances, once the company is properly capitalized through traditional means.
In addition, although it lessens the amount of working capital needed, - a very good thing - franchise sales, pre-construction price sales, or the sale of other rights, are not considered raising capital because these are booked as sales and are finite in nature. We do consider any commercial lending activity as part of a capitalization plan or deal structure, which would include bank loans and lines of credit-SBA guaranteed or not-factoring of receivables, and purchase order financing. We embrace reasonable amounts of debt as part of the overall capitalization mix, because it is the least expensive form of financing, if one assumes success. However, before one can obtain reasonable amounts of debt financing from banks, one should have substantial amounts of equity raised or retained through earnings from a sustained operating history, which eliminates most start-up and early-stage companies.
To raise capital in the United States legally, you must do one of the following:
- Produce a business plan and submit it to institutional sources of equity and/or debt capital, such as venture capital firms, commercial banks, private equity firms, etc., then allow them to offer the terms of the financing. When they make the offer of terms by issuing a term sheet to your company, it is not considered a securities offering because your company is not making the offer.
- Conduct a securities offering. There are only two ways to legally conduct a securities offering within the United States:
- Register the securities on the federal and state level or
- Issue a private placement of securities by claiming or qualifying for an exemption from federal and/or state registration.
Our Premise. As you may know, submitting business plans for substantial amounts of funding, to institutions, such as; venture capital firms, commercial banks, investment banks, and private equity groups, simply does not work for most start-up, early-stage or seasoned smaller companies. When it does work for the very few, there is often too much equity and control given up to make the funding worth it. Therefore, we developed a process to enable you to compete directly with those institutions for individual investor capital, until you become the "quality deal flow" that they seek. Once you have achieved that goal, you will be able to deal from a position of strength, enabling you to dictate the terms of futures rounds of financing.
Now its time to discover how to gain a substantial edge over all other entrepreneurs seeking capital, by showing you how to issue privately or publicly placed securities that can compete directly with other investments and ultimately with financial institutions.
The really good news is that you have a proverbial "perfect storm" in place for capitalizing your company based on a dramatic shift in the patterns of two closely related segments of the securities industry. The first part of the "perfect storm" is the current state of publicly-traded fixed-income (Bond, Preferred Stock, Mortgage and Certificate of Deposit) markets: the limited availability of high-yielding investments coupled with an insatiable market demand for that type of investment vehicle or security. The second part of the "perfect storm" is the amount of talent available, already highly trained by the large securities brokerage and investment banking firms, who are finding it more difficult every year to make a decent living in their present positions. Many of these professionals would love to work for your company in a senior-management-level capacity.
The first part of the "perfect storm" lies with recognizing that individual investors are feverishly seeking high-yielding cash flow from their investments because they are always in need of additional income to supplement their retirement lifestyle. From the late 1970s throughout most of the 1980s, individual investors invested hundreds of billions of dollars in twenty to thirty-year bonds issued by the United States Treasury, U. S. corporations (for taxable income) and municipalities (for tax-free income). The yields on these bonds at the time of their issuance where at all time highs. US Treasuries sold with 14%, 16%, even up to 17% interest rates; corporations issued bonds at even higher rates. Municipalities issued bonds at 12% to 14% because the interest is not taxable to investors at the federal level and the interest is not taxable to investors at the state level if the investors reside in that state. These bonds are now maturing and being refinanced at substantially lower rates. Investors are receiving very large lump-sum payments of principal due to the maturing of these bonds and are zealously seeking higher yields than are currently available in the marketplace.
Imagine an investor who owned $1,000,000 in tax-free municipal bonds with a 12% coupon or interest rate. The investor was living on $120,000 in annual tax-free income until the bond matured and received his $1,000,000 principal back from the issuer. Now the investor can buy the same bond with the same maturity (thirty years) and with the same quality rating, but only with a 4% coupon. Yes, the investor just took an $80,000 hit on his or her annual tax-free income. This is not a phenomenon; it is just economic reality based on obligations (bonds) that were created twenty to thirty years ago, which are now maturing and will continue to mature for the next decade or so. By issuing competitive high yielding securities, your company will be able to capitalize on this opportunity over the next decade or two. Knowledge is power. The average entrepreneur has little knowledge about what is happening in these fixed-income markets, but now you do. The question is; what are you going to do about it?
Because the financial institutions have market constraints, they cannot offer 8%, 9% 10%, 11%, or 12% yields on investor funds by issuing notes or bonds. Banks cannot issue five-year CDs with an 8% yield if they are lending at 6.5% on home mortgages or car loans, because they can't make money that way. Publicly traded corporations that are healthy cannot issue 10% bonds when they can issue them at 6%, as the Board of Directors would be in breach of their fiduciary duty to the shareholders. And, guess what, retiring baby boomers will be purchasing more and more of these fixed-income instruments (i.e., bonds, notes, CDs, and preferred stock) to supplement their retirement income stream. When their demand exceeds supply, which is already happening and will continue for some time to come, they will continue to bid up the prices of these fixed-income instruments, thereby inherently lowering the yields.
Because your company is privately held-or even for those that are publicly traded, you have the ability to set the "yield" component on your securities above current market rates, thereby attracting investors in droves who are hunting for yield.
In the not too distant past, if the management team of a start-up and early stage company attempted to sell and issue these types of fixed income securities, they would be looked at as "needing their collective heads examined." Common equity was the only sensible form of security to be issued. However, when the fixed income markets' demand became insatiable for high yield, issuing common equity (too much for too little too early) became a little ridiculous as it was less attractive to most individual passive investors, henceforth the dynamic shift in what type of securities you should be selling.
How does one market these securities? Under Regulation D, you can issue securities through a private placement. The offering must be just that: private. You cannot use the general media or any other marketing effort that is considered mass marketing, such as direct mail. Depending on how well connected you and your management team are, (for later stage companies don't forget about your new VP of Finance here) you may be able to raise the required amount for the first round or two.
Eventually though, you may need to consider qualifying for an exemption from registration under Regulation, A or CA (1001), or register the securities at the state level (SCOR) to attract and build a whole new pool of individual investors. This involves a pre-filing for qualification of the exemption with the SEC and the state(s) regulatory authority concerning securities regulations where the securities will be solicited. By qualifying for the exemption, you are allowed to advertise your securities offering through the general media. Now you are competing head-to-head with financial institutions for individual investors - based on the ability to provide a higher "current yield" and consistent cash flow to investors.
Over the next few decades, there are and will continue to be literally millions of investors looking to invest trillions of dollars in the U.S., who are seeking high-yielding investments. Yes, trillions of dollars because, in the mid-1980s, the U. S. budget reached over five trillion in debt, most of which was financed with twenty- to thirty-year treasury bonds that are now coming due. (That figure doesn't include corporate or municipal bonds.)
The second part of the "perfect storm" lies with recognizing that one can hire, relative to the past, securities professionals who have investor contacts and skills sets to assist you in raising substantial amounts capital for your company. As previously mentioned, one should have ample capital on hand and or sufficient cash flow before considering this part of the process. Remember, this is an additional option, primarily for early stage companies, not a requirement of the process. This option is rarely used for start-ups.
The securities industry has become, and continues to be, commoditized. Because of the advent of online trading, investment portfolio management, and information available on the Internet, those investors who have the time, can easily learn how to manage their investment funds on-line over the Internet without the need for professional advice. As a result, firms in the securities industry have been cutting costs to compete for the "hands on" advisory business that still is available. Services are being increased and prices decreased. That's good news for the average investor but bad news for the industry, and especially for the financial advisor profession. Most investment portfolios are managed in "fee based accounts" that started out with annual fees of 2% to 3% in the 1990s, are now down to as low as 0.25% to 1%, and could continue to move lower.
Let's analyze this further. Let's say the fee for the average account size under management is 1%. The average commission payout to the financial advisor at most investment firms is 35%. Therefore, a new financial advisor will need to attract and raise a lot of capital just to eat. To be fair, most firms will pay a salary for one or two years for the Financial Advisor Trainee, but if the commission payout doesn't warrant the salary paid to the financial advisor, then he or she is let go.
Let's say a financial advisor can raise $20,000,000 in the first two years of employment. Assuming the 1% fee with the 35% commission payout, the financial advisor will start the third year off at $70,000 in income. The financial advisor had to raise only $192,307 a week on average (52 weeks per year times two years with no time off) for an annual income of $70,000 in the third year. What's the big deal, right? Imagine having to sell securities at a rate of $200,000 a week with nothing special or different to sell! The financial advisor is selling the same commoditized services as everyone else in the industry. They're all fishing in the same publicly traded pond. No one has an edge over anyone else, so as an informed investor why would I want to move my funds from one firm to another? In addition, what happens to our friendly financial advisor when markets crash? Investors move into other things, like real estate and private placements of new companies. What happens when markets rise? Investors don't move from one brokerage house to another for no reason. However, they do feel wealthier when markets rise, so it is easier to get them to invest a small amount of their total portfolio in riskier ventures like your company.
It's common knowledge in the securities industry that 82% of all new trainees leave the industry after their twenty-fourth month. As a licensed professional in the securities industry for over twenty-two years, I saw these trends coming some time ago; that is why I decided to get out - ahead of that wind of change. The point is financial advisors now have to kill themselves to eke out a living within the framework of the securities industry. The average cold call quota for the major Wall Street firms is two hundred a day-a thousand a week-and it's closely monitored. Can you imagine what kind of degrading work that must be? Fail to make the calls? You're fired, period. Make sure your desk is cleaned out by close of business. And, oh by the way, thanks for opening accounts for all your friends and family members.
What does this mean for you concerning raising capital for your company? I think you can answer that yourself. Do you think these financial advisors would like to be part of your company's senior management team, starting out with a respectable base salary, not to mention some semblance of self-respect for their intellect and investor contacts, or continue to slug it out over the phone like dogs fighting over a bone? Do you think they may know individual investors who would be interested in investing in your company? Do you think they have the selling skills and compliance knowledge to handle the task? Could you afford one or two if they each raised $200,000 a week, a month or a quarter for your company?
The fact is that most of these young professionals are caught in proverbial high-end sweatshops; they are looking for a way to use their knowledge; and most would jump at the chance to come in as a part of the senior management team of a promising start-up or early-stage company. Most have the selling skills to sell securities and handle the administrative compliance to get the job done. And better yet, there are many older former professionals from the securities industry that have huge contacts (for capital and otherwise) who are just itching to get back in the game - part time of course. Imagine having one or more of these heavy hitters on your board of directors or board of advisors fulfilling the need of high level introductions to your firm. Get creative here!
How do you hire one or two of these highly trained professionals who have investor contacts? Put an advertisement in your local newspaper or use any other familiar method you have used when seeking talented employees. This is not rocket science; it's what Wall Street firms do every day. If you believe hiring a VP of Finance is appropriate for your company at this stage, then once you have started the securities offering document production process, you should immediately start the hiring process by placing advertisements in the employment section of your local newspaper. Alternatively, if you're in a small city, consider placing one in the newspaper of the closest large city. Collect resumes for a week or two, set up and conduct interviews in weeks three and four. By the time the interviewing process begins, your securities offering document draft should be completed and you can show a prospective VP of Finance what he or she will be expected to sell. If hired, be sure to add their biography to the Management team in the securities offering document.
What happens to your new VP of Finance once the capital is raised? First of all, many entrepreneurs feel that they only need to raise a certain dollar amount of capital and the business will then fund its own growth. Rarely, is that the case. Typically, to grow a company to its full potential, there is a consistent need for additional capital. You will need your VP of Finance to plan, prepare and oversee you company's ongoing financial needs and capital-raising efforts, as well as handle administrative compliance duties of any securities offerings. The VP of Finance does not replace a Chief Financial Officer (CFO). A CFO is generally someone versed in accounting practices, such as a CPA who "accounts" for all the financial transactions of the company. The VP of Finance, on the other hand, plans for future capital needs, researching what capital and financial structures are best suited for the company to meet its goals. The VP of Finance will generally oversee all securities offerings, refinancing efforts, leasing arrangements, and franchise sales if applicable. The point is, the VP of Finance's work is rarely done and if your company grows, affording the VP of Finance is never a problem. Your Finance Department may just be the cornerstone of your company's success, not a beast of burden.
This second part of the "perfect storm" simply recognizes that you can hire former (early retirees from the securities industry) or current Financial Advisors away from these Wall Street firms in any town, city, or village that has a branch office of investment firms, for a reasonable base salary and benefits.
Current securities laws state that there are only two ways to legally raise capital for your company: produce a business plan and send it to financial institutions (for a 1.5% probability of funding). Or, after creating the required securities offering document, sell securities directly to individual investors, in compliance with federal and state securities laws (for a much higher probability of funding) or engage an SEC registered investment bank / NASD member broker dealer to sell the securities on your company's behalf. Only SEC-registered investment banks/securities broker-dealers (investment firms) or bona fide employees of the issuing company can legally solicit and sell your company's securities. Reputable broker-dealers will not engage a start-up or a very early-stage (generally defined a companies with revenue less than $5,000,000 annually) company. Therefore, if you do not have a qualified person to handle these tasks already, you may need to hire a qualified bona fide employee to become your company's VP of Finance, away from a broker dealer or better yet, one that has recently left the industry to search for new opportunities or is getting a little bored with early retirement. If a financial advisor applying for the position of VP of Finance can't raise money then you shouldn't hire him or her. Hire those who are willing, ready, and able to handle the task of raising capital for your company. It's that simple.
We know exactly what most entrepreneurs want and expect. They want and expect someone or some entity to raise the capital for their company on a straight commission basis with no up-front fees and they need the money within 30 to 60 days. Most think selling securities to raise capital is like listing property with a real estate brokerage firm. Nothing is farther from the truth for a start-up or early stage company. The problem: only SEC Registered Broker-Dealers can legally solicit and sell your company's securities for a commission. SEC Registered Broker-Dealers charge prospective companies between $25,000 to $100,000 up-front in due diligence fees (depending on the complexity of the deal) before they commit to an engagement, and most will not engage start-up and early stage companies under any circumstance. Even if the company qualifies for an engagement with a SEC Registered Broker-Dealer, the due diligence process can be 60 to 90 days and one should not expect the money within the aforementioned time constraints. The 60 to 90 days is needed just to make a decision whether or not to engage your firm in a securities underwriting agreement. Once that has been accomplished, then the securities offering documents must be prepared - which can take another 60 days and cost anywhere from $30,000 to $50,000 for a private placement memorandum to $250,000 or more for an exchange listing. The point being, this is not a real estate listing arrangement, its serious business and the real players know it. Now, you do too.
If you produce securities and the requisite documents with competitive yield and income participation components (we'll get there soon enough) that meet investor demand relative to the risk, you can attract some of the massive amounts of capital available from maturing bonds. If you set up and staff your Finance Department with trained professionals from the securities industry to handle the task of soliciting and selling securities in compliance with federal and state laws, you will raise as much capital as you need. You'll be amazed at how easy it is once you have learned the process and have built an effective finance department.
There is only one legally viable alternative to submitting business plans to financial institutions and that is to create a securities offering with a "marketable" deal structure, establish an in-house Finance Department and staff it with those from the securities industry who have the ability and the financial contacts to get the job done. The Financial Architect System™ simply shows you the process to use other peoples' money, legally.
No matter how you look at it, the capital raising process costs time and money. You may be thinking that it doesn't cost much to send business plans to venture capital firms. How much do you think failure to receive the funding costs? How much do you think success of funding costs with this approach? Well, it's far more costly in the long run if you assume your company becomes a success because the venture capital firms may take more equity than you need to give up.
If you have yet to appreciate the logic behind this simple process, I suggest you go back out there with the rest of them and get kicked around with broken promises a bit more. Eventually you will either appreciate the process and embrace it or you won't.
You may be thinking. "Why does this need to be this complicated?" Federal and state securities regulators are interested in mitigating securities fraud, so they set up hurdles one must go through. Most won't go through the process because they really believe that there is an easier softer way. There's not. Take heart, if this was easy, everyone would be doing it and you would have to work twice as hard for the same result.
I am often asked; "What are the common denominators that differentiate those who succeed in raising capital and those who don't." Ironically, I wrestled with this for some time, but I concluded that dedication, focused concentration and a "take no prisoners" attitude and commitment to the process of a series of securities offerings seems to be the common denominators for those who succeed. Conversely, entrepreneurs who "don't have a clue" about what they're doing, have an entitlement mentality and expect someone to do this for them are the common denominators for failure - on all fronts, not just securing capital. I say I "ironically" wrestled with that question for some time, because these are exactly the reasons why we created the Financial Architect System™ in the first place. It simply took more time for me to get to the point than I initially intended.
One last comment before we move on to the mechanics of the process. You only get one first bite at the apple. If you do this without the proper deal structure, the requisite disclosures required within a securities offering document, and the marketing fire power to get the job done, you may ruin any chance you have. Most securities offering documents we see are not only a joke (deal structure wise) but potentially dangerous from a regulatory point of view. Many of those securities offering documents are simply insufficient to claim and exemption from registration. An investment in time now, making sure you do this right the first time will enable you to take many more bites of the apple over time.
Read the Rules of the Game for more information.