Rules of the Game

Rule #1: Understand Institutional Sources. For the vast majority of start-up and early-stage companies, which include most firms with less than five years of operating history and less than $5,000,000 in annual sales, substantial amounts of institutional equity or debt capital are generally not available. Institutional equity or debt capital means capital secured primarily through professional investors, such as; venture capital firms (VCs or VC firms), formal angel groups, family offices, private equity investment firms, retirement or pension funds, insurance companies, and capital secured through the sale of securities offered through investment banking firms.

It is a given in the venture capital industry that on an annual average, less than 1.5% of all start-up and early-stage companies searching for capital receive their needed funding through any institutional source, in good times or bad. In good times, there is more money available but there is more quality deal flow. In bad times, there is less money available, but there is less quality deal flow. It's all relative. If your start-up or early-stage company is within the lucky 1.5%, the institutional equity capital source will most likely control the terms of the deal and they will most often demand voting control. You may have to give up substantial equity and upside participation to seal the deal. On average, out of five-hundred-plus deals venture capital firms review each year, they will generally fund two, three, maybe four.

Why do most Venture Capital firms operate this way?

It's true that there is now more venture capital money available than at any other time in history, but it's not being invested due to a lack of quality deal flow. In the VC industry it's called "capital overhang." The VCs cannot lower their investment criteria (funding start-up and early-stage companies) primarily because they have raised capital through a prospectus to individual and institutional investors which limits their flexibility. They have raised capital for their Funds by setting criteria within the prospectus to limit their company selection in which they can invest. They may have stated something like "the Fund will only invest in portfolio companies that are engaged in the medical supply and health care industries; Nano-tech as it relates to medical supplies and surgical application and other related technologies (sector positioning); with a minimum of seven years of operating history; (later stage); annual sales of at least $15,000,000 (size and stage limitation) and the average capital commitment of $20,000,000 (capital commitment limitation)." They have painted themselves into a corner through prospectus limitation. Granted, they believe that this limitation protocol mitigates portfolio risk, which it does to one degree or another - depending of course how one looks at it. But more than that, it mitigates capital-raising risk. What do you think would happen if they took a prospectus to an institution looking to invest a couple hundred million dollars with little or no limitation protocol? They would be laughed out of the room, that's what would happen. It would be commercial suicide to do so.

I only need $500,000, why won't a Venture Capitalist just cut me the check?

Unless they make a radical departure from the "old school" position and protocol of investing and managing "portfolio companies" for their funds, it is a mathematical certainty that they will never be able to afford to do so. Not only is it commercial suicide for a VC to limit investment criteria protocol for attracting capital for their funds, but they couldn't afford to manage the amounts invested in smaller companies. Let's say for instance, a VC was able to raise $10,000,000 in a new fund just to invest in start-ups. Let's say the average amount to be invested is $500,000 per company and the fund plans on investing in 20 companies this year (for diversification) with the average holding period estimated to be 10 years. After making such investments, the fund has 20 portfolio companies, which need to be looked after. The VC needs to employ professional managers within the VC to look after these companies. How many companies can each manager reasonably look after, 2, 3 or 5? Remember, the VC has a fiduciary duty to its shareholders of the fund, so it can't skimp here. Let's say each manager looks after 5 companies (the high end of the number). In this scenario, the VC needs to employ 4 managers to look after all 20, portfolio companies. How much should the VC pay these managers in annual salaries? Should the VC pay $100,000, $200,000 or $300,000 each? Where's the line to further assure that the fund is hiring competent managers to protect the VC's fiduciary duty? Let's assume that $100,000 is the line (the low end of the cost spectrum). That's an annual cost of $400,000 in salaries alone. Who's going to pay for these? Typically, the portfolio companies need to provide returns to the fund to pay these costs. Most start-ups would be hard pressed to afford annual contributions to the fund of $50,000 each. But let's assume that they can.

After the average holding period of 10 years, the total cost of managing these funds is $4,000,000 in salaries alone. Add an additional $2,000,000 for other costs for a total of $6,000,000 over that 10-year period. Now, the accepted truism in the industry is 80% of these firms will fail and 20% will succeed to a degree that should make up the losses of the other 80% and then some. We had 16 companies fail (80%) for a total capital loss of $8,000,000, plus the additional costs of $2,000,000 that were not funded by the portfolio companies, to total $10,000,000 in net loss - the original total fund value. The other 4 companies with initial investments of $500,000 each need to be liquid with average values of at least $31,250,000 each (assuming an 80% ownership interest acquired in each by the fund - for a $25,000,000 net value to the fund) to meet the risk / return criteria of the fund of 10 times the money in 10 years. (10,000,000 to $100,000,000 - (4 companies x $25,000,000 in fund value each)). That ladies and gentlemen is a far reach. Not only that, if you had a company with the potential to be worth $31,250,000 in ten years would you sell 80% of the ownership for $500,000 today?

The math simply does not make sense for a VC when one assumes the traditional VC fund model would be employed. In addition, it doesn't make much sense for an entrepreneur to sell too much equity too early for too little either.

You may be thinking, "But I read in all the trade magazines that venture capital groups are springing up all over the country and are funding deals left and right." You're reading about the rarities. Remember that the publishers of these magazines need to sell "hopes and dreams" and, ultimately, their publications. Consider the source before you jump to conclusions. They produce good stories that motivate. That's a good thing, but if you want to raise substantial amounts of capital while maintaining the vast majority of ownership control, you should produce securities (and the offering requisite documents) and execute a series of successful securities offerings to spearhead your capital-raising efforts - a much better thing.

You may be thinking, "But we are different because we are being romanced by a couple VC firms right now." Sorry, it may be a false romance. VCs must generate massive deal flow so they can cherry pick. It costs them virtually nothing to keep you and every one else hanging on. You can't blame them; it's the nature of the industry. If they didn't operate this way to one degree or another, they would go out of business.

They are all waiting for the next "big thing," but most of them will not know what the next big thing is until it's too late. Eventually, they will need to adjust their investment criteria or, like any other industry that doesn't change to meet market demands, many will cease to exist.

To hedge your position and to increase the probability of success, you need to compete directly with those institutions to attract capital from individual passive investors. Remember, institutions need to attract capital from individual investors as well. Banks need depositors and venture capitalists need shareholders in their funds. No matter how you look at it, it boils down to attracting individual investors, because they ultimately have and control the money. Business plans and executive summaries do not meet the stringent legal requirements to raise capital from individual investors, only securities offering documents do. However, the production of securities offering documents with "marketable" deal structures was extremely expensive-until the creation of Financial Architect®.

Rule #2: Conduct a Series of Securities Offerings to Raise Capital. What constitutes a securities offering? First, we need to define what constitutes a security. The courts have generally interpreted the statutory definition of a security to include traditional as well as nontraditional forms of investment. Section 2(1) of the Securities Act of 1933, as amended, defines the term "security" to mean "any note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest, or participation in any profit-sharing agreement, collateral trust certificate, pre-organization certificate or subscription, transferable share, investment contract, voting trust certificate, certificate of deposit for a security, fractional undivided interests in oil, gas, or other mineral rights, any put, call, straddle, option, or privileges (including convertible rights) on any security and any interest or instrument commonly known as a "security" or certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing." See SEC v. W. J. Howey & Co. US 293 (1946).

In Landreth Timber Co. v. Landreth, , 4712 US 681 (1985), the Supreme Court adopted a two-tier analysis that basically further interpreted as follows: "For purposes of securities laws, a security in an investment of money, property or other valuable consideration made in the expectation of receiving a financial return from the efforts of others." To summarize, anything you trade an investor for an investment in your company where the investor expects a return on the investment, is a security.

Now that we have defined what constitutes a security, we need to define what constitutes an "offer" or "offering" of a security. Presenting a business plan (without a specific deal structure) to an institution, such as a venture capital firm, for obtaining capital will not constitute a securities offering as long as the financial institution offers the terms of financing. The offer must come from the source of capital to avoid your company inadvertently making an offering of securities. Even before the issuing entity is formed, the regulatory authorities may still consider the distribution of equity or debt before, at, or shortly after the original meeting of incorporators (in the case of a corporate entity being formed); or a meeting of organizers (in the case where an LLC or a partnership is the entity to be formed) as an offering of securities.

When the regulatory authorities consider the distribution of equity or debt a securities offering, (even before the entity actually exists) there are simple intrastate exemptions from registration of those securities available. That is the reason why most start-ups do not necessarily violate securities laws. Some states allow for as little as six and up to fifteen entities, individuals, or organizations (founders or principals) that reside in that state to form an organization and distribute securities to the founders, without the need to register the securities or qualify for the exemptions from registration.

Every state has its own uniform offering exemption(s) and you must comply with the state's stipulations to qualify for claiming those exemptions. However, you cannot rely on the intrastate exemption if one founder is from another state. In this case, the issuing entity must qualify for federal exemptions from registration under Regulation D or the Accredited Investor Exemption 4(6) (if all founders are accredited) to rely on the Accredited Investor Exemption from registration.

In the past, the production of securities offering documents used to take a great deal of time and effort. No matter who produces the securities offering document, it will take some time and effort on the part of the entrepreneur and/or the company's management team to create an attractive business plan, and to respond accurately and factually to questions regarding disclosures and disclaimers included in the securities offering document. However, Financial Architect® enables anyone to produce securities offering documentation in a fraction of the time, at a fraction of the cost.

Even when dealing with accredited investors only, where technically no documentation is required for conducting a securities offering, (The Accredited Investor Exemption � 4(6) of the Securities Act of 1933, as amended) your offering may still be subject to the no-general-solicitation rules and provide no protection from the antifraud provisions of the Securities Act of 1933 (and amendments thereto), irrespective of the degree of disclosure your documentation contains or lack thereof.

Most successful capital-raising efforts are orchestrated as follows:

  1. The process begins with conducting a "seed" capital round, ranging from $200,000 to $1,000,000 or more, using a private placement securities offering under Regulation D. Regulation D enables the management team to raise capital from personal and professional contacts - including any pre-existing relationship (i.e., customers, as well as, from friends, family, business associates and suppliers). An ample amount of seed capital is necessary to launch a successful capital-raising effort. Seed capital is generally raised through the issuance of 1, 2 to 3 year "Seed Capital Convertible Bridge Notes"; "Notes with Equity Kickers"; or "Participating Preferred Stock." Producing these deal structures and the securities offering documents is relatively quick and inexpensive.

  2. A portion of the "seed" capital is used to: (a) further the protection of the company's assets, (i.e., intellectual property); (b) expand business operations; (c) provide ample working capital to pay executive and staff compensation and (d) more importantly, to hire or fund a V.P. of Corporate Finance to manage the capital-raising process. Remember, only SEC Registered Broker-dealers and bona fide employees can legally solicit and sell your company's securities and you cannot pay a bona fide employee a commission from the sale of securities. Financial Architect® can train your V. P. of Corporate Finance to build your Company's finance department as an Issuer Agent, thereby avoiding the need for a broker-dealer until your company is ready.

  3. A portion of the seed capital is used to produce the next securities offering document for an Intra-State registered offering known as a SCOR offering - limit $1,000,000 per 12-month period, which enables one to advertise and sell directly to the public within the State. A portion the seed capital could be used to qualify for an SEC exemption from registration under Regulation A and/or CA (1001) for California Companies - limit $5,000,000 per 12-month period, if necessary. (No SEC Reporting or Audited Financials necessary). This enables the company to advertise the securities to compete with financial institutions legally, to attract individual investors locally or, over the Internet.

  4. A portion of the seed capital is also used to fund the advertising and promotion of the securities. Advertising a security with a "Marketable" deal structure that meets current investor demand is the key. Advertising common stock simply does not work, unless it has a stated dividend like a Real Estate Investment Trust (REIT). We generally recommend offering a participating preferred stock with a high stated dividend so that the "Yield" can be advertised. This is because the fixed income markets (i.e., Notes, Bonds, and Preferred Stock) are 15 times the size of the equity markets (common stock) and is growing larger every year due to the baby boomer generation entering into retirement and looking to generate income from their investments.

  5. If your company has sufficient cash reserves or cash flow, (i.e., "seed" capital), to conduct a development or expansion capital round using Regulation A, consider using a Regulation D offering first. A Regulation D with the same terms as the Regulation A can quickly start the process of the larger Regulation A securities offering, as it is relatively quicker to produce than a Regulation A. This process enables your Management Team to approach their private investor contacts, while you wait for a Regulation A offering to be produced, filed and qualified by the SEC and the State(s), a process that usually takes 2 to 3 months. Also, the amount raised under Regulation D is not necessarily included in the limitation amount of $5,000,000 per 12-month period under Regulation A, so you may be able to raise more than $5,000,000 in the 12-month time period, if necessary. In addition, some or possibly the full amount of the Regulation A offering may need to be escrowed before being released. Not so under Regulation D, which allows the proceeds of securities offering to be used as received.

  6. If additional funds are required for future expansion or if the founders are ready to start liquidating some or all of their holdings, you should hire a team of professionals to assist your company's Finance department in the listing of its securities on the over-the-counter bulletin board ("OTCBB"), thereby making the securities liquid or "free trading." SEC reporting and audited financials are necessary to qualify for OTCBB listing. Once your company's securities are listed for trading on the OTCBB, you can simply "float" or sell more securities into the institutional markets to raise capital. Will your company's securities sell? They will if they have a marketable deal structure and you provide a discounted price to the institutions.

Most private or public placements do not sell well because of (1) a bad deal structure (no investor protection components in place); (2) no thorough capitalization planning; (3) no real exit strategy for the investor; (4) no realistic and conservative pro forma financial projections that conform to GAAP (generally accepted accounting principles) standards; (5) no internal rate of return assumptions; and (6) insufficient seed capital to market and sell a series of securities offerings.

Financial Architect® enables you to: (1) determine and create a marketable deal structure; (2) develop a thorough five-year capitalization plan; (3) provide for a real exit strategy for investors; (4) produce pro forma financial projections that conform to GAAP standards; (5) calculate and illustrate internal rate of return assumptions; and (6) create a seed securities offering document with its patent-pending system of interconnected worksheet templates.

Rule #3: Use Hybrid Securities to Maintain Voting Control and Equity Ownership. You can raise sufficient capital without giving up substantial common equity interest through issuance of hybrid securities such as, but certainly not limited to, convertible preferred stock, notes, bonds, non-voting common stock with married put options, participating preferred stock, notes with equity kickers or through issuing royalty financing contracts. In the current market environment, participating preferred stock, with a high stated dividend and generous participation in net income, is very attractive to investors.

Selling common equity in the early stages of the company's existence generally results in selling out the company's most precious element-ownership-for too little, too soon. In the world of finance, there is what is known as "cheap" money and "expensive" money. It's relative and it changes. Bank debt with a high interest rate seems to be expensive money in the beginning. However, if you assume success then bank debt will become cheap money because selling common equity in the early stages of the company's existence will be a mistake because it will be more valuable and inherently become expensive money. For example, if you borrowed $1,000,000 at a 10% interest rate for five years, that's $100,000 a year in interest or $500,000 total. This scenario seems expensive, but if you sold 30% of your company's common stock for $1,000,000 and your company is worth $5,000,000 at the end of the fifth year, that's a value of $1,500,000 or a net expense difference of $1,000,000 (the value of 30% of the company: $1,500,000 less the $500,000 in bank interest = $1,000,000). The common stock is technically lost forever, so the net cost may be more as the company continues to grow. That's expensive money.

If you want to control the terms of the deal, maintain voting control of your company and the vast majority of equity ownership, all while increasing the probability of receiving the funds, then you will need to conduct a securities offering or a series of securities offerings using hybrid securities. Searching for capital in any other fashion generally results in everyone attempting to change the terms of the deal, which results in lost time and money and is extremely frustrating.

Rule #4: Test the Waters. Prior to structuring the deal, producing the proper securities offering documentation, or conducting a full-blown securities offering effort, one could "test the waters" by researching the local geographical area for "angel investor" interest, as well as their own personal market of private investor contacts, with one or two prototype offering structures. This process is known as a "red herring" test. Some states do not allow for a testing of the waters through general solicitation (the media), so you should check with your legal counsel before you engage in this activity. An example of a red herring document is available in the Commonwealth Capital Club. You will receive the User ID and Password for the Commonwealth Capital Club in the instructions to Financial Architect® Module(s).

There is peril associated with "testing the waters". Although you may think you are saving money by holding off on securities offering document production, if your indications of interest are positive, then you need to be prepared to sell the securities quickly. If your documents are not completed, it could take too long to finish them and investor interest may change. I prefer to strike when the iron is hot. If you agree, you should have your documents completed and ready for those who have an interest. Otherwise, it may appear that you don't really have your act together: a bad thing when asking investors for money.

Actions to determine indications of interest are used by Wall Street firms, but you can avoid most of the formal research by simply shopping for high-yield investments. What's out there? Check on what the bank is offering for three-, four-, or five-year CDs. Call a stockbroker and find out rates where five-year corporate notes and preferred stocks are trading. Once you've done a cursory investigation, you'll know how to price your company's securities. Just beat the yield and offer upside potential against your deal's risk involved by designing securities that meet investor demand and you will raise capital.

Rule #5: Use Seed Capital to Raise Development/Expansion Capital. There are no guarantees when it comes to raising capital, only degrees of probability. The probabilities increase in direct correlation with the amount of seed capital available to promote expanded capital-raising efforts. The more seed capital you have available, the higher the probability for a successful securities offering. You are simply marketing and selling an intangible asset in a highly competitive and highly regulated environment.

Whether selling private or limited public placements internally or engaging in a NASD syndicate selling effort, you must have ample funds (seed capital) to support the related sale and marketing efforts. If you do not have a sufficient amount of seed capital, then raise it through a seed capital securities offering first. Depending on your company's situation, $100,000 to $200,000 of seed capital should be sufficient to obtain the larger $1,000,000 to $5,000,000 amounts of start-up, development, or expansion capital.

In a publication called, "Small Business Financing Insights," Richard Wulff, chief of the Office of Small Business at the Securities and Exchange Commission in Washington, DC, was quoted as saying, "If you're trying to raise $5,000,000 in a private offering you've got $100,000 in expenses, printing, lawyers, phone calls, etc." (April 1998). It's much more now!

Rule #6: Minimize Your Capital Requirements. For start-up and early-stage companies, your capitalization plan should seek the minimum amount of capital needed to bring your firm to $5,000,000 in annual sales necessary to engage an investment bank to sell your company's securities. If you need $1,000,000 in development or expansion capital to accomplish that goal, you should consider raising, say, $200,000 to $400,000 in equity capital through a securities offering, and obtain the $800,000 to $600,000 balance with bank debt if your company is considered bankable.

Rule #7: Capitalize to Compete. Most entrepreneurs are under the impression that the technologies, inventions, patents, processes, or trade secrets that make up their company's product or service line(s) offer investors the greatest opportunity ever because nothing like their situation has ever occurred before, and they have a lock on the marketplace. No entrepreneur can predict, with any real accuracy, when or if a competitor will introduce superior products, services, or technologies to the marketplace and so marginalize said entrepreneur's product or service line(s). Most entrepreneurs are also under the impression that the technologies, inventions, patents, processes, or trade secrets that make up their company's product or services will allow for sufficient net operating margins to expand their firm's growth with internally generated funds after they have received their initial funding. In theory, only a true monopoly can achieve that feat. Any direct or indirect competition will eventually lower those margins. Outside capital must be employed to keep up with the competition, especially if the competition is formidably capitalized (i.e., publicly traded). Be sure to raise sufficient capital through a series of securities offerings so that your company can get and stay ahead of the competition curve.

Rule #8: Create a Finance Department to Compete for Capital. Once you have sufficient "Seed Capital" raised and/or current cash flow permits, form a well-staffed finance department within the company to compete with financial institutions for capital from individual investors. The reason this part of the process sounds obvious to some and strange to others is that most entrepreneurs come from large corporations where the corporation has a marketing department, a human resources department, a production department, an operations department, an administrations department, and so on. Most large corporations do have an accounting department, but it doesn't serve as a finance department because the financing is handled or outsourced to large investment or commercial banks.

If you want to expand your company aggressively through the acquisition of competitors, suppliers, and/or customers, you will need to develop a strategy to become a publicly traded company now or in the immediate future. Did you know that your company could apply to list its securities for free trading on the Over-the-Counter Bulletin Board (OTCBB)? The OTCBB is a limited trading platform that does require the company to become an SEC reporting company, and that does require you to produce audited financial statements, but has less stringent requirements in other areas. Once your securities are listed, they become "currency". You don't necessarily need to sell or "float" a secondary offering of securities into the public markets because you can use your securities as currency to purchase other assets, including other companies.

Note that I did not mention listing common stock on the Over-the-Counter Bulletin Board; I mentioned securities. Let's say that you listed a participating preferred stock on the Board with a high yield relative to all other securities of the same class and quality. Let's say, for example, your preferred stock was listed on the Over-the-Counter Bulletin Board at $100.00 per share and a $9.00 stated dividend. That's a current yield of 9%, and you offer the participation feature. If all other preferred stocks with the same quality are trading at a yield of 8% then you should easily be able to sell additional shares into the market because your company's securities are simply beating the current yield in the market place. As an alternative to selling the shares directly into the market, you could simply offer the same preferred stock to a company that you wish to acquire. I've used the analogy that dealing with liquid securities is like turning a faucet on and off. If you need more capital, then "float" or sell more securities: turn it on. When your capital needs are satisfied: turn it off. Once you understand the process of operating with publicly traded securities, it's not that difficult.

Rule #9: Don't Rely on Others to Raise Capital. Most entrepreneurs believe that raising capital is like selling real estate. They believe there are entities out there that will raise capital for them for a commission. There are - they are called SEC-registered investment banks or broker-dealers, which must also be NASD Members. However, they do not fund start-ups or early-stage companies. There is very little money in it for them because the deals are too small. Most start-up and early-stage companies are also too risky (history shows that 85% of all start-up and early-stage companies will fail within their first five years, primarily due to the lack of sufficient capital reserves). If your company wants to pursue this route, you should be aware that your company will also need to invest in marketing support for an engagement contract. The expense associated with the broker-dealer's due diligence is separate. On top of those up-front, out-of-pocket expenses, you will need to pay a generous commission, generally 10% to 12% of monies raised and, depending on the market environment; you also may need to give up some other goodies, like a portion of the company, by issuing warrants to the broker-dealer(s). In addition, you will be doing most of the work of actually selling the securities in any event - through the proverbial "Dog and Pony Shows" - because there is nothing like the enthusiasm of members of the company's management team�.hence, the further justification to hire a VP of Finance.

WARNING! HIRING MONEY FINDERS CAN BE EXTREMELY DANGEROUS AND RARELY WORKS. YOU SHOULD NOT PAY ANY UP-FRONT "INVESTOR INTRODUCTORY" FEES AND YOU CANNOT PAY THEM A COMMISSION, PERFORMANCE OR SUCCESS FEE FOR OBTAINING CAPITAL IF AN OFFERING OF SECURITIES IS INVOLVED, IT IS YOUR RESPONSIBILITY TO COMPLY WITH FEDERAL AND STATE SECURITIES LAWS: NOT THE MONEY FINDERS'.

Rule #10: The Key. Raising capital for start-up and early-stage companies in any economic environment can be difficult if not properly orchestrated. In good times, investors can make good returns on their investment in the stock market, where the investment is easily accessible because one can sell (liquidate) their securities at any time. Their resistance is in tying up their money in an illiquid security in a private company. However, that can be overcome with the proper securities marketing and selling techniques. In bad times, investors are always waiting for good times to reappear before they make any changes to the investment portfolio. When you are competing for capital in any market environment you simply need to compete on the basis of immediate return (yield), long-term return (profit participation) and to maximize the number of investors you contact. As with all sales, it's a numbers game. In any market environment, it's far more effective to raise small amounts from many investors by being able to compete directly in the fixed-income securities markets with high-yield securities.