You have started your business and things are ramping up with opportunities to grow your company and take it to the next level. This will often come with a need to raise capital to fund expected growth.
Typically, an early-stage company has used either self-generated funds (bootstrapping) or has secured friends and family who participate as angel investors. While those sources can sometimes be tapped for additional growth funding, scaling the business often requires more serious financing.
Debt financing, generally the least expensive form of financing, allows the company to borrow money in exchange for pledging collateral or guarantees by the owner(s) to ensure payback of the monies borrowed. Debt is good source of financing because it is the least expensive form of financing and ownership retains control over the business. One downside to debt financing is that it often requires scheduled payments that can place a lot of stress on cash flow during business downturns. A second downside to debt financing is that bank financing, often the least expensive source of all, is not available to early-stage companies who are not generating cash.
Equity financing is more expensive form of financing, but it generally lessens the risk borne by the company because it provides needed financing with cash payment requirements that tend to be much lower and easier for the business to accommodate. In this type of financing, operating cash is not required to service debt payments (interest and/or principal), but a degree of control over the business will be lost, depending on the amount of ownership sold to secure the financing.
Capital Structure
A company’s capital structure is the composition of various forms of debt and equity that are being used to finance the business. A company’s use of debt is considered leverage that has a direct impact on the company’s risk profile, and the degree of leverage is a main determinant in the cost of raising capital.
The type of debt or equity determines where those obligations reside in the capital structure. This capital stack defines seniority in the case of liquidation from sale, restructuring or bankruptcy. Low-risk, low-cost obligations have seniority over high-risk, high-cost financing sources. In other words, the most senior capital providers are paid first in the event of a liquidation, while the more junior capital providers will likely receive a fraction of their investments, if anything.
Senior debt is usually the highest on the capital stack followed by subordinated debt, preferred equity then common equity. Debt owners have a claim to principal and interest while equity owners have a claim to the future profits of a company, including a percentage of the sale proceeds if the company is sold.
The capital structure is highly scrutinized when determining risk for investment in a company and allows investors and management to determine how expensive financing will be. If debt is a higher percentage than equity in the capital structure, this leads to greater risk to the company as servicing the principal and interest payment requirements during business downturns puts a strain on cash flow
Debt
Debt financing provides ownership with the ability to finance growth without diluting ownership. Debt enables a company to smooth working capital in the instances of delayed accounts receivable, seasonality of a business or other considerations where cash flow is not evenly spread across time. The types of debt include senior debt, subordinated debt, mezzanine debt and convertible debt.
Senior debt typically consists of loans issued by banks and lending institutions. Senior debt holders have first rights on the claims of a business in the event of a liquidation. This includes lines of credit which are generally first in line, followed by senior term debt such as mortgages or equipment loans, then unsecured senior debt.
Subordinated debt ranks below senior debt when claims on assets occur, and consequently this debt carries a higher price.
Mezzanine debt is a type of subordinated debt that merges the features of debt and equity but does not initially dilute ownership. Mezzanine debt usually has warrants attached providing lenders the right to purchase equity in the future, and while it carries a higher cost, it can often contain features that are advantageous to a company, such as deferring cash interest payments.
Convertible debt is the last debt on the capital stack. This is debt that converts to equity according to a predetermined formula. Typically, convertible bonds are issued which convert into equity. The lender or debt holder has the right to determine when a conversion will occur. The conversion normally occurs when the holder determines that the risk of liquidation is much lower and that a higher investor yield will be realized from an equity instrument.
While debt was described in some detail above, early-stage companies often turn to equity financing to fund growth because debt financing can constrain growth due to its servicing requirements. As a result, the remainder of the discussion will focus on equity financing.
Equity
Equity financing comes in a multitude of forms. The most general descriptions of equity investments are common stock and preferred stock, although there are many, many forms of each of these. Following debt instruments, preferred equity is next in the capital stack, and represents an ownership stake in a company. Preferred equity generally has fixed dividends in addition to future growth potential. Preferred shareholders get dividends paid before any dividends are paid to common shareholders. These shares may be convertible into common shares allowing further upside potential for the preferred investor. While converting to common stock pushes the preferred investor further down the capital stack in terms of liquidation rights, the conversion is normally done only when the likelihood of a greater return as a common investor is high.
The following discussion outlines various stages of equity funding and the strategies that are normally pursued for each stage.
Venture Capital
Following angel investors (friends and family, etc.), a typical form of equity financing that is next utilized is venture capital (“VC”). There are specific levels of venture funding that venture capitalists will use to invest in a business.
Seed funding is for businesses that are in the pre-product stage or the very early product development stage. These funds get a business from ground floor to a level of developing a marketable product. While initial sales may be generated, there typically is no profitability at this stage. Like angel investments, seed funding is usually in the tens to hundreds of thousands of dollars.
Following seed funding, Series A funding is generally the next step. The average investment in Series A funding tends to be around $10 million. Series A funding will require some serious consideration as the venture capitalist will want a large piece of the business. Though you will be giving up some control and seats on your board, venture capitalists typically have experience in assisting companies grow and offer sound advice to achieve success in the business. The venture capitalists are protecting their investment while the company is getting strategic leadership on the board. As a result, vetting the VCs is extremely important, as you want to know if they have experience in your industry and whether they have investments in competitors to your product or company.
To raise venture capital, you will be required to create a pitch deck which is basically a presentation used for talking to a venture capitalist. This should address the market opportunities, where the business fits into that market, financial projections and core competencies and strength of the management team. CEOs will need to show how the investment funds will be used and how that usage will facilitate the growth of the company.
A VC interested in your company will present a term sheet showing the type of investment proposed (typically preferred stock), its voting rights, liquidation preference, the compensation of the board and employees from an option pool, and any drag along rights which are rights to force owner and shareholder into a transaction in the form of liquidation, merger or acquisition that is in the interest of the VC but may not be in the interest of the owner/founder.
VC investors will perform due diligence to ensure there are no threats, weaknesses or liabilities that might impact the company from making a profit. This includes a close look at the owners of a company, the accuracy of the financial forecasts in the pitch deck, the ability to generate business, the product or service being produced and any pending or threatened legal action. This is an arduous process for the management team.
At this stage companies usually thrive or fail. Thriving companies are sometimes acquired by strategic entities after Series A funding, providing owners and investors with a return of capital and profits on the investment.
However, in instances of continuous growth, Series B funding would be the next step in reaching growth objectives. This typically requires a robust valuation of the company that is in the tens of millions of dollars. At this level investors want to know what growth looks like compared with previous operating cycles. Series B investments often average $20 to $30 million.
If a company reaches Series C funding the business is traditionally looking for investments north of $50 million and valuations that exceed $100 million. Early-stage VCs and other investors might not be able to raise rounds at this level, thus requiring late-stage VCs or private equity groups to be involved. Early-stage VCs and investors will usually be given pro-rata opportunities to still invest.
Private Equity
Private equity (“PE”) investments are from high-net-worth firms and individuals that buy shares of a private company or take a public company private. Large institutional investors and pension funds are among the typical accredited investors in private equity.
Unlike VC investments that are in the early stage of a company, private equity firms buy mature, established companies to streamline operations to increase revenues and profitability. PE firms often require majority ownership. A private equity firm investment will usually increase valuation then look for a strategic exit after a few years to secure a substantial return on their investment. PE firms generally do not invest for the long term.
Conclusion
CEOs and CFOs need to consider the long-term of their capital strategy. To facilitate funding growth, it is critical to raise funds in a way that maximizes a company’s value, considering future funding needs and balancing those needs against relinquishing some degree of ownership, depending on the funding source. Funding with debt is good solution in a low-risk-of-failure environment, as it is the least costly and does not require relinquishing any ownership. Equity financing is best when you want to preserve cash and the risk of failure is higher, and a strategic partner is needed to accelerate the growth of the business. The hard and soft costs of each funding source need to be considered as well. Any financing source will become a business partner, and while lenders will want to understand the business, equity investors will want to participate, in varying degrees, in the operation of the business. Consequently, it is important to identify partner(s) whose objectives are in alignment with you and your company and the people involved are ones who fit your culture. This latter point is every bit as important as the investment itself, as it is a long-term arrangement that is extremely difficult to unwind once it is in place. As a result, aligning yourselves with the right team of advisors goes a long way in achieving an optimal outcome. It is important to remember that you are investing your company in these financing sources as much as they’re investing in you. We at Nperspective CFO and Strategic Services are well-versed in these issues and can assist you with formulating your capital strategy as you plan your company’s growth.
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