Use Other People’s Money?  It Depends…

The Risk of Other People’s Money

By Mike Doherty

Often clients come to me indicating they want to raise money.  So I get to ask the next questions: “Equity?” “Debt?”  “Or some combination of these?” The response is too frequently a glassy-eyed: “You tell me.”  To compound  their initial frustration, my answer is usually, “It depends.”

Everything has a price, including money.  At its most basic, that price is normally interest or return on capital.  In the real world, however, the intangible conditions associated with outside funding can be as costly to the entrepreneur as any additional premiums charged to a high-risk loan.  Lender-imposed covenants on an investment will often bring unforeseen obligations:  how much cash must remain in the bank, what earnings are necessary to avoid defaults and rights-of-offset, as well as a myriad of other specific requirements for compliance.  Onerous covenants can hamstring your financial operations and become the bane of your CFO’s existence. 

The alternative to debt is equity, selling part of your company as a means of raising funds.  For the record, I am not opposed to equity or venture capital.  But accepting equity opens a Pandora’s box of tradeoffs.  The pitfalls--dilution, valuation, preferences, earn-outs, and potential loss of operational control--mean that equity agreements must be carefully negotiated and structured, preferably with the support of an experienced advisor.  In addition, the entrepreneur taking equity funding incurs a fiduciary responsibility to his shareholders, which will dictate how he runs and grows the business.    Many start-up entrepreneurs, hungry for the funds necessary to make their dream a successful reality, don’t understand how outside money will change the way they run their company--until it does.   

Equity, debt and its combinations are viable means of financing a growing venture and taking it to new levels.  The key is to understand what the costs are, so that you can make financially sound choices in raising capital.

Types of Financing

Seed Financing involves a relatively small amount of capital provided to an inventor or entrepreneur to realize a concept or to qualify for start-up capital. This may involve product development and market research as well as building a management team and developing a business plan, if the initial steps are successful.

Series A Financing is provided to companies completing product development and initial marketing. Companies may be in the process of organizing or they may already be in business for one year or less, but have not sold their product commercially. Usually such firms will have made market studies, assembled the key management, developed a business plan and are ready to do business.

"B" round describes a financing event when professional investors such as venture capitalists are sufficiently interested in a company to provide additional funds after the "A" round of financing. Subsequent rounds are labeled "C," "D" and so on.

Working capital is funding necessary to grow day-to-day operations for the initial expansion of a company that is producing and shipping, and has growing accounts receivable and inventories. Although the company’s business is somewhat established and profitable, it does not yet show a profit. Working capital can be raised through either early stage debt financing or later rounds of equity financing.

Mezzanine Financing is provided for major expansion of a company that is breaking even or profitable and whose sales volume is increasing. These funds are used for further plant expansion, marketing, working capital, or development of an improved product.

Bridge Financing may be needed when a company plans to go public within six months to a year. Often bridge financing is structured so that it can be repaid from the proceeds of a public underwriting. It can also involve restructuring of major stockholder positions through secondary transactions. Restructuring is undertaken if there are early investors who want to reduce or liquidate their positions or if management has changed and the stockholdings of the former management, their relatives and associates are being bought out to relieve a potential oversupply of stock when going public.

Buyout funds, like venture capital funds, use equity rather than fixed-term debt (which helps strengthen  both balance sheet and cash flow, since the amount of debt is not increased and no cash outflow for debt payments are required).  Buyout funds usually demand a good share of the company's profit to compensate for the risk of investment, resulting in dilution for the existing shareholders. An investment by venture and buyout fund investors will also require a predetermined exit strategy to realize the returns on their investment.

The Sources

Founder Capital – The entrepreneur’s own assets including bank balances, certificates of deposit, shares and bonds, cash value in insurance policies, real estate, pension funds, etc. 

Friends & Family – As the name implies, these are funds raised from those around you who support you and your endeavor.  These funds may be obtained as a loan or as an investment

Angels – Typically “accredited” investors who meet certain net worth and income qualifications, and are considered to be sufficiently sophisticated to make investment decisions in complex situations. Investment by these accredited investors does not trigger  SEC security registration and reporting requirements. These experienced investors are frequently high net worth executives or entrepreneurs looking for investment opportunities.

Venture Capitalist - Venture Capital is investment made for the purpose of developing, launching, and expanding the commercialization of new products or services in high-growth markets.  It is offered by  individuals or firm managers who fund startups for an equity stake in the business. These are professional investors with vast experience, good contacts and sound business skills, which they bring along in with their capital.

Mezzanine Capital - A hybrid form of capital, mezzanine financing is sandwiched between senior debt and equity on a company's balance sheet.  Structurally it is subordinated, or "junior" in priority of payment to senior debt, but senior to common stock or equity. 

Bank Financing - There are many forms of debt financing available from SBA loans to venture debt.  The key consideration for the entrepreneur is that DEBT REQUIRES DEBT SERVICE or cash repayment. 

How Much Does It Cost?

Mezzanine investors expect an 18 to 20 percent internal rate of return (IRR) on their investment, compared to 25 to 35 percent for venture capitalists.  Traditional debt requires returns in the range of 6 to 15 percent.

How much of the company will the investor own? The first stage of  discussions between an investor and the founders is to decide how much the company is worth (valuation), which determines how much the founders give up in ownership in exchange for the  investor's investment..  This is the “real cost” to the entrepreneur. 

Typically, the amount of equity investors are willing to invest is based on the pre-money and post-money valuations of the company.  Equity investors take into account how much the company is worth without a proposed investment (pre-money), and with their investment (post-money); they project their exit strategy, the future event that will allow them to recover their equity investment plus estimated  returns of anywhere between 16 to 30 percent usually, depending on the risk, investment size, and expected commitment term.   Similarly, lenders focus on the level of debt service that a company can support currently and estimates based on future revenue and cash-flow growth to determine the appropriate size of the loan. 

A Table of Ownership or Capitalization (Cap Table) of a start-up after the first round of equity financing might look like this:

Most outside investors like to see some form of employee ownership in their "investment" companies. It demonstrates a commitment of key employees by ensuring they are vested into the corporation through ownership: their goals are thus aligned with those of the investors.  After an IPO, the employees, including founding employees and the CEO, will generally own between 20 and 35 percent of the company.

As a general rule, however, the more outside equity you raise, the less of your company you will own. With each additional round of equity financing, the ownership percentages will shift from the founders to the venture capitalists.  Dilution, the reduction in the fraction of a firm's equity owned by the founders and existing shareholders associated with a new financing round, becomes a very sensitive point of negotiation between  most entrepreneurs and their investors. 

Simply put, however, most successful entrepreneurs will be forced to choose between controlling 100 percent of a smaller enterprise (whose growth is limited by insufficient funds to expand) or a percentage of something much larger (whose growth is expedited by being sufficiently well-capitalized to take advantage of market opportunities). 

Certainly this is a simplified overview of financing decisions that are best undertaken not alone, but with the advice of professionals who have been through these exercises before.  For anyone who has been successful enough to have grown a business to the point where outside funding is a necessity, financing will likely present a series of difficult choices and emotional challenges. But at the end of the day, it is important to remember that these are stimulating challenges to face.  

These are the lemonade opportunities.

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About the author:  Mike Doherty, the founder of Doherty & Associates, has an extensive background in corporate investments, including the evaluation and underwriting of over $100 million in venture debt financing for emerging growth companies. Prior to Doherty & Associates, he was a director at Third Coast Capital where he focused on originating and underwriting venture staged debt products.

Prior to Third Coast Capital, he was a principal of Southport Systems, Inc., a consulting firm advising clients on asset management, leasing operations and credit underwriting. In addition, he has served as portfolio manager for numerous leasing portfolios.

Mike earned a BS in Commerce from DePaul University in Chicago. 

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