The following is an excerpt of Chapter 1 of the forthcoming Second Edition of Sheehan Phinney Bass + Green's booklet "Raising Capital for the Emerging Business." Excerpts of the other chapters of the booklet will appear in future editions of Good Company. Hard copies of the full booklet will be available by request to info@sheehan.com.
Most emerging businesses, particularly in the technology sector, require a substantial amount of capital to fund basic development work on a proposed product. Once basic development work is complete, additional capital is needed to test the product in market conditions and adapt its functionality to developing customer needs, before the emerging business can commence regular business operations. The capital that is used for these purposes is typically referred to as "seed capital."
Raising seed capital is one of the most difficult obstacles for an emerging business to overcome. Only the most risk-tolerant investors are willing to invest in an unproven technology or product, for which there may not yet be a viable market. In addition, the reward for a successful investment at this stage is very attenuated. At the seed capital stage, an exit strategy for investors is almost always a very remote conjecture. Investors in these types of offerings are often very difficult to find; they are commonly referred to as "angels" for the good fortune involved in finding them.
Managers of an emerging business seeking seed capital can be encouraged by developments in the lowest segment of the capital markets. Although still far from being organized, the market for "angel" capital has developed rapidly over the last decade or so. Sophisticated angel investors often are willing to provide seed capital, together with management and financial advice, to emerging businesses on relatively favorable terms. Although the rise of angel investing has been associated with the general technology and Internet booms of the 1990s, angel investors are likely to remain a permanent part of the capital markets even after the recent retrenchment in the technology and Internet sectors.
Sources of Seed Capital
Sources of seed capital are endlessly varied and often difficult to identify. Managers who are fortunate enough to have means of their own may fund some or all of their seed capital requirements with personal resources. Although self-funding has obvious advantages because of its flexibility, it can also have disadvantages. For most managers, personal funds can only provide a small portion of the necessary seed capital.
Many managers are able to tap well-heeled friends and family for seed capital. With personal connections, the manager of an emerging business can often arrange an investment on relatively unobtrusive and patient terms. Managers with a track record in a particular industry will often have connections with other industry insiders who are prepared to trust the manager with seed capital. Although such industry insiders often are reluctant to give investment terms the same soft touch as friends and family, their participation may be extremely valuable for the practical advice and credibility that they bring to the business.
A startup business should almost always accept seed capital where it can find it. Perhaps the only exceptions to this rule are where the prospective investor does not meet the legal standards for participating in a private offering, either because he or she does not meet the test for "accredited investor" status or otherwise lacks the sophistication to understand and bear the risk of an investment, or where the prospective investor is part of the shady underworld of the investment community. Whether a prospective investor is legitimate may be somewhat more difficult to determine, but shady investors follow certain modus operandi which we at Sheehan Phinney Bass + Green have come to recognize.
For example, an emerging business is sometimes approached by a firm purporting to be in the investment banking or venture capital business that is, in reality, a finder. Some of these firms may initially give the impression that they have the ready ability to provide the necessary capital, but in reality only intend to act as agents to find other sources of capital. Some of these firms can, in fact, place an offering; others offer assurances, which are never realized. Managers of an emerging business should ask tough questions about the structure of the fees charged, the identity of the actual investors, the firm's track record with private offerings and the firm's licensure as a broker-dealer under the laws of the states in which it operates. We at Sheehan Phinney Bass + Green will be happy to help review the status of proposed investors or finders.
The manager of an emerging business seeking seed capital will usually find that it takes an active search process, which spans several months to locate the right sources of capital. Experience has shown that the "yield" of actual investors compared with the number of persons expressing an initial interest in an investment is relatively low, for various reasons. The process of lining up angel investors can be very unpredictable, as befits an activity as complex and idiosyncratic as early-stage investing.
Choice of Entity
With the rise in popularity of the limited liability company form of entity (LLCs), many founders of emerging businesses have been led to consider whether their entity should be formed as an LLC. As is common knowledge, LLCs are treated for most tax purposes as partnerships, in that the income and loss are attributed and taxed directly to the members rather than being taxed at the entity level and the individual level. While it is certainly advantageous if profits are taxed once instead of twice, many other considerations bear on the issue of entity choice in the context of an emerging business.
Investment Terms
An emerging business typically locates the source of seed capital before determining the terms of the investment instrument. From the perspective of the emerging business, common stock is the ideal investment instrument for seed capital. By its nature, common stock provides plenty of room in the business' capital structure for priority equity instruments like preferred stock and subordinated debt to be issued in later rounds. Common stock also corresponds with the risk/return profile which many angel investors are prepared to accept.
Industry insiders and other shrewd angel investors will often agree to take a low-priority preferred stock. A low-priority preferred stock will often carry a nominal dividend rate and have priority over common stock in the payment of dividends and liquidating distributions. However, this type of preferred stock will often allow the company to later issue preferred stock with senior distribution rights. In order to compensate the investor for the degree of risk assumed, an investor in preferred stock will typically also ask for some way of participating in the return to common stockholders, in the event that the emerging business is a success. This participation right may take the form of a warrant to purchase common stock at a discount to fair market value, a common stock conversion feature, or a "double-dip" feature allowing the preferred stock to receive its liquidation preference plus a portion of the liquidating distributions to which the common stock is entitled.
While circumstances will dictate how much room for negotiation the emerging business has over the terms of a seed capital investment, counsel can recommend legal and structural protections to existing owners and point out the benefits and disadvantages of various terms proposed by new investors. Although an emerging business typically has very limited ability to engage in power negotiations with new investors, an effective tool in those negotiations may be an insightful analysis of odd results that flow from a particular set of investment terms. For example, a set of investment terms which provides management with little incentive to maximize shareholder return under a realistic scenario, can give management powerful arguments in favor of a modification to those terms.
Management and Ownership Arrangements
One of the most important issues faced by management of an emerging business seeking seed capital is how much management and voting control should be ceded to investors. Angel investors will, appropriately enough, ask for a substantial percentage of the emerging business' common stock equivalents. These discussions will usually center around some notional value which the parties assign to the business at that point in time. That is, the angel investors may be interested in owning, for example, 20% of the emerging business for an investment of $1 million, thereby implying a post-money value for the company of $5 million. However, it is vital for both parties to consider what the overall ownership might be several years in the future, assuming that substantial additional capital will need to be raised. Even a very optimistic company and its investors must plan around the probability that additional capital will need to be raised before the emerging business crosses the magical break-even threshold. The key question is not whether, but at what price, new capital will be raised.
The Dilution Conundrum
Many founders of an emerging business and many early-stage investors focus a great deal of attention and expectation on the percentage size of their interest in the company. While percentage ownership is a useful tool for negotiating the terms of a seed capital investment, management and investors alike should recognize that the percentage size of their interest is usually a fleeting thing. In fact, it is normal and healthy for most emerging businesses to need more capital. The key question in this regard is: At what price?
When managers and investors of an emerging business discuss the subject of dilution, they sometimes confuse two related but very different concepts: percentage dilution and economic dilution. Percentage dilution in most contexts is actually rather meaningless, but economic dilution is crucial. The reason is simple. An emerging business which is growing and creating value for itself is able to sell its shares at a higher common share equivalent price than in previous financing rounds. Under this scenario, new investors buy shares at a higher price than existing investors. Existing investors surely suffer percentage dilution, but they also enjoy economic accretion. This is a good thing for existing investors, because although their percentage interest in the emerging business goes down, the value of their economic interest in the company goes up.
By contrast, an emerging business, which is struggling to create value for itself, will only be able to sell its shares, if at all, at a lower common share equivalent price than in previous rounds. Existing investors will suffer both percentage dilution and economic dilution—and sometimes in spades. Depending on the severity of the dilution, a new investment round at a lower common share equivalent price may be referred-to as a "down round" or a "washout round."
Of course, many early investors will wish to maintain a constant percentage interest in a growing company and enjoy economic accretion. While this is certainly preferable, it is not very realistic in the context of an emerging business. Realistically, an early-stage investor should only expect to avoid percentage dilution by providing additional capital as needed by the company.[1]
Legal Considerations
In addition to the challenges that an emerging business faces in finding willing investors, the federal and state securities laws impose restrictions on how a private offering of securities may be conducted and who may participate in such an offering. In essence, the federal Securities Act of 1933 and analogous state laws require any offering of securities to be registered with the Securities and Exchange Commission, unless the offering meets the requirements for one of several exemptions from those registration requirements. The most popular and arguably the most useful exemption is the safe-harbor exemption for private offerings which meet the requirements of Rule 506 of Regulation D under the Securities Act. In layman's terms, Rule 506 limits issuers to offering securities to carefully-targeted "accredited investors" and other sophisticated investors, who are fully informed of all material information about the investment and who agree to take "restricted securities" in the issuer.
One very important requirement of Regulation D is that the issuer refrain from engaging in a "general solicitation." Although this term is a legal term of art, it means that the issuer must limit its solicitation to small groups of investors who the issuer reasonably believes to be sophisticated in evaluating privately placed securities. Mass-mailings, newspaper ads, television or radio spots and open-access Internet listings clearly violate this requirement and should be avoided under all circumstances.
Another technical requirement of Regulation D requires the offering to be made only to "accredited investors" or other sophisticated investors who can understand the merits and risks of the investment. We strongly suggest that issuers limit their seed capital offerings to persons who fall within the definition of "accredited investor," since this classification gives the issuer substantially greater leeway in the preparation of disclosure materials.
If the offering is limited to accredited investors, disclosure need not follow any particular format, although it should be sufficient to inform investors of all material facts about the investment. This disclosure is usually embodied in a private placement memorandum or other written materials. The contents of such a document will vary with the circumstances, and the dynamics of the document are beyond the scope of this booklet. It suffices to say that experienced securities counsel should prepare and/or edit such a document. If the document does not properly describe all material risks, then the investor will have the legal right to rescind the investment and receive his or her money back—obviously, a catastrophic situation for most any emerging business.
The Role of Counsel
Counsel can typically play a very helpful role in structuring and closing an offering of seed capital. If counsel is consulted early in the process, he or she can advise the manager of an emerging business about what its capital structure should look like, the type of investor that is most likely to be interested in participating in the offering, what type of investment instrument is most appropriate for the offering, how to structure negotiations with investors most efficiently and advantageously, how to make sure that the offering meets all of the requirements of the relevant legal exemptions and how to make appropriate disclosures to the investors. With the right planning, an offering of seed capital can help an emerging business move beyond the initial hurdles which it faces, to reach a point where it is a candidate for professional venture capital investors.
[1] When this type of arrangement is provided for contractually in investment or charter documents, it is sometimes referred to as a "pay-to-play" provision.
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