Raising Capital for Startups

May 17, 2016|Business finance
Rodriques Law

Raising capital for startups and emerging businesses can be quite a challenge; where and how you obtain financing can determine whether your business succeeds or fails; and the financing options available to a startup are dependent on several factors, including, its type of business, exit strategy and choice of business entity.

Business Plan

Before starting your business, you should develop a written business plan. A good business plan is primarily used (1) to test your assumptions and help to determine if you can make your new venture successful; (2) to secure funding from prospective investors or other funding sources; (3) to secure participation of key players or key employees; (4) to provide potential investors a way to value your company, including, information about your management team qualifications; business model; the market for your product; innovative technology; the competitive environment; scalability; how the business can be made successful in a reasonable timeframe; intellectual property; financial statements and projections; projected exit valuation; and present and future capital needs; and (5) most importantly, to show prospective investors and potential partners that you have a firm grasp on the business of running the business.

Sources of Capital

For many entrepreneurs, the primary source of capital are loans from debt financers, including banks, credit unions and credit card companies. The advantage with this form of financing is that you retain all of the equity in your company; the lender generally has no say in how you run or manage the business; and your interest payments may be deducted as a business expense on your tax return. The downside to borrowing money is that your fledgling start-up may have to make loan repayments when the need for cash is greatest.

Another important, albeit expensive, source of business capital is private equity financing. This form of financing is achieved through the sale of stock or interests in your company in exchange for a capital contribution of money or property. The advantage with this form of fundraising is that you generally only need to repay investors if the business makes a profit. The downside to this form of financing is that, you have a responsibility to take the investor’s interests into account when making business decisions, even if it’s not in your best interest as an entrepreneur; the investors may take away a large percentage of the business profits if the business is successful; and the investors may put a cap on your salary.

Private investments may take the form of a convertible preferred stock equity interest. Investor financing may also involve the use of convertible debt instruments or ownership options. This allows the investor an option to convert the debt into an equity investment at either a specified time or if certain conditions are met. The investor is thus protected by retaining a debt claim if the startup does not do well or can profit by converting the interest into equity ownership if the venture succeeds. Another strategy the investor may employ is to seek an equity interest coupled with some guaranteed exit provisions, such as a mandatory buyout (a put option requiring the business to repurchase the stock at the investor’s option), or an IPO (Initial Public Offering).

Perhaps the most common source of equity financing for small businesses and startups is friends and family or “angel” investors. Angel investors are private investors who are high net-worth individuals who provide capital for early-stage companies or startups. The downside to this form of fundraising is that the amount of funds you can raise this way may be limited due to prohibition on general solicitation and crowdfunding limits imposed by federal and state securities laws. In addition, under Regulation Crowdfunding, the new equity crowdfunding rules recently implemented by the Securities and Exchange Commission (SEC), which lifts the prohibition on general solicitation, thus, making it possible for startups to raise capital from ordinary investors online, the dollar amount a company can raise in a 12-month period is limited to $1 million.

While angel investors often provide the seed capital to get a business up and running, entrepreneurs turn to venture capital funds for early stage financing or expansion. Venture capital is an illiquid investment, with the end goal of reaping a substantial profit through the sale of a private company or an IPO. However, only a handful of startups eventually go public, and only a small number of seed stage companies are able to obtain venture capital.

VCs generally invest in companies which have revenues in excess of $2 million and a preexisting capital investment of at least $1 million. According to the MoneyTree™ Report by PricewaterhouseCoopers and the National Venture Capital Association based on data from Thomson Reuters, in 2015, VCs invested a total of $1.2 billion in 197 seed stage deals, representing a mere 2% of all venture investment dollars, down from 5% in 2014.

It is increasingly common for startups to organize as a limited liability company to minimize the overall tax burden of their founders. However, only C corporations can go public. Therefore, if you organize your startup as an LLC and you plan to go public, you may have to convert to a C corporation in advance. In addition, for tax reasons, VCs usually do not invest in flow-through entities, such as, LLCs and partnerships. Therefore, if you are organized as an LLC and plan to seek VC funding, you need an experienced business attorney who can help you to convert your LLC or partnership to a corporation without adverse tax consequences.

In the unlikely event you do qualify for venture capital funding as a startup, an alternative to converting your LLC into a corporation is to utilize a “blocker” corporation to receive the capital investments of the fund’s tax-exempt investors. A blocker corporation may be established as a “parallel fund” or “alternative investment vehicle” (AIV) structure, to receive the fund’s tax-exempt investors’ investments, which then invests in the LLC, while the fund’s taxable investors’ investments go directly from the fund to the LLC and without using a blocker corporation.

If your business will be operated as a sole proprietorship it is less likely that it will gain equity financing. Investors generally want to protect themselves from personal liability for business debts, especially if they are not actively participating in running the business. The limited partnership, limited liability company and corporation are attractive for equity financing because an investor has limited personal exposure and does not need to be involved in day-today management responsibilities.

Private equity investors are sometimes partners or board members and who often offer valuable advice and experience that can strengthen the company. However, unlike LLCs and corporations, investors in limited partnerships generally may not take an active role in the business’ management and affairs. Thus, the limited partnership may not be an option for the investor whose wants to be involved in management and whose managerial or technical expertise can be an asset to your company.

If your startup will be established as an S corporation, you will not be able to receive venture capital, nor have institutional or foreign investors. S corporations can issue only one class of the company stock, and the shareholders must be individuals who are U.S. nationals.

Conclusion

The costs and complexity of raising capital necessitate that you work with an experienced attorney to help you through the process. In addition, the complicated legal issues of Crowdfunding, including required securities disclosure, make it advisable that you seek adequate counsel to properly advise potential investors both as to the opportunity and all of the risks of investing in your startup.