There are many options to finance a business. While making the correct financial choice will lead to success, implementing the wrong type of financing will cause a company to fail. Many startup businesses are unable to fund their operations with just operational cash flow. Therefore, it’s critical that the appropriate financing be obtained with minimal interruption to the growth of the business. This means that the business not only needs to have enough cash flow to fund the day-to-day activity, but it also must obtain sufficient funds to promote investment in capital assets and/or research & development.
Balancing the financial needs of a company is over looked by many entrepreneurs. This is evident in the statistics which reflect that 25% of startups fail within the first year of business. Worse is that approximately 50% of the startups fail after four years of business. Many of these failures are the result of an inadequate business plan, aggressive pricing of product/service, stiff competition from established industry leaders, and/or the lack of a basic fundamental understanding of financing.
A startup is driven by a great idea that captures the owner’s desire to entertain some level of risk. This risk may be in the form of one’s reputation, time and/or assets. Typical startups are initially formed with the owner’s own capital. Additional capital may come from the owner’s family or friends which may be sufficient for small companies to finalize their infrastructure and to keep their doors open for a limited time. Other owners have the mass market dream and aspire taking on greater risk for the betterment of their idea. Entering the mass market requires a different financial strategy and involves a more complex business structure. In this case, it’s important the business not be solely dependent on the entrepreneur but rather capitalize on the relationships it maintains with individuals within and outside the organization. A key resource for the stability of the company is the partnership that it maintains with the individuals associated with its financing.
Common Types of Financing for Startups
There are many financing alternatives available to a company, and each one entertains some level of risk. The responsible parties must decide between paying interest associated with debt or diluting the ownership structure. Many times the owners do not want to give up their stake and opt for debt financing which burdens the company with interest expense that reduces its cash flow. Some debt financing comes with financial covenants that restrict the company from making capital investments as certain financial ratios (e.g. working capital) must be maintained. Therefore, it is necessary for the stakeholders to consider various equity financing alternatives before locking into any specific structure. Some of these equity alternatives include:
- Angel investor – this is an individual investor that invests in the company through the purchase of equity interest or will lend the company money at a premium interest rate. This is usually an investment that is considered seed money. Angel investors are high net-worth individuals that are willing to take on moderate to high risk in order to make investments that can yield a high return. Angel investors typically seek companies that are slightly beyond the startup phase and need funds to broaden research and development and/or expand marketing. The downside with Angel investors is they usually take large stakes of ownership and seek out quick exits to maximize their returns.
- Venture Capital – similar to an Angel investor a in early-stage businesses and seeks high returns. Venture Capital companies represent a pool of investors that look for high-risk private companies that have the potential to be very profitable. A partnership with a venture capital company usually leads to an initial public offering.
- IPO – Initial public offering is a long and enduring process. The company will usually engage an underwriter/investment bank, SEC lawyers and auditors to assist them with the IPO process. The services provided by these professionals will be very expensive and will take several months to complete. A registration Form S-1 will be filed and reviewed by the SEC. Once the SEC completes its review, the registration will allow the underwriter syndicate team to sell the shares to the public. Smaller companies that are looking to raise $50 million or less can consider the SEC’s Regulation A+, which is less involved than filing a Form S-1. Under Regulation A+ tier 2, the state compliance (Blue Sky Law) was eliminated and allows funds to be raised from qualified investors (unlike Regulation D - Rule 56 (c) which requires funds be raised from accredited investors only). Regulation A+ is a good option for stable private companies that need to raise capital without going through the extensive IPO process.
- Reverse Mergers – when a private company wants to go public quickly it usually considers the benefits of a reverse merger. Typically, a private company will find a public shell company that is significantly underperforming (usually has a toxic structure) and will complete a due diligence. If the private company is satisfied with the due diligence’s results and considers the price to acquire the shell company reasonable, then it will purchase the public company. This structure will then allow the company to raise capital by selling shares to the secondary market within a short period of time. The complexity of this transaction varies if the acquired company is traded on a national exchange or the pink sheets. The downside of the reverse merger is that, though it’s cheaper than an IPO, the acquiring company will still have to pay for accounting and legal professional fees in addition to the purchase price of the public/shell company.
- Private Equity – if the company is looking to bring in a partner to raise capital or unwind a significant portion of ownership then it can consider being acquired by a private equity company. Private equity companies will assist the company with realizing its full potential by not only providing it with capital resources but also offering industry expertise. Professionals at a private equity will know how to maximize the company’s value and work with management to create long term sustainable growth and success. Many private equity companies will want significant control over the company to ensure they have the ability to make the appropriate managerial decisions. Private equity financing offers the owners a quick option to obtain capital or cash-out at a minimal cost when compared to IPO’s and reverse mergers.
Selecting the appropriate financing alternative is one of the most important decisions for a profitable company. The company needs to insure that it selects the correct financing structure that is in line with its long-term goals and will allow it to enhance its overall value for the owners.
Jeffrey Luft resides in New York and is an active CPA. He currently works for NewNet Communication Technologies (a Skyview Capital portfolio company) and previously worked for Arthur Andersen, Goldman Sachs and KPMG.
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