Partners and Investors

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Overview

The purpose of this Interactive Business Tool (IBT) is to explore the issues facing a small business when management decides to expand an existing business using partners, private placements, venture capital or other outside investors.

The focus of this IBT is to help a small business owner determine whether bringing in partners or outside investors is appropriate, the methods a business can use toward achieving this goal, and the problems a business is likely to face in the process. By its nature, this will be a very general discussion. Keep in mind that your unique situation will probably differ in some ways from this general outline. You can obtain specific advice from your lawyer, accountant, banker or other financial advisor.

Outline:
  1. When Is Outside Financing Necessary?
  2. Equity or Debt?
  3. Worksheet: Are You Ready to Bring in Outside Investors?
  4. Types of Equity and Debt/Equity Hybrids
  5. Types of Offerings and Investors
  6. How to Interest Professional Investors
  7. Investor Expectations
  8. An Alternative: The Strategic Alliance

When Is Outside Financing Necessary?

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Once a business has made the decision to expand, the next step is to determine how to finance the expansion. Some firms produce sufficient cash and cash flow to finance their plans out of operations. However, when a company is not in that position, management must find sufficient outside financing to make the proposal a success.

There are a tremendous number of options, but ultimately the company must decide whether to use equity or debt to expand. A company can obtain debt financing from both traditional and non-traditional sources, such as banks, commercial loan companies, factors, venture capital firms or individuals. Many venture capital firms prefer hybrid securities with features of both debt and equity.

A company can find equity financing from a number of sources, including family members, business associates, venture capital firms and "angel" investors. As an alternative to financing the expansion, a company can form a partnership or strategic alliance with an existing company in the area in which it intends to expand.

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Equity or Debt?

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Expanding businesses have a decision to make: Should we raise expansion capital using equity or debt? For some entrepreneurs, selling equity in their company may be too difficult. However, there are significant advantages to equity financing, such as:

  • No repayment burden on cash flow from operations
  • On balance sheet, it is listed under stockholders' equity and not liabilities
  • Professional investors, such as venture capital firms, can bring substantial expertise to help your business succeed

Of course, there are also some significant disadvantages, depending on one's point of view:

  • "Advice" from investors could be seen as interference
  • Once outside investors are admitted into the company, the founder must run the business for the good of all the stockholders
  • Professional investors will require audited financial statements and independent accountants
  • Professional investors will also require a voice on the board of directors

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Worksheet: Are You Ready to Bring in Outside Investors?

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Answer the following questions to help you determine if you are ready to bring in third-party investors to your company.

  1. Do you run a "one person" show, where you call all the shots?

  2.  Yes No
     
  3. Do you have other family members or partners in your business now?

  4.  Yes No
     
  5. Have you ever had a dispute with a partner that resulted in either you or that partner leaving the business?

  6.  Yes No
     
  7. Do you employ an independent certified public accounting firm to audit your company's books and produce an audited financial statement?

  8.  Yes No
     
  9. Have you ever felt that key employees ask too many questions about how you run your business?

  10.  Yes No
     
  11. Have you ever granted your key employees stock in your company as a bonus or a gift?

  12.  Yes No
     
  13. Have you ever ignored the advice of your lawyer or accountant, whether the result was a success or failure?

  14.  Yes No
     
  15. If you run several related businesses, is each one kept separate, with no commingled funds or other blurring of the lines between them?

  16.  Yes No
     
  17. Do you hate being second-guessed by anyone?

  18.  Yes No
     
  19. Are you open to suggestions from others, including persons you may not like?

  20.  Yes No

Give yourself one point for each "no" answer to an odd-numbered question and each "yes" answer to an even-numbered question. Then subtract two points for each "yes" answer to questions 1, 3, 5 and 7 and five points off for a "yes" answer to question 9. If you still come up positive, you might just be the right type of owner to bring in outside investors.

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Types of Equity and Debt/Equity Hybrids

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Depending on the type of entity, a business can issue several different types of equity and hybrid securities. For purposes of this discussion, we will focus on corporations, realizing that other types of entities exist. Some types of equity include:

  • Common stock, which represents an ownership interest in assets and the right to a vote for members of the board of directors. Common stock may be divided into classes with different voting, dividend and liquidation rights.
  • Preferred stock, which represents an interest in the assets and revenues of the corporation. Preferred stock usually has rights giving holders a preference in dividends upon liquidation. Preferred stock may also be divided into classes or series with different rights.
  • Hybrids ˆ… Professional investors often purchase a convertible preferred stock or convertible debt, both of which are convertible into common stock. This structure gives the investor the advantage of a first call on cash flow and assets, with the ability to take advantage of capital appreciation.

Of course, there are a multitude of variations on this theme. In fact, there are probably as many forms of equity and equity/debt hybrid securities as there are new situations your business could encounter. Here are just a few

  • Class A and Class B Common Stock ˆ… There can be as many classes as you wish. Say an owner is willing to give up a substantial part of the ownership of the company but wants to keep firm control. Before the offering, the company authorizes two classes of common stock: Class B (owned by the entrepreneur) has 10 votes per share, while Class A (sold to investors) has one vote per share. As long as the founder owns roughly 10 percent of the total common stock, the founder maintains voting control.
  • A company may issue different classes of common stock in a merger, where the dividends paid on the particular shares are tied to certain business segments
  • Preferred stock can be voting, non-voting, convertible, redeemable (at the option of either the company, the holder or either one); preferred stock can have provisions that force conversion into common stock upon certain events (a date, a stock price, a sale of certain assets, etc.)
  • A company can issue common stock combined with warrants, which evidence a right to buy additional shares in the future. This is particularly useful where the company foresees additional needs in the future. Warrants can also contain provisions that force the holder to exercise if certain conditions are met, usually if the company's common stock reaches a threshold price.
  • A company can issue debt instruments, such as debentures or notes, which are convertible into common or preferred stock. A company can include mandatory conversion provisions, forcing a conversion under specified conditions.
  • Preferred stock dividends can be made payable only when the company has sufficient cash available, and can be cumulative or non-cumulative. If dividends are cumulative, and the company is unable to pay during a dividend period, the dividends are accrued and paid when the company has funds.
  • Dividends on both common and preferred stock can be paid in cash or additional shares of stock.

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Types of Offerings and Investors

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Assuming you and your management team have decided that it is appropriate to seek outside equity, you have a number of choices. Equity financing is based on the company selling part ownership of itself to other investors, either privately or to the public. A company can sell the equity (often common stock) itself or it can engage an investment banker for assistance. Equity offerings can be private or public, depending on the manner of the offering.

In its simplest form, the owner of a company decides to raise some additional capital by selling shares of stock to family members, business acquaintances or key employees. This type of offering can be relatively informal. However, both federal and state securities laws regulate all offerings of securities, and you should consult competent professionals prior to any offers or sales.

One step higher in complexity is a formal private placement of securities to a small number of sophisticated investors (so-called angel investors) or a venture capital firm. At this point, you should consult with counsel to determine whether to sell the offering yourself or try to interest an underwriter. Generally, an underwriter will be interested in a private placement only if your ultimate goal is to go public and give the underwriter's clients an "exit strategy."

Angel investors are generally wealthy individuals who invest in early stage companies or mature companies wishing to expand, with the hope of earning a substantial return on their investment. Small companies can contact angel investors through local investment clubs, personal references and the like

Businesses can contact venture capital firms through a number of avenues. There are a large number of printed directories of venture capital firms, updated annually, listing the types of deals the firms engage in, the industries they specialize in, and the names of key contact persons. This information is also available in electronic form from a number of firms. The Internet is also a great source for mining information about venture capital firms. Be prepared to wade through a large number of commercial sites for consulting firms that specialize in preparing business plans and acting as an intermediary between investors and businesses seeking investment.

Another type of equity financing is a public offering of securities through an underwriter. This can be a long process, involving lawyers, accountants, the underwriter and a host of other expensive professionals. Usually, the company has gone through several rounds of financing earlier. A public offering can provide significant capital, but also involves significant costs, time, effort and distraction from running the business. This complicated subject will be the source of a future IBT.

For businesses needing only $1,000,000 to $5,000,000 in financing, there are a number of firms that offer direct public offerings over the Internet. Although the success of these types of offerings is very difficult to gauge, it does appear that a number of companies have been very successful in this area. However, most of the success stories are anecdotal and involve high-tech or Internet companies.

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How to Interest Professional Investors

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Presumably, a business owner can sell equity in the business to friends, family and business associates based on his or her credibility. However, professional investors have specific needs for financial and other information in making investment decisions. A typical professional investor weeds out 95 percent of proposals submitted by companies after a very short review. To be a success in this market requires a company to give the investor a reason to take a closer look and then have something real to show.

To evaluate an investment in your company, professional investors want:

  • A business plan
  • Five-year financial projections
  • Current audited financials (if available)
  • A reason to invest in you

The business plan is the most important document that your company can produce. It should contain a short summary, a history of the company, a proposed plan of operations, detailed financial projections, management biographies, a funding request and use of proceeds which tie into the financial projections. If available, the company should include historical financial statements. The executive summary should be as short as possible and include summary projections. The financial projections should be reviewed by your accountant and contain detailed notes as to the assumptions underlying the numbers. Note that you will be challenged to justify each number.

Once a venture capitalist is satisfied that the investment works from a financial point of view, the investor takes a very close look at the management team. The investor must decide that the current management is capable of putting the business plan into effect. Often, a venture capitalist will negotiate for control of the company, at least concerning financial matters, and he or she will also invariably get representation on the company's board of directors.

A company must expect that any deal with angel investors or venture capitalists will be heavily negotiated. An investment may be contingent upon the company hiring a new chief financial officer or chief operating officer or making other significant management changes. An investor could require approval of budgets, prior approval of certain expenditures and monthly financial reports. These conditions could become more restrictive if the company does not meet the goals set in the financial projections. The company's leverage depends on its need for the investment and the tolerance of the owner for oversight by others.

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Investor Expectations

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Professional investors usually have specific expectations as to investment returns. Angel investors have differing expectations, but will require substantial profits. Most venture capital firms expect a 50 percent per year return on their investment, and the financial projections you provide must support that kind of return. This is the case because so many companies fail at this stage of their development and even the best investor picks companies that will fail. All professional investors need an exit strategy; the investor must know when and how the company proposes to make his or her investment liquid. The exit strategy can be a public offering or a buyout with a substantial return on investment.

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An Alternative: The Strategic Alliance

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Sometimes, a company wants to expand its reach, but does not or cannot finance the expansion. One alternative is to develop a partnership with another company in the area with similar goals. By cross-selling a partner's products or services, a small business can extend its reach. This alternative is becoming very common in the high-technology arena, where large hardware manufacturers routinely partner with small, innovative companies to ensure compatibility of products and to supply customers with a wide variety of products and services. In return, the small businesses are able to leverage their relationship with the larger enterprise to increase visibility..

These partner relationships may result in the merger of the partners into one enterprise. This benefits both parties, since it is usually easier to acquire a business than to build it from scratch.

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