A Venture Capital Attorney Explains how Entrepreneurs can Get Funding for Start-Ups and Early-Stage Companies
Are you looking to raise capital for your company from friends and family, angel investors or venture capitalists? Have you been hearing about the new SEC rules that will allow crowdfunding of start-ups and other growing companies by offering stock for sale directly to investors? Or are you considering a web or email-based capital-raising campaign to take advantage of the new SEC Rules permitting advertising and general solicitation to accredited investors? I am an experienced, results oriented venture capital attorney. I and my associates are business and securities law experts located in Los Angeles and serving Southern California, offering quality services at rates that are a fraction of those charged by large corporate law firms. Call now at (424) 256-8560 for a free consultation, or send us an email via our contact form.
I have prepared this Guide for entrepreneurs to help them in planning and structuring their companies with the goal of successfully raising capital from friends and family, angel investors an professional venture capitalists and other professional and institutional investors.
Can My Company Attract Venture Capital?
The most important question you can ask yourself is whether your company is capable of attracting venture capital or other institutional capital. Professional investors are not interested in investing companies that do not have a reasonable possibility of quick growth, ability to capture significant market share, significant competitive advantages and very high investment returns. The reality is that most small businesses, such as a dry cleaner, restaurant, or clothing store will not meet these criteria and will have little or no chance of raising investor capital. Investors are looking for companies that have the potential to grow quickly through innovative products or services, usually based on a new technology or other innovation. Patent protection or other uniqueness is usually required.
According to the National Venture Capital Association:
“Today, the majority of venture capital is invested in high technology companies including software, biotechnology, medical devices, media and entertainment, wireless communications, Internet, and networking. In the last five years, the venture industry has also committed itself to investing in the clean technology sectors which include renewable energy, environmental and sustainability technologies and power management. However, venture capitalists also invest in innovative companies within more traditional industries such as consumer products, manufacturing, financial services, and healthcare services and business products and services.”
Tech Coast Angels publishes a list of key traits for companies seeking funding that is well worth studying.
Types of Investors
Investors in start-ups and growing companies may be divided into five groups: friends and family (F&F), angel investors, business incubators, strategic investors and venture capitalists.
Friends and Family
Along with the founders and initial management team, friends and family investors are usually the earliest investors. As a result, they generally receive the lowest price for the stock as the valuation of the company is at its least before any funding has been obtained. Aside from the low stock price, F&F investors generally have fewer legal protections than later-round investors. For example, they may receive common stock, while angel and venture capital investors usually receive preferred stock or convertible debt, which typically have much more detailed legal documentation and contain many more provisions that favor the investor.
Angel investors are wealthy investors who invest in start-ups and early-stage companies, often through clubs, associations or angel investment groups. One well known example is Tech Coast Angels, which has invested a total of $120 million in over 200 companies. Many angels are successful entrepreneurs who have successfully started and then sold or taken public their own company and wish to invest in future start-ups. In addition to supplying capital, they are often experts in their fields and can be a valuable source of advice and guidance to the companies in which they invest, as well as extensive contacts with other experts, potential management team members and venture capital companies.
Business incubators are programs that provide entrepreneurs with assistance and support in starting and growing their business, including business and strategic advice, networking, and training. Often the incubator provides office facilities i a shared workplace environment where participating entrepreneurs can interact and network. Typical assistance includes presentation skills training, assistance with developing business plans, high-speed internet access, networking with potential investors, management team members, advisors, mentors, banks, vendors, etc. Often, legal assistance and assistance with intelectual property is also provided.
Forbes Magazine has published a list of top business incubators, and similar lists can be found through an Internet search.
Strategic investors are established companies that invest in start-ups and early-stage companies, usually in the same industry. Their investments are only partially motivated by the potential return to be earned. Usually there are strategic business interests that drive the investment, such as the desire for access to new technology to be developed or access to new products or markets. The investment terms for a strategic investment are often less onerous than for purely return-driven investors, such as venture capitalists. Finding strategic investor is usually difficult if the entrepreneur does not have good contacts and an established reputation in the industry. The most common form of strategic investment is from the entrepreneur’s former employer.
Venture capital companies typically invest in later stages, after F&F and angel investors have seeded the initial start-up of the company, although some will fund start-ups if the entrepreneur has previously had a successful start-up with venture capital, is a well known leader in the industry, or posses a unique patent or other technology. They are primarily motivated by the potential for a very high investment return either through a sale of the company or an IPO. Venture capital companies tend to be focused in a few industry sectors, such as software, internet, communications, high tech, biotech and medical devices. They tend to be concentrated in high tech areas of the country, such as California’s Silicon Valley and Boston’s There are approximately 800 active venture capital funds in the U.S. today, managing approximately $175 billion in committed capital.
Investor Accreditation and Private Placements
Any time a company sells or offers for sale shares of its stock or other securities, it must comply with the Federal and state securities laws. These laws typically divide securities offerings into two classes: public offerings and private placements. A public offering is an offering to the public, typically by a listing on a stock exchange or into the over-the-counter market. A private placement is an offering not involving a public offering, and is limited to a small number of purchasers. Until recently, this meant that the issuer could not utilize advertising or general solicitation; recently, the federal JOBS Act and regulations of the Securities and Exchange Commission (SEC) have relaxed this requirement for offerings made solely to accredited investors (see below). The JOBS Act also enabled companies to raise up to $1 million per year through equity crowdfunding. In September 2013, the SEC adopted proposed regulations implementing this provision, which are expected to go into effect in 2014.
Accredited vs Unaccredited Investors
A traditional private placement is limited to 35 unaccredited investors plus an unlimited number of accredited investors. A private placement utilizing advertising or general solicitation must be limited solely to accredited investors, and the issuer must take reasonable steps to verify the accredited investor status of each investor. Thus, the definition of the term “accredited investor” is important.
Briefly, accredited investors include natural persons with (1) net income of at least $200,000 in each of the two most recent years (or $300,000 joint income with his or her spouse) or (2) net worth (individually or with his or her spouse) od=f at least $1 million, exclusive of his or her primary residence. A number of types of corporations, trusts, partnerships and other entites are also accredited if they meet certain requirements, such as minimum net worth standards.
Equity crowdfunding was authorized in Title III of the JOBS Act, and the SEC’s implementing regulations are expected to become effective in 2014. Equity crowdfunding is a new form of corporate finance that allows investors to purchase stock and other securities in private companies through Internet websites that are either registered with the SEC (known as funding portals) or are operated by registered securities broker-dealers. Currently, equity crowdfunding is not permitted in the U.S. Many crowdfunding sites, such as KickStarter and IndieGoTo, do allow entrepreneurs to raise money for specific projects, but they may not offer stock or other securities. These sites are based on a “perk” or “bonus”-based model: the listing company may offer bonuses or perks, such as tickets to a movie project seeking funding or a copy of an app to be developed.
Equity crowdfunding will have limits on the amount that may be invested by each person (a maximum of 10% of net worth or $100,000), extensive disclosure requirements concerning the listing company and its business plan (including financial statements that may be required to be reviewed or audited by an independent accountant), and a number of other hurdles, and limitations on advertising, forms of compensation paid for investments and other matters. It remains to be seen whether equity crowdfunding will become a significant form of equity finance following the implementation of the final SEC rules in 2014.
Accredited Investor Internet Offerings
An alternative to equity crowdfunding for an entrepreneur is to list the private placement on an accredited investor investment site or to set up a site specifically dedicated to the company and the private placement. There are many accredited investor financing websites on which a company can list to offer its stock to accredited investors. Often, these are focused on a particular industry, such as real estate (e.g., RealtyMogul) or tech (e.g., AngelList). A company may also set up its own website and conduct a private placement to accredited investors, using advertising and general solicitation. This may be viable if the company has in-house e-marketing expertise or can hire a consultant to market the placement to potential investors. However, this route should not be taken without the help of an experienced securities attorney, as failure to comply with the applicable Federal and sate securities laws can result in the offering not complying with the law.
The advantages they have over equity crowdfunding platforms are: they are available now; the disclosure and auditing requirements are usually more flexible; there is no limit on the amount that may be raised or the amount any one investor may invest; and the cost is anticipated to be lower. The main disadvantage is that by only allowing accredited investors, who constitute approximately 8.5% of U.S. households, most potential investors will be unable to participate.
How to Find Investors
There are many ways to find potential investors; some of the more common ones are listed below:
Networking among your business contacts is often the best way to find investors or to get leads to potential investors. Go through your contact list and seek out former employers and colleagues, friends and family members, industry contacts, professionals (accountants, lawyers, etc.) and others who can refer you to potential investors..
Placement Agents, Finders, Consultants
You may wish to hire a professional placement agent or consultant to find potential investors for you. Typically, they will charge a percentage of the funds raised, usually between 5 and 15%. Many will insist upon an up-front retainer, which is a cash amount that is non-refundable regardless of whether or not any funds are raised. Many placement agents and finders will insist on a retainer to cover their out-of-pocket expenses, such as preparation and printing of marketing materials and travel. Retainers should be kept to a minimum and only paid to firms or persons who have demonstrated success in raising funds for similar companies. All to many so-called professionals make a living by collecting retainers and then not performing when it comes time to raise the funds.
Angel investor groups, such as Tech Coast Angels, are excellent sources of capital. Be sure to carefully study their investment criteria to make sure that your company fits their parameters. Their websites should also explain in detail the process for preparing and submitting investment proposals.
As discussed above, internet sites for both accredited investor and equity crowdfunding can be an excellent source of capital. Try to find a site that is specifically oriented towards your particular industry.
Advertising and General Solicitation
With the implementation in September 2013 of the JOBS Act rules relaxing the prohibition on advertising and general solicitation in private placements to accredited investors, companies seeking funding may for the first time directly solicit accredited investors. This opens up new possibilities for companies seeking funding, especially those that already possess marketing talent and resources. For instance, a company can utilize the resources of the Internet, including mass emailings, SEO-based web marketing campaigns, webinars and the like to seek out potential investors.
Companies going this route should make sure to involve the services of a qualified venture capital attorney. The new rules have imposed rather stringent requirements for verifying the accredited status of each investor, which will require legal review. In addition, it must always be remembered that the anti-fraud provisions of the securities laws are still applicable to accredited investor offerings, and the disclosure information should always be reviewed by an experiences securities attorney.
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If you would like a free consultation on raising capital for your company, please call us at (424) 256-8560 or send us an email via our contact form.
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