This blog post is part of an in-depth series based upon our recent E-Guide, Increase Your Potential for Success: Seven Strategies to Consider in Raising Private Capital. Today, we’ll take a deep-dive into Strategy 5: Does Your Offering Have a Compelling Structure?
I spoke to a friend recently who called to ask for advice about her current fundraising effort. She was having great conversations with prospective investors for her $12M capital raise, but having difficulty getting firm commitments. She was told by the potential investors that they liked the project and saw good upside potential for the opportunity with a high probability of success. Needless to say, she was frustrated that is seemed like all talk and no action.
I asked her to walk me through the pitch as though I was a potential investor. She spent 20 minutes on her presentation, and by the end of the call, the problem was clear to me.
The project was interesting; she had built a strong business plan, had multiple exit strategies and demonstrated her ability to manage the project. However, the problem was how she'd decided to structure the deal. It was complicated, had too many moving parts and differed from what her other projects would typically use. For this deal, she was trying to raise both equity and debt. Investors could select one or both types for their investment. The debt had different tranches with different terms and rates of return. The debt could be converted in the future; and if not enough capital was raised, she had the option to increase the amount of equity or debt as required. There were warrants available for early investors which had a yet-to-be-determined conversion calculation.
Basically, by offering too many options to investors, my friend turned a good project (that should've easily raised capital quickly) into something that started to make sophisticated investors hesitant. And, worst of all, because she'd already raised some money for the project, she wasn’t able to change the terms of the PPM without starting over again.
Many people raising private capital have either lived through a similar experience or heard a comparable story. The quality of a project is one thing, but the way in which investors will participate is another. While you may have an idea of how you want the deal structured, your attorney, your CPA and your advisors may have some input as well. The more people you ask, the more input you’ll get. But, all that matters in the real world is what the market will accept.
Once you’re ready to create your PPM, one of the first things you need to do is determine the type of capital you want to raise. This can be equity, debt or a hybrid of the two. You can also incorporate derivatives, such as warrants or options, if you prefer. The more unusual the offering, the more difficult it may be for investors to comprehend. Think about how investors will interpret the type of investment. If they can’t easily explain it to their trusted advisors, it's likely they won’t want to get involved.
Also, different project types will have specific capital types. Real estate projects usually only raise equity and get debt from banks, whereas start-up companies may use convertible notes (as valuations are more difficult to determine early in the lifecycle of a new company). Another item to consider is whether you want to have different tranches for each type of capital. There can be separate share classes with each share class offering its own special terms. This occurs often in the public markets but not as much for private capital raises less than $50M. If you want different tranches, make sure you have a compelling reason for investors to want to invest in any of the different share classes. For example, if all of the attractive benefits will occur in investing in the first tranche, then why would a smart investor want to invest in the second? My suggestion is to keep it simple. That seems to have the best effect on investors, especially with smaller capital raises.
Next, determine the length or term of the investment. The project lifespan does not always need to directly correlate to the investment term. So, be thoughtful about what's in the best interest of the investor as well as the project. For example, you may have a simple real estate project that you plan to buy and then sell within 5 years. The investment term could be set to 5 years as well. But, what happens if the project takes longer than expected to reach its performance targets? What if you receive an attractive offer to sell the building quickly but at a lower overall return than initially expected?
There are similar considerations to take into account with a start-up company. Do you plan to sell the company in the future? Take it public? Or simply operate it as an ongoing entity for many years? The shorter the term of the investment, the more attractive it can be for those that prefer a faster timeframe to achieve liquidity. But, there are other ways to provide liquidity, such as recapitalizations, that can allow you to have a longer time horizon for a project but still provide principle back to investors. Ask those you may be interested in investing in your project for their opinion about what they think would be appropriate for a project like yours. Often, this is the best method to get open and honest market feedback.
After the term, it’s critical to make a decision about how you'll provide profits and principle back to investors. There are many ways to do this and there's no simple formula that can be used. Profits can be distributed as interest, dividends, capital gains and warrants as the primary forms. You can determine the timing of when you return principle and distribute profits. There can be calculations on how you split the profit and this can change over time or when specific performance metrics are achieved. There's no right or wrong way to do this. But, your approach has important consequences in your ability to raise capital for the project. Length of time can affect IRR. There can be tax consequences for projects to return profit too quickly. Tying up principal may be an issue for some investors, while others may prefer to have their capital generating returns for long periods of time. Think through this carefully and keep in mind the type of investor that you want to include in your project.
Finally, there are a number of non-core items to consider in the overall structure. These won’t make or break a potential investor, but still need to be addressed to complete your PPM. Examples of these types of items include the ability for an investor to sell their shares to someone else, any caps that you may have in the total number of investors and even the type of corporate structure you want to utilize such as LLC or C Corp. Your lawyer and CPA will review these things with you as they are required to be addressed when forming your corporation as well as completing your PPM. It’s good to get feedback on these, but there's no reason to be concerned about the potential effects they may have on attracting investors. I’ve never known an investor to walk away from a deal because it was set up as a C Corp instead of a LLC.
All of this may seem a bit overwhelming, especially for those that aren't experienced in raising capital or have extensive financial backgrounds. To serious investors, the structure of the deal is sometimes just as important, if not more important, than the deal itself. Savvy investors know that returns are dependent upon the quality of the project, the experience of the team—and the structure of the deal.
Be sure to check back for a look at our next strategy to consider when raising private capital.
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Disclaimer: WealthForge provides this information to our clients and other friends for educational purposes only. It should not be construed or relied upon as legal advice.