I spend a lot of time representing entrepreneurs as they raise money to build or grow businesses or buy existing ones. With sophisticated clients, other law firms and professional advisers are already involved, but with many others, I end up introducing them to the legal and practical universe of raising capital. I often spend as much time in initial meetings explaining the fundamentals of raising money to the client (and sometimes to referring counsel), as I do drafting documents. I thought it would be useful to assemble the considerations that every client (and lawyer) should think about in the fundraising process before diving into the universe of share purchase and related agreements.
Here’s the starting scenario: your client has a great idea for a business, whether to launch, expand or buy one, but doesn’t have enough capital to do it on their own. What’s next?
Start by asking the client these basic questions:
- How much money do they need?
- Where is their business plan?
- Where does the money come from?
- How much is the business worth now?
- When should they retain counsel?
- How do they keep their investors happy (and stay out of legal trouble)?
How much money do they need?
I get lots of calls where clients say things like, “I want to raise $2 million at a $10 million valuation.” This means they want to sell 20% of the business they’ve formed or intend to form, in order to grow it.
I could don my lawyer hat and start drafting documents, but I find it more effective to see if they can explain three things to me before getting started:
First: Why is their business worth $10 million today (or soon)?
Second: How can the $2 million investor expect to get $4 million dollars back in 7 years? This question often results in a pause in the conversation. If they can’t answer this question, I point out that a mutual fund might provide the same or better return.
Third: How much cash do they actually need? If a client is launching a business from scratch, they typically need, depending on the industry, enough to launch their concept and cash flow for 12 months.
If clients can’t answer these three questions, I encourage them to turn to a critical component of launching any business – the financial part of a business plan.
Where is the business plan?
If the client doesn’t have a business plan, or hasn’t created realistic projected financials, I typically make them do their homework first. Even if the plan is wrong or needs adjustment after six months (which it most likely will), they need some ability to project 12-60 months of revenue, expenses, cash flow and profitability to raise capital.
Sometimes I have to discourage clients from doing too much planning and not enough doing. Some spend years overworking a detailed 50 page business outline, including oodles of market data, competitive analysis reports, every relevant press quote, bios of a ten member advisory board and pages of projected financials. I remind them that most investors (whether professional or family member) will probably only make it through five pages at most. They don’t need a document worthy of an SEC filing, it just needs to be enough to make the case.
Once the business plan shows how the business will reach profitability, the client has some choices in the business plan and hopefully in real life:
- Pay themselves more
- Reinvest in the business
- Pay their bank loan (if there is one)
- Start making distributions to investors
Initial instincts often lead to taking a bigger salary or reinvesting in the business, but prudent entrepreneurs should focus on paying investors. Remember, not all investments end in a sale of the business or an IPO (and most do not). The investment can be paid through monthly or annual distributions or upon the sale of the business (if that’s the game plan).
Where does the money come from?
Once the client calculates how much they need, and assuming they aren’t sitting on a pile of cash, they want to know whereto raise the money. Businesses generally have three choices:
Generate it by selling products or services for more than they cost (often called “bootstrapping”). I admire this approach the most as it leaves business owners with more control. Although it generates far less fees for attorneys and other advisors in the short term, a profitable business leads to other work for me and better outcomes for the client. An example could be a restaurant growing through organic expansion by adding a second location or larger space using existing cash flow. However, some businesses have a larger vision that is not practical. For example, someone developing implantable medical devices will need lots of cash upfront to get through clinical trials and FDA approval before a single device can be sold.
Borrow it via loans (“bank financing”). This is typically only realistic for smaller or newer businesses as many business owners are already familiar with ordinary borrowing sources, including Small Business Administration (SBA) loans or local banks. The SBA specializes in lending to small businesses, and will also finance the purchase of existing enterprises. Local banks are also an option, however, most banks are unwilling to give significant loans to untested concepts.
Raise it by selling a piece of the company in the form of shares (“equity financing”) or convertible notes (for the purposes of this article, “debt financing”). If your client has exhausted their ability to borrow, or the business is truly untested, they can jump into the great American enterprise of selling a piece of their actual (or theoretical) company. This is equivalent to taking on an economic (as opposed to operating) partner. To do this, the client needs to figure out how much the company is worth, both today and in the future, and how the infusion of capital will help generate (or increase) profits.
How much is the business worth now?
Determining a company’s worth is called “valuation” and it’s a different concept in fundraising than in other legal venues, such as taxes, divorce and estate planning. In most of those circumstances, the parties are trying to figure out how much an existing company is worth today. From an economic perspective, the value is assessed by what a willing seller would pay a willing buyer. For example, in September, Amazon’s marketing value peaked at just over $1 trillion, based on its share price and the number of shares outstanding. If Amazon was sold tomorrow, would its assets be worth $1 trillion? Probably not, but Amazon investors believe that the potential for future profits or a sale make it worth that much.
Newly launched or acquired businesses require a different approach when measuring value. Successful investment in startup or speculative ventures requires trying to calculate the future valueof a company today. Or if purchasing an existing business, how much more profitable can it be if we invest in improving it? If your entrepreneurial client is going to be good (and honest) at raising money, they should consider these items when it comes to setting a value on their business and the right return to offer investors:
How investors make money. Every dollar taken from an investor should provide a decent return to the investor. Somewhere between 6% return per year (on the low end) to a 15% return per year (generated by some private equity funds) is expected. An 8% return per year is not unreasonable. That doesn’t mean that investors get checks each year representing an 8% return, unless it’s a stream of income business like rental properties, but rather there is hope that the company will be sold in 5-7 years for double the amount of the investment or generate equivalent amounts of future cash.
Valuation isn’t everything. The basis for all equity investments (and to a lesser degree loan decisions) is valuation. Just as a bank lends against a house through a mortgage based on what they think the home is worth, the same applies for equity investors. If the business is worth $2 million (today, or more likely, next year), and the client raises $500,000, their investors are going to own 25% of the business on a pre-money basis. Entrepreneurs get twisted into knots over valuation, especially after reading stories about Uber, Lyft, Pinterest and others, as they believe that their business offers huge potential and should be valued as such. However, clients need to remember that the more money they raise, the more they need to return. If someone raises $1 million at a $5 million valuation, and can only sell the business for $2.5 million, their investors would have been better off putting their money elsewhere.
Don’t be greedy. Although this sounds counterintuitive, I often tell clients not to raise more than they need because they will alwaysspend what they have. Although savvy entrepreneurs plan for multiple rounds of fundraising at (hopefully) increasing valuations, in my 25 years of practice, I have yet to have a client tell their investors that they over-raised and are sending money back. For example, everyone loves graduating from a borrowed cubicle to a posh, leased office space as soon as they raise money, but it’s not always the most effective use of capital, and I’ve ended up drafting many subleases for formerly flush clients.
Choose investors wisely. If the client is raising money from friends and family, which is the most common approach for those starting out, they should consider how much risk these investors can accept and who they can afford to disappoint. Setting securities laws aside, if friends and family are not sophisticated or wealthy (or both), do not raise money from them. Separately, raising money from a professional investor, such as an equity fund, may require accepting advice or budgeting limits, wanted or not, from newly appointed directors.
Know your options. Debt financing throughselling convertible notes,a hybrid of debt and equity, has become a more common way of raising money without negotiating valuation. It consists of investors lending money to the company that if not repaid, will convert into equity in the future, based on the valuation agreed to between the company and future investors. It assumes that the company will go through at least one other round of investment and defers the valuation debate until a later day. Another popular model is a Simple Agreement for Future Equity (“SAFE”) that eliminates the debt portion of convertible notes. SAFEs are beyond the scope of this article, but involve the same set of preliminary questions.
When does your client need counsel?
Once clients are ready to raise money, I encourage them to hire counsel before they take their first dollar. Issuing equity, convertible notes, SAFEs or just borrowing from friends and family, combine the legal and business pitfalls of taking on a partner and selling securities. Taking on a partner without legal planning is a recipe for disaster, such as lacking a well thought out exit strategy, and selling securities, if not done properly, is illegal.
How do they keep their investors happy (and stay out of legal trouble)?
An importantpiece of non-legal advice I often give clients is to keep investors informed. Short of sending investors regular piles of money (more than they put in), which makes them the happiest, stockholders want to know how their investments are doing. Investors and lenders would much rather hear information (good or bad). Quarterly, annual or even periodic emails (even if not required by the specific investment documents), are way less painful then leaving investors in the dark and telling them later that the money’s all gone or that you need more right away.
Asking these questions to entrepreneurial clients upfront not only makes the fundraising process more seamless and profitable for them, but it also builds a trusting relationship with you as legal counsel, so that they are more likely to bring you along for the ride as the company grows and thrives.
Reprinted with permission from the April 1, 2019 issue of The Legal Intelligencer. © 2019 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.
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