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fail with the private investor.
Why? One reason has already been discussed: These investors protect
their privacy. Here is another reason, also briefly mentioned earlier: The
private investor™s reasons for investing are not always exclusively economic.
Therefore, the entrepreneur faces difficulty in judging which approach
to adopt in trying to locate, attract, and build a relationship with angel
investors.


THE PROBLEMS WITH CONVENTIONAL WISDOM
In locating an angel who can work financial miracles, many entrepreneurs
employ conventional wisdom. Its precepts are predicated on the procedures
applied to financing from banks, professional venture capitalists, and bro-
kerage of public securities. Such a strategy is handicapped. What are these
precepts and why don™t they work?
In their advice for accessing capital, many popular business books sug-
gest networking for your venture in the hope of securing promising referrals
by talking to your accountant, attorney, doctor, dentist, or some other
adviser. Networking is a term widely used, yet it refers to a concept often
misunderstood. Networking is overworked; more important, networking
works indirectly. Instead of approaching the investor directly, networking
lodges faith in the hands of someone else, hoping that he or she will be able
to help, for example, doing initial prospecting and qualifying of the “poten-
tial” investor.
Another tenet of conventional wisdom proposes that you concentrate
largely on people who understand your industry, in the belief that staying
abreast of it will link you to people familiar with your type of company. This
presumably qualifies them as investors for your venture. But industry spe-
cialization is only one consideration in an investment decision; many other
things can influence a private investor™s preference. Remember, we said that
37
The Solution: The Private Placement


the private investor™s agenda can be significantly more diverse than merely
considering internal rate of return or industry experience and specialization.
For example, investors may show more interest in investing in a business
geographically close to home. Or they may be interested in a new, emerging
industry that has been an avocation for many years while they were working
in another industry. Or they may be looking for something exciting and
fun, perhaps a change from what has long since become drudgery. This type
of investor may be looking for something new and different. Thus, over-
reliance on industry sources narrows rather than widens the pool of prospec-
tive investors.
Conventional wisdom also advises that you advertise. Just peruse the
Mart section in the Thursday afternoon edition of the Wall Street Journal,
and you will discover numerous solicitations for investors advertised there,
thinly disguised as business opportunities. These types of classified adver-
tisements supposedly provide another vehicle that entrepreneurs can rely on
in order to generate investor contacts. But be warned: In many places, ad-
vertising a private placement investment is illegal. This restriction has been
eased in some states, for example, in California. The California Corporate
Code™s 25102(n) statute permits small business entrepreneurs to advertise for
wealthy angel investors. But restrictions have not been eased everywhere.
Even where it is legal, the entrepreneur must be cautious. An advertisement
for a private placement investment that reaches inappropriate or unqualified
investors could instigate legal problems about the way these investors were
solicited. By definition, a private placement investment is the limited offering
of securities to a small group of private investors with whom the entrepre-
neur has an established relationship and whom the entrepreneur believes are
appropriate and qualified for that investment opportunity. So be careful with
advertising, regardless of the extent to which others may engage in it.
Last, conventional wisdom advises entrepreneurs to turn finally to fam-
ily and friends, people who know them, have the money to invest, and retain
a genuine interest in supporting the entrepreneur. Family and friends should
be the first”not the final”source you entreat after you have personally
invested a substantial portion of your own net worth. Many people eventu-
ally appeal to family and friends after networking, canvassing industry, and
ferreting out investment bankers. Family and friends and one™s own re-
sources should be the initial sources of capital at the earlier stages of financ-
ing a venture.
On close examination, then, conventional wisdom may be conventional,
but it hardly qualifies as wisdom. In Chapter 3, our strategy offers a better
way, a plan that works.
3
CHAPTER

The Solution: A Strategy
That Works

Anyone can sell cold drinks to thirsty people. Marketing is the art
of finding or inventing ways to make people thirsty.
”Herman Holtz, Consultant

Can I give my whole philosophy? Two phases with every brand.
Getting there. Staying there. As difficult as getting there can be
under today™s conditions, staying there is even more difficult.
”Steve Meisner, Marketing Director, Ferrari-Carano


AN “INEFFICIENT” MARKET DEFINED
Early on, the investment banking business tagged the private capital market
as “inefficient.” When investment bankers or venture capitalists portray the
private placement or angel market in this way, precisely what do they mean?
Why inefficient?
Inefficiency in the private equity market is important for entrepreneurs
to understand because it is a problem that leads to underinvestment. This, in
turn, contributes to the capital gap we mentioned earlier. The absence of an
organized capital provider system creates hardships for the entrepreneurial
earlier-stage companies regardless of whether seed, R&D, start-up, or an ex-
panding small business. Systems and the critical information for entrepre-
neurs and investors to make fast, informed decisions are simply not readily
available.
First, no professional analysts are available to tout the private equity of-
ferings or issue research reports, activities characteristic of major investment
houses in their effort to increase interest in public stock offerings. Publishing
efforts to create periodicals and research journals regarding this market have
not been financially successful, and are not widely endorsed.
Largely, however, market information on private offerings is severely



39
40 THE CHALLENGE AND THE SOLUTIONS


limited, both on the micro level (i.e., at individual companies) and on the
macro level (i.e., at technical fundamentals underlying the capital market™s
dynamics). As a result, it becomes difficult for private investors to perform
comparative analyses on their deals against baselines of compiled statistics
on groups of other deals. Entrepreneurs need to appreciate that investors are
forced to operate blindly, without information on valuations, deal structures,
terms, return rates, and liquidity multiples or alternatives. Absence of this
baseline information slows the investors™ evaluation of deal risk/reward po-
tential, leaving subjective nature and personal experience as the tools to rely
on in determining if a venture is promising.
Also, no Securities and Exchange Commission (SEC) requirement forces
disclosure of such offerings, a notable dispensation for private investors
who, above all else, prize their privacy. Moreover, by the very nature of the
transactions, the market is inefficient and inconvenient for buyers as well as
for issuers and sellers. Were you choosing to sell a publicly traded stock, for
instance, you could pick up the phone, call your broker, get a bid on your
stock, and sell it”none of which is an option with a private placement in-
vestment. You possess, instead, an illiquid commodity. Finding an investor
whose idiosyncratic investment criteria match your deal becomes problem-
atic. Moreover, the search for deals worthy of consideration requires consid-
erable time by the investor too.
The search is also extremely inconvenient for the entrepreneur seller be-
cause of the angel penchant for privacy. Angels make themselves scarce and
difficult to find. The difficulty in locating high-net-worth investors with the
qualifications and inclination to do high-risk investing creates barriers and
bottlenecks in the capitalization process.
So entering the direct investment market becomes expensive, often pro-
hibitively so. Professional assistance and advisory counsel is expensive. Costs
inevitably add up for the entrepreneur: a financial intermediary to help gen-
erate investor prospects for the deal; legal counsel to keep you within the re-
quirements of an exempt, private offering (e.g., restrictions on public
advertising); investment banking counsel on structuring of the transaction or
calculation of valuation; and management consulting support in developing
business plan documentation. Furthermore, in private placements, no real-
time liquidity exists. From the investor™s point of view, unloading your stock
may rush you headlong into restrictions: You may be bound by terms and
conditions requiring you to hold the stock, or you may confront tax impli-
cations of dumping stock too early, thus having to pay excessive taxes on
capital appreciation or capital gains.
Based on our proprietary research, the average hold time before liquid-
ity is eight years among ICR™s investor network. It is this loss-of-use capital
that characterizes the risk in the entrepreneur™s early-stage deal. The diffi-
41
The Solution: A Strategy That Works


culty posed by the investor™s inability to get out of the venture is one of the
great inefficiencies of the angel market, with significant implications for en-
trepreneurs seeking investment capital.
Also, the conditions of the exchange itself remain fuzzy and undefined.
How do you transfer a privately owned stock from one private investor to
another? Transferring privately owned stock activates a different type of
transaction from that of holding stock in a public offering. Also, investors
may find themselves having to go back to the company in order to transfer
documents to another party. Moreover, the company often has no history,
leaving all financial information about the venture resting on “blue sky,”
that is, exclusively on projections. This circumstance leaves the investor un-
able to accomplish a fixed analysis, even through due diligence. Therefore,
the time dedicated to due diligence remains unspecified, relinquished entirely
to the subjective values of this type of analysis. Finally, novice entrepreneurs
who bring attorneys into their transactions too early tend to draw out these
transactions more than investors do, making them more expensive, compli-
cated, and time consuming.


A STRATEGY THAT WORKS
Therefore, in this inefficient market, the problem arises of how to maneuver
it more proficiently. In accessing the affluent, hard-to-find private investor,
ICR advocates a strategy different from the conventional suggestions mas-
querading as wisdom. In contrast, our answer to proficiently searching for
investors is shown in Exhibit 3.1.

Build a Capitalization Strategy
We have found from our informal research with successful entrepreneurs”
those who have completed their financing rounds and raised the needed cap-
ital”that successful money raisers have been those who have understood
that the responsibility for that task rests squarely with them, that it is a crit-
ical feature of their job description. The task of raising money never goes
away from seed, start-up, and early growth through to the establishment of
the company in equity markets. The money-raising responsibility changes
only in form. During early stages, the task is to convince fellow founders,
friends, and family to trust in your vision and integrity. Next, entrepreneurs
turn with their deal to nonrelated angels. If they can grow, venture capital-
ists may get involved, again for equity Series A rounds. If the company sur-
vives and prospers, commercial banks provide corporate debt. And, if the
venture becomes sustainable, if it grows to meet stock exchange require-
42 THE CHALLENGE AND THE SOLUTIONS


Close
Sell
Go directly to investors

Database development and maintenance
Line up precommitment

Build investor relationships
Anticipate due dilligence
Budget for financing program
Management, not documents
Capitalization strategy

Exhibit 3.1 How to Increase Efficiency in the Private Placement Process
Source: International Capital Resources


ments, the company might be traded on the quoted equity markets. Savvy
entrepreneurs embrace the challenge of raising capital as a defining charac-
teristic of their chosen roles, and incorporate development of winning strate-
gies into their professional skill development.
Many companies fail in their capitalization strategy because their ini-
tial capital is insufficient to support operations through to the next mile-
stone. A major tenet of capitalization strategy is to raise only enough
funding to accomplish that next step in the venture™s development, and to
add to this an amount to cover the costs anticipated to raise the next round
of required financing. This strategy will save the company from surrender-
ing too much equity when its valuation is lowest. Many companies raise
too much money too early, while not spending enough time to understand
their financial requirements. This understanding requires analysis and fore-
casting of cash flow and timing the offerings so that achievement of the
next milestone represents a significant step down in the investor™s perceived
risk in the venture.
Reducing the perceived risk associated with the venture improves the val-
uation in the following rounds, letting the company raise more money while
ceding less of it. For example, one entrepreneur confided to us that he had
taken his company public, raising $23 million. However, by the end of the
process he owned less than five percent of it, a perfect example of failing to
develop a sound capitalization strategy. To his deep regret, he had surren-
dered too much of the company too early, that is, when its valuation was low.
As you develop your capitalization strategy and establish clear mile-
stones, you need to understand the correlation of stage of development with
43
The Solution: A Strategy That Works


private capital sources and the amount of capital required at critical stages
in the development of the venture. A classic study by one of the five largest
accounting firms of the time found that 328 manufacturing and service com-
panies had successfully achieved sales of $1 million to $50 million in the pe-
riod between 1989 and 1994. They found that it took an average of 28
months for successful companies to pass from seed and start-up through sur-
vival on to the initial market growth stage.
One of the interesting findings is the correlation between the amount of
capital needed at each of those stages and the source of the private capital
(Exhibit 3.2). During the seed and start-up stages, these companies success-
fully raised on average between $75,000 and $150,000 from those investors
who had an affinity for the entrepreneur and the founders. Typically, these
individuals included family, friends, neighbors, acquaintances, business as-
sociates, professional colleagues, and providers of professional services to
the entrepreneurs, who often were also investors.
During the survival stages, generally these ventures successfully raised
$200,000 to $210,000 from individuals and investors, a group that typically
includes suppliers and distributors, future suppliers and distributors, em-
ployees, potential employees, and customers”all people with an affinity for

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