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volves more than capital; venture capital involves adding value to the money
Rather than just throwing money at a company as the government does,
investors help a company by knowing about growth and having extensive
contacts in the business community. Angel investors add much more than
just capital: they provide alliances with corporate partners; assist with equity
offerings and with joint ventures and acquisitions; provide industry contacts
with customers and vendors; assist in strategy development and recruitment;
and bring knowledge-based experience to help grow and guide development
of a sustainable company. Venture capital means having extensive research
resources with which to analyze the market as well as having financial re-
sources to analyze projections and evaluate valuations. So, unable to influ-
ence early-stage ventures because its premises are flawed, the government is
not designed to be a venture capitalist. Government programs are designed
only to throw money at businesses, not furnish critical added value.
Nor are the venture capitalists themselves likely to offer the necessary
degree of added value. As David M. Flynn observes in “The Critical Rela-
tionship Between Venture Capitalists and Entrepreneurs: Planning, Decision-
Alternative Sources of Capital

Making, and Control” (in Small Business Economics, 1991), “Venture
capitalists (VCs) are less involved with their affiliated new venture organiza-
tion than may be necessary for long-term survival.” Entrepreneurs may
properly dominate the early stages of a venture, explains Flynn, but in the
venture™s ongoing development, the venture capitalist might add expertise
that the entrepreneur lacks. For example, technical skills may concede to ad-
ministrative skills so the enterprise can survive. Thus, Flynn urges a higher
level of involvement in ventures on the part of the venture capitalists. But the
question remains: Will venture capitalists be willing?
In addition, the person trying to raise capital has a dual burden: compli-
ance with federal SEC regulations as well as compliance with the regulations
of the state Department of Corporations and Commissions. Even when the
SEC has tried to reduce the cost and complexity associated with raising cap-
ital in private transactions, the states have chosen to take a more aggressive
stance on their statutes. State regulations prevail, causing the nagging bottle-
necks that have blocked capital in early-stage investment.
In conclusion, the entrepreneur will find angels involved in a range of al-
ternative early-stage financial sources: private placements, licensing, venture
leasing, cradle equity, SCOR offerings, private equity funds, direct offerings,
incubators, private lending, and even barter investments.

We know that professional venture capital performs an excellent service,
placing billions of dollars in American companies, creating jobs, expanding
the tax base, and even putting hundreds of millions of dollars into very early-
stage deals. But for the early-stage venture, venture capitalists impose rigid
criteria, leaving numerous companies unable to qualify. Thus, as venture
capital is the real contributor to later-stage deals, angel capital has become
the indubitable contributor to early-stage deals, the resource for the majority
of companies. The primary source of capital is the direct, private investor”
even though these angel investors possess an inimitable advantage: They do
not have to invest.
A problem arises for many people who think that finding a securities
firm to underwrite their efforts on a “best-efforts” basis is a guarantee that
money will be raised. The problem is that once a firm commits, it has to con-
vince its brokers to sell that offering to their customers. The entrepreneur
who chooses a direct public offering by enlisting a securities broker has man-
aged to entail only front-end fees to create documents in line with a public
offering. But the transaction still requires that somebody else sell the offer-

ing. So the entrepreneur™s faith lies in brokers who must convince their cus-
tomers to buy it.
In the January 1995 issue of Entrepreneur, David Evenson sends this
sobering message to those hoping for an IPO: “Getting an underwriter to say
it will take you public can be a hollow promise unless there™s broad-based
support within the financial community.” Obviously, brokers should have
been integrated early enough to harvest their feedback, enthusiasm, and
commitment. Broad support must come from those who will analyze the op-
portunity and provide written reports.

As we have explained, the private placement is the issuance of treasury secu-
rities of a company to a small number of private investors. This investment is
an offering of debt, stock, warrants, or various combinations of these secu-
rities. Although the greater number of private placement investments to in-
stitutional investors involve debt securities, exempt offerings of direct,
equity, and/or debt investing by private investors are common. These private
investors often become involved in a venture in order to limit the downside
risk associated with illiquid investments. These participatory investors also
begin with transactions requiring less money. Moreover, these transactions
move quickly compared with a public offering, are more flexible due to the
lack of SEC requirements, and are much less expensive.
A more practical and useful definition of the private placement, how-
ever, is any deal you legally can put together, then write up and reach agree-
ment on. As Exhibit 4.2 shows, legal definitions for the private placement do
exist: cash for equity; all types of offerings not publicly sold; issuance of
treasury securities to a small number of sophisticated, private or institutional
ventures; and the circumvention of onerous public offering requirements and
access to a nonaffiliated market without full registration compliance. But be-
cause this is a highly illiquid security that is not bought, it must be sold. So be
warned: The expectation is unrealistic that investors”high-net-worth, so-
phisticated investors”will beat down your door to buy a highly illiquid,
“story” security in the current climate of fear and cynicism that pervades the
public stock market. Therefore, rather than overly structuring the security
and the transaction prematurely, have a more open mind, and take a more
negotiable, flexible posture. Then gather a circle of investors and bring in the
assistance you need”legal, accounting, and so on”to structure an agree-
ment acceptable to all the parties involved.
Let us clarify a highly illiquid story security. Selling a story security is a
Alternative Sources of Capital

EXHIBIT 4.2 Private Placement, Legal Definition

• Cash for equity
• All types of offerings not publicly sold
• Issuance of treasury securities to a small number of sophisticated private or insti-
tutional investors
• Allows company to circumvent onerous public offering requirements and access
nonaffiliated market without full registration compliance

Source: International Capital Resources

concept that you are selling blue sky. That is, what you are selling is a story,
a compelling, believable story. Your task is to find people who believe the
story. Once you accomplish that, you can reach a legal agreement on the fi-
nancing of the story.
Is your venture suitable for an individual participatory investment?
Think about two things: first, the kind of financing typically appropriate
to your venture™s stage of development; and second, the sources of such
That you are accurate in the assessment of your company™s development
is an underlying assumption. But without some understanding of how these
stages are defined, it will be difficult to define your stage of development.

Seed. A venture in the idea stage or in the process of being organized.
Research & Development. Financing of product development for early-
stage or more developed companies.
Start-up. A venture that is completing product development and initial
marketing and has been in business less than two years.
First Stage. A venture with a working prototype that has gone through
beta testing and is beginning commercialization.
Expansion Stage. A venture that is in the early stage of expanding com-
mercialization and is in need of growth capital.
Mezzanine. A venture that has increasing sales volume and is breaking
even or is profitable. Additional funds are to be used for further ex-
pansion, marketing, or working capital.
Bridge. A venture that requires short-term capital to reach a clearly de-
fined and stable position.
Acquisition/Merger.A venture that is in need of capital to finance an ac-
quisition or merger.

Turnaround. A venture that is in need of capital to effect a change from
unprofitability to profitability.

When entrepreneurs are asked their company™s stage of development,
confusion often reigns. Without knowing how to define the stages, entrepre-
neurs will waste time targeting the wrong investors. This is especially true
in the earlier stages of development, because the earlier the stage, the higher
the risk.
For example, a seed company is looking for a small amount of capital
(between $50,000 and $250,000), and needs to think through its concept
and develop a prototype. Market research has begun but is not yet finished.
The business plan is in development and the management team is being
formed. Compare a start-up. The start-up is a year-old company, legally
structured but already in business. It may be test marketing its product or
service and may even be bringing in revenue although not yet making a
profit. Management has been assembled and is starting to form a team. The
business plan has been completed, and the company is prepared for manu-
facturing and sales. It lacks only capital.
The differences in stages of development are substantial, and investors™
tolerances for risk vary widely. It pays to differentiate your stage of develop-
ment to target those investors interested in one or another stage of develop-
ment. This is true because to varying degrees all investors are risk averse. But
it is no accident that the primary transaction structure used by angels is the
private placement investment. The benefits of this investment are shown in
Exhibit 4.3.
First, since angels prize their privacy, confidentiality is an attractive fea-
ture of the private placement. Second, from a legal point of view, there are
fewer and less onerous disclosure requirements, which is good because com-
plying with state and federal disclosure requirements raises the ante. The
benefit for the entrepreneur in incurring less cost spills over to benefit the in-
vestor. Thus, in the private placement or exempt offering, privacy is pro-
tected and money is preserved.

EXHIBIT 4.3 Benefits of a Private Placement

• Confidential
• Flexible
• Less costly
• More than capital
• Rapid time frame
• Accommodates smaller transactions

Source: International Capital Resources
Alternative Sources of Capital

Flexibility is also demonstrated in transactions with an institution: an in-
surance company, a pension fund, or an independent third party such as a
later-stage venture capital firm. In these transactions, the private placement
will accommodate subordinated debt. This is attractive to entrepreneurs be-
cause senior debt capability is left unencumbered. This means that if the
company proceeds apace, it can obtain long-term bank debt. Subordinated
debt provides the cash, is essentially less secured, and has a subordinate po-
sition to senior debt, but does not close off acquiring long-term debt as the
company increases its cash flow and develops assets. From the entrepreneur™s
point of view, the accommodation of subordinated debt becomes another at-
tractive feature of a private placement.
Likewise, from the investor™s point of view, subordinated debt com-
monly has convertibility when the terms and conditions are negotiated; con-
vertible subordinated debt, or convertible debenture, offers some protection
on the downside of a failed company. For example, if a proprietary technol-
ogy in the venture is resalable at a later date, or if the company folds and the
technology is liquidated, once senior note holders are taken care of, the sub-
ordinated note holders will be able to recover some of their money. This pro-
vides insurance on the downside.
And convertibility, combined with a subordinated debt, permits sharing
on the upside if the company is successful.
If the company is successful, investors convert the principal of the note
into stock. Even the interest becomes convertible”if it has not been paid
over time or has been held in abeyance. With success, investors will be able
to convert to stock and share in the capital appreciation by having previously
negotiated a purchase price. Since the company is successful, the price of the
stock is higher. The investors will be able to purchase the stock at a lower
price and in time liquidate it for appreciation and a return on the investment.
If the company is not highly successful (e.g., does not go public or is not
acquired but experiences a reasonable degree of success), the investors™ debt
can be repaid from cash flow. Hence, they will get their principal and their
coupon or return on interest. If the company fails, the investors are in line to
get some of their money back when the company™s assets are liquidated.
All this provides flexibility. Debt can be used in several ways: sub-
ordinated debt, convertible subordinated debt, equity, debt and equity, or
even royalty financing. In royalty financing, individuals do not take an eq-
uity position, nor do they get a note for their money. Instead, they develop
an agreement in which portions of the revenues of the company over time
will be paid back until a multiple return is reached, perhaps two or three
times the original investment. These kinds of transactions are common in the
restaurant business, for example, so that the owner will have no partners or
note to pay off. Without thus burdening the balance sheet, the valuation of

the venture from the bank™s point of view expedites a loan. In effect, a por-
tion of the cash proceeds from the business will divert to the investors until
they secure a predetermined return on their investment. Gradually they slide
from the picture. Flexibility appeals to entrepreneurs and investors alike.
Seed is a riskier investment than a start-up venture but holds the prom-
ise of a greater return. In a classic study of 200 companies and 500 financ-
ings by venture capitalists from 1978 to 1988, 41 percent of start-ups
provided returns to investors compared with 35 percent of seed investments.
However, successful seed deals provided an average of 19.4 times the money
invested, compared with 9.7 times the money invested in start-ups. Besides,
the hold time was not significantly different: 7.2 years for seed deals to pro-
vide returns, compared with 6.4 years hold time before harvesting returns
from start-ups. Ten-year returns for early-stage/seed investments by venture
capital firms with 2003 as the investment horizon performance date have
held steady at 35.7 percent.
Another benefit of the private placement is that it is less costly than other
types of offerings, for example, a public offering. The private placement is
less costly in time and money. The entrepreneurial team can expect to spend
in a public offering 900 hours of its time in completing an IPO, whereas the
private placement can be completed much more quickly, allowing the princi-
pals more time for running the business. In addition, significant variations


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