- You can raise capital via debt, preferred stock, and mezzanine securities and equity via Reg D.
- There are benefits and drawbacks to each layer of the capital stack, and issuers need to be aware of them.
- Rational issuers limit their capital raises to the amount they need immediately to prevent share dilution or overleverage.
- Voting rights, liquidation rights, and convertibility are factors to consider.
- There's a difference between warrants and options; you might need one, the other, both, or neither.
- It would be best to have an exit strategy in mind, but there are factors to consider before spelling them out in your PPM.
‘Unregistered’ doesn’t mean ‘uncomplicated’
The whole point of Regulation D is to provide exemptions to small firms seeking to raise capital without the added expense, and time-suck of registering capital raises with the Securities and Exchange Commission. And while it's true that Reg D simplifies the process considerably, it's also true that financial services is a heavily complex, highly regulated business – so even at its simplest, it’s not all that simple.
So before you write up that private placement memorandum, you should take a few minutes – or more – to be sure you’ve considered all the permutations of what your company’s financial structure might be. To that end, we’ve identified six topics for your consideration.
Not deciding may be a huge mistake
- Type of instruments
Essentially, there’s equity and debt. That’s not the end of the list, but let’s start there. Every founder wants to sell equity just for the bragging rights; “My company is worth $10 million” sounds better than “My company is a billion dollars in hock” after all. But either way, you raised $1 billion in the capital markets and, if you sold equity, then you just invited the whole world to be your partners and have a say in how you run your company. If you raised debt, though, you generally have a lower cost of capital – and an even lower one when you consider the tax advantages of paying interest rather than dividends. Of course, if you have a bad quarter, you can always suspend your dividend to shareholders; that won't work with creditors.
- Too much of a good thing
Whether you raise cash via equity or debt instruments, don’t overcapitalize. It’s nice to have all those stacks of cash to roll around in a la Scrooge McDuck, but you shouldn't attract more capital than you need to achieve your next strategic goal. Your shareholders will complain about dilution, and your bondholders will complain about overleverage. Either way, having too many investors could make it harder to attract more of them when you need them. “Most operating companies sell 5%-30% of their company for a first-round [of] funding – obviously there are exceptions, but this tends to be the average range,” according to Colorado-based PPM prep shop Regulation D Resources. “A real estate project or real estate fund, or oil and gas company typically deploy a different structure regarding investor share of operating income and providing participation in the accretive value of the asset(s).”
- The part in the middle
Common equity and senior debt aren’t the only options; they’re opposite ends of a continuum – more commonly viewed as the top and bottom of a stack. Below common equity is preferred equity which is considered a block of corporate ownership but which functions more like debt; dividends are steady, subject to neither cancelation in lean years nor increases in flush years. Preferreds are most frequently issued by companies that are still courting private equity because they establish a boundary between economic interests – which founders are willing to share – and operational control – which founders generally aren’t. Between the preferred shares and the senior debt is yet another layer of capital: mezzanine debt. This becomes important if the investing community believes that buying into your business is riskier than the market as a whole (tip: it does). If the company has to be liquidated, the senior bondholders get paid first, then the subordinate bondholders, then the preferred shareholders, then – if at all – the common shareholders. The higher the risk of losing money in the case of insolvency, the higher the cost of capital the market will demand of your company.
- Investors’ rights
But there has to be more to what an investor's paying for than risk. While liquidation rights are nested to some degree by the type of security being issued, PPMs ought to spell out exactly which bonds are subordinate to which. They should also spell out the different voting rights – or lack thereof – of the different equity classes. Of course, the formula for converting debt into equity is crucial, as is callability – whether it is the issuer’s or the investor’s decision if and when to make that conversion.
- Options and warrants
All companies are built on two things: other people’s brains and other people’s money. Savvy founders are great at getting both as cheaply as possible. To attract talent during the persistent cash crunch that comes with being an early-stage startup, management often sets aside an option pool – a chunk of equity that can be used to make prospective employees partial owners, incentivizing them to realize the project’s total upside potential. “A typical size for the option pool is 20% of the stock of the company, but, especially for earlier stage companies, the option pool can be 10%, 15%, or other sizes,” according to equity compensation attorneys Joshua Levy and Joe Wallin. “Well-advised companies will reserve in the option pool only what they expect to use over the next 12 months or so; otherwise, given how equity grants are usually promised, they may be over-granting equity.” Your PPM's cap table should show how much has been set aside for the option pool and what dilutive effect it might have on invested capital. To smooth this over, issuers often provide warrants similar to employee options, except they're directed toward the funders. By giving them the right to buy more equity at a strike price later, you might be able to convince them to take a lower preferred dividend today. These warrants become even more valuable if they can be detached from the underlying security to be sold separately on the secondary market.
- Exit strategy disclosure
If you ever get yourself into something that you have no idea how you’re ever going to get out of, may the ghost of Lyndon Johnson haunt you all your days. That said, you should never have just one exit strategy. You might prefer to sell your company to a large, legacy competitor and continue on as an “acqui-hire." You might prefer to go public or to be taken over by a blank-check company. You might want to buy back your shares, pay off your debt and keep the whole company insider-owned. You might not be looking past becoming a private equity firm’s portfolio company then letting the managing partners sort it out from there. The question is, how much of your planning should you disclose to investors – and responses vary. We favor, though, disclosing something. Perhaps you could identify the one exit strategy that you find most likely (unless that's bankruptcy, but that goes without saying). Then, as BusinessPlanTemplate.com points out, it is "to prove the likelihood of your exit strategy." That means do your homework into projects comparable to your own. If you intend to go public, then "provide research including the names of those companies, the dates they went public, and the returns their investors received conversely, if your most likely exit strategy is to sell your company, list potential buyers. … Ideally, show other companies these firms have acquired in the past and at what price points. Finally, as much as possible, show other companies that were similar to yours that were recently acquired. As much as possible, determine the sale price of these companies and the returns their investors might have received upon the acquisitions.”
At the close
This is a concise summary of just half a dozen thoughts about topics rookie issuers haven't spent enough time on as they prepared their prospectuses.
As you pursue Reg D fundraising, you need to be aware that investors are being inundated with PPMs from scores of other entrepreneurs. They understand that everybody is a rookie once, but you should endeavor not to appear to be a rookie twice. As you learn these – and myriad other – lessons, consider how you can apply them directly the next time you approach the investor community.
Private placement investors are at least as sophisticated as the buy-side for mega-cap, AAA-rated corporate securities, but they count on issuers to be far less sophisticated than these more established issuers. It is within you, though, to flip that script and raise all the capital you need without paying loan-shark rates for it.
William Freedman writes about business, technology, and finance for Global Finance, Macrotrends, AlphaSense, Sharestates, and other news outlets. He holds an MBA in international finance from The American University and serves on the board of governors of the New York Financial Writers’ Association.