As you may recall, there may be many motivating factors that investors have when making investment decisions. However, there are only two primary fears investors have: 1.) The fear of investment capital (or hope) loss (principal risk) and 2.) The fear of missing out on a great investment opportunity (opportunity risk).
View your securities offering from the perspective of the investor. To do so, you must know about investment risk vs. return. Risk and return go hand-in-hand. The higher the risk the higher the return potential should be. Every savvy investor knows this. Your job is to shift the risk of investment capital (or hope) loss to the fear of missing out on a great investment opportunity, which is most effectively done through proper corporate engineering.
Inflationary Risk. The risk of purchasing power erosion in the currency you hold (or securities are exchanged into) or will receive. Every investment has some form of risk. Federally insured certificates of deposits and interest-bearing bank savings accounts have risk—not necessarily principal or interest-payment (aka credit) risk but inflationary risk. If you are receiving 3% on your money in a two-year CD at the bank and if your combined state and federal marginal tax bracket is 33%, you net out about 2%, after tax. If inflation were to rise to 5%, you would actually be losing 3% (2% Real Return -5% Inflation =-3% Net Purchasing Power Return) on your money in the form of purchasing power. Normally, most companies will not be affected by inflationary risk, unless you’re mining precious metals or other inflation sensitive assets as an Operating Company or acquiring those assets in a Fund.
Principal Risk. The risk of losing all or a portion of the total original amount of an investment. Swinging the pendulum back, one may view investing in penny stocks, options on futures contracts, foreign currencies, or other derivatives as high-risk concerning investment principal, but with potentially very high-returns. These types of investments generally have a higher return potential to make up for the higher principal risk. In general, risk and return potential go hand-in-hand. The higher the principal risk one takes on in an investment, the higher the potential return should be. Although the company itself may not be the direct subject of principal risk, its securities, used to raise capital, will most definitely be.
Opportunity Risk. The risk of not investing in an investment opportunity when presented. The securities of your start-up or early stage company most probably will not be subject to inflationary risk, but may be viewed as very high in principal risk by most savvy investors. Therefore, a very high return potential must accompany the purchase of your company’s securities to justify the risk of investment principal. But the high return potential should not be too high, otherwise it becomes inherently unbelievable or a “too good to be true” scenario. The trick to attracting capital for start-up and early stage companies is to reduce or mitigate principal risk through proper corporate engineering. By doing so, you inherently increase opportunity risk for the investor.
Your goal is to keep the return potential high, while reducing the risk, by strategically breaking down and mitigating specific risk categories. That is what’s meant by warping the risk return continuum.
The basic premise is to keep it simple and use a systematic approach to develop a comprehensive capitalization plan, which illustrates a series of securities offerings that provide for realistic exit strategies. Properly done, this strategy should recycle previous investment into subsequent rounds.
If you want to attract serious capital, you must mitigate risk of an investment in your Company and its securities. There are three, critical types of risk you cannot control, but you can mitigate or limit—operational risk, financial risk, and litigation risk.
You mitigate operational risk in your Company with well-thought-out future operating budgets. Revenue expectations and Cost of Goods (or services) Sold should be very conservative, as well as the General and Administrative Overhead and Capital Budgets. Underestimate Revenue and Overestimate Expenses is the rule when producing pro forma financial projections. You want an investor to look at the financial assumptions and think, “Wow, this looks real!”—not some proverbial hockey-stick graph to the stars. In addition, you mitigate operational risk by providing budgets to cover intellectual property (“IP”) development and protection. You further mitigate operational risk through budgeting and paying for insurance premiums, such as General Liability Insurance, Key Person Insurance, Directors & Officers’ Liability Insurance, Errors & Omissions Insurance, as well as Lawsuit Insurance.
As the corporate engineering process unfolds, you learn to adjust (or completely change) the mode of operation to mitigate operational risk. When addressing the mode of operation, for instance ask yourself the following: ‘should I actually be building a company, or should you be licensing or selling the Company’s technologies; can I build 100% of my sales force through affiliation networks; and can I build my management team, with real equity partners, by attending the right conferences?’ The process of examining, rethinking, and then changing the mode of operation with regards to how your Company will conduct business and grow is designed to enable you to reduce operational risk to the lowest degree possible. “Lean and Mean” is not just a business cliché, it’s first the way of survival then becomes a position to thrive. You will learn this as you move through the actual Financial Architect System™ within the Corporate Engineering Conservatory.™
Financial-risk mitigation involves lowering the risk of owning the securities that are being sold to capitalize your Company. You mitigate financial risk with proper capital budgeting and through the issuance of hybrid securities (convertible notes and preferred equity) that protect investors’ interests first. Hybrid securities normally are temporary or short-term investments by nature; therefore, they achieve the goal of financial-risk mitigation because of a liquidity event for the security itself, as opposed to a need to sell the company issuing the security as an exit strategy.
One also achieves the goal of financial-risk mitigation by creating and issuing securities that put the investor first in liquidation preference if the company fails and goes through bankruptcy. One further achieves the goal of financial-risk mitigation by enabling short-term immediate return, or cash flow, to the holders of the hybrid securities by issuing interest (in the case of selling short-term bridge loans—Notes) or dividends (in the case of selling preferred equity). You set the interest or dividend rate to the degree you want to attract investors—and to the degree you can live with. In addition, by planning and executing a listing of the hybrid security on a publicly traded securities exchange, you have essentially reduced financial risk to the investor(s) to the lowest degree possible.
Creating a 5-year capitalization plan, using hybrid securities with different deal structures, with a rolling forward strategy, reduces the financial risks of the securities being sold while maintaining the high-return potential for the investor. A rolling forward strategy means using the proceeds of one securities-offering to replace a previous securities-offering. For instance, raising $5,000,000 in preferred equity and using $1,000,000 out of those proceeds to pay off previously issued short-term Notes, is a form of this strategy and is perfectly legal as long as it is properly disclosed with the securities offering documents that are used to raise the $5,000,000 in preferred equity.
For instance, imagine investing in a new company or project in the following manner. You invest $1,000,000 for 20% of the company’s common equity, but you lose 80% of your investment immediately due to dilution of founders’ shares. (Only a fool invests where dilution is present.) Or you invest $1,000,000 by buying 100, $10,000 1-year convertible bridge notes. Once the notes mature, you roll over the $1,000,000 into a participating preferred stock being offered by the company that returns 10% in stated dividends and your portion of the offering participates in 5% of net profits of said company. By selecting this combination as your Company’s deal structure, you would have reduced financial risk while maintaining a high, potential return.
However, those tactics listed above are micro-tactics of financial-risk mitigation from an investor’s perspective. Financial-risk mitigation from an entrepreneur’s perspective is on a macro-scale. Tactical financial-risk mitigation stems from the position inherently available only through a securities offering, which enables many investors to invest relatively small amounts of their discretionary investable funds in your company. By doing so, if your company does fail, and millions of dollars are lost collectively, that business failure is not a hardship on any one individual investor. This macro-tactic is also a way to mitigate civil-litigation risk, as well. Who sues for $1,000, $5,000, or even a $10,000 loss?
There are actually many different types of litigation and regulatory risks, which are not mutually exclusive, in that one civil suit can lead to regulatory fines and other forms of punishment and vice versa. Regulatory risks stems from one or more non-compliant acts. Simply comply with regulations with documented legal counsel oversight (make sure you can prove it) to mitigate most regulatory risk. Reliance on opinion of legal counsel is an affirmative defense in regulatory proceedings.
Civil and criminal litigations are two categories all other types of litigation risk fall under. In Capital for Keeps, Russell C. Weigel, III, Esq., gets into the gritty detail of this subject matter; but he summarizes here for your benefit, so we’ll leave this area to Russ—as appropriate.
LEGAL PERSPECTIVE – by Russell C. Weigel, III, Esq.
Keeping investors happy may seem to be an improbable proposition, but attempting to do so is a primary means of avoiding litigation. Certainly, investors sue great companies and highly profitable companies all the time. Some of these suits can be characterized as being opportunistic, but others probably are the results of investor expectations not being met. How can you meet investor expectations?
I think there are four general ways to meet expectations: (1) know what the expectations are and exceed them, (2) deliver on promises, (3) communicate frequently and truthfully, and (4) continually strive to provide increased-investment value. Any company that is managed with a focus on these four items may not avoid all lawsuits but at least will reduce their probability.
Know and Exceed Expectations. Management should always know what the expectations are in the minds of those who have entrusted them with their investment funds. Obviously, as a general rule, investors expect management will take reasonable steps designed to increase investors’ returns on investment. However, I’ve seen many times, and to my surprise, management takes a contemptuous view of their investors. Such managers must think investors are hostile and greedy. There is certainly a basis in truth for that perspective, and I do not suggest that perspective to be irrational. We have a litigation culture in this country. Private enterprise is the frequent target of governments, lawyers, and class-action suits, social groups, environmental groups, labor groups, politicians, news media—the list goes on. How management treats its employees and vendors may serve as a telltale of how it will treat investors. A management culture that is growing a healthy corporation and well-run enterprise from within will almost inevitably have a beneficial outlook on the treatment of investors. A great place to work should mean the enterprise is a great place to invest. In my view, investors have low expectations; so every point of contact with them that is a positive experience is likely to exceed their expectations and promote a feeling of well-being. The corporation that executes investor relations well should implicitly be inoculating itself from the prospect of avoidable negative publicity and lawsuits.
Deliver on Promises. Each person who communicates with prospective investors is personally liable under state and federal securities laws. If you promised investors something and failed to deliver on it, the broken promise is likely to be the basis for a lawsuit premised on investors’ claims of reliance on your promises and their inducements to tender their funds to you. Even if you state in writing to prospective investors that you and your company are making no representations whatsoever to induce the investors to invest, you and your company continue to have an inescapable duty of good faith and fair dealing or a fiduciary duty to investors. You can execute this duty easily and effectively and within the protections of your business judgment if you keep track of what you said and do what you said you would do or exceed it.
Frequent Truthful Communications. For example, public companies are required by the federal securities laws to make and disseminate current, quarterly, and annual reports of financial and other material information. All of this information is required to be truthful and accurate. By the same token, a private company should consider the merits of frequent, truthful communications if it does not have legal obligations to report to the public and to the shareholder base. Having a system in place that ensures investors are receiving regular and balanced updates on the company’s performance will go a long way to building up the investors’ confidence in the company. Even if the news is all bad, it would be better for you and the company to be the ones who are the first to tell the story before others tell it and put their own spin on it. The truth will come out eventually anyway, whatever it is. Take the high road and disclose information investors want to know—don’t sugarcoat the news. You are striving to be credible, and you want the investor base to be conditioned to know it can rely on the company’s version of events in good and bad times.
Deliver Increasing Value. Most public-company executives understand one of their primary duties is to ensure shareholder value is maximized. Private-company executives need to have a similar mindset. While business cycles may make it impossible to always deliver increased earnings per share, this should always be one of private-company management’s goals. Again, this goes back to the understanding when you have the control of investment funds provided by others, you need to act in their best interests ahead of your own interests or the interests of the corporation. If you have this mindset and can demonstrate the steps you take consistently to maximize shareholder value (even if you do not avoid lawsuits), you’ll be in a better position to defend them.
Without belaboring the point: Do this right the first time and you’ll mitigate all three litigation risks as much as can practically be expected, which inherently increases your probability of capital attainment to the highest degree possible.
Conservative Pro Forma Financial Projections
It is critically important to remain conservative in your pro forma financial projections. We suggest you understate your annual revenue projections and overstate your cost of goods sold or services delivered; general and administrative expenses; as well as capital budgets. The performance, determined primarily by gross and net operating margins (and annual increases thereof) of the company is one thing and the Internal Rates of Return (IRRs) of the various types of securities to be issued in another.
Internal Rates of Return of Securities.
Although somewhat dependent, the IRRs of hybrid securities, such as; convertible notes and or convertible preferred equity, are separate and distinct from overall company valuation and therefore common equity performance. The point is, project overall company performance conservatively as possible, and then adjust the attributes (interest or stated dividend rates, conversion rates and participation rates) of the securities (convertible notes and or preferred equity) to enhance the IRRs for the security to be sold to raise capital. Let the hybrid securities do the job of enhancing returns, as well as mitigating financial risk.
Illustrate Various Scenarios.
The IRRs of convertible notes and or preferred equity should illustrate 3 separate end game scenarios, as follows: 1.) Based on full maturity of the notes or “Call” of the preferred equity; 2.) Based on full conversion of the notes or preferred equity into the common stock– privately held; and 3.) Based on full conversion of the notes or preferred equity into the common stock – publicly traded. Not to worry, we got you covered as CapPro™ within Financial Architect™ automatically accounts for all three scenarios.
Can you offer higher returns to investors for larger investment amounts? The answer is yes, as long as it’s fully disclosed within the securities offering documents. This includes the securities offering documents to be used for offers outside a Regulation Crowdfunding portal, as well as on Form C for crowdfunding offering, inside a Regulation Crowdfunding portal, if crowdfunding is necessary. The IRRs (as illustrated for all three scenarios previously mentioned) for the securities offered are normally standardized at the Original Offering Price. One doesn’t adjust the IRRs for larger investment amounts. One either offers “volume discounts” or additional benefits for larger investments.
For instance, you can offer share or note price discounts on securities based on larger investments, thereby enhancing the IRRs. However, by doing so, you may alienate smaller investors, but that is easy to deflect in that the smaller investor doesn’t want to be the only one to invest, so attracting larger investors can be seen as a plus. You can also bonus for larger investments. If you recall, when our CEO built the 18-hole championship golf course in 1993, they gave away “goodies” for various amounts. As you may recall, for a $200,000 investment, investors received $200,000 worth of fully diluted common stock, a charter membership worth $25,000 and 3 building sites worth $65,000 each. That’s an immediate $220,000 or 110% return, with no out-of-pocket cost for the firm, as the building sites were developed by another entity and he made that entity give us 23 building sites as part of the right to build.
In addition, it’s not unusual to offer directorship positions for larger investments. Due to the fact that directorship positions come with executive compensation packages, including cash and equity, awarding the position inherently and immediately enhances ones return on investment.
Ignite The Offering.
You can offer discounts to share, unit or note prices based on entry level timing, as well. For instance, a $1,000,000 offering of seed capital, whether notes or preferred equity is a lot of money for most start-ups. Most investors are leery about becoming the “only one in the pond.” There’s more risk for the first $100,000 invested than the last $100,000 invested. You can offer price discounts on those securities based on the timing of entry. For instance, one may offer a 20% discount for the first $250,000, a 15% discount for the next $250,000, a 10% discount for the next $250,000 and 0% discount for the final $250,000. You do run the risk of not being able to sell the final $250,000, but you most likely will have raised $750,000, so you may want to plan on not receiving the final “tranche.” However, if you make enough progress with the $750,000 investors may clamor for the last $250,000, as there would be a lot less risk.
Remember, any such arrangements as mentioned previously must be fully disclosed in your company’s securities offering document to avoid claims of securities fraud.
The two most popular deal structures for start-up and early stage companies (convertible notes and or preferred equity), derived by proper corporate engineering, slightly change the risk-return continuum for the benefit of the investor. These deal structures allow for maximum upside while minimizing the downside. You can get creative with these structures by themselves or in combinations with each other.