Testing the Waters

Prior to conducting a full-blown securities-offering effort, one could “test the waters.” This is done by researching the local geographical area for angel-investor interest, as well as your management team’s personal private-investor contacts, fortified with one or two prototype offering structures. This process is known as the “red herring test.” Most states do, but some states do not, allow for a testing of the waters through general solicitation—i.e., public media—so check with your legal counsel before engaging in this discovery activity in any particular state.


A Red Herring document is used to test the waters for indications of interest of a proposed securities offering. It can consist of a simple letter stating your intentions and the proposed capitalization plan and potential securities offered. It generally includes an executive summary and a summary of the proposed securities to be offered. If securities are involved, be sure you include the following disclaimer on the front page of your Red Herring document:


“This correspondence does not include an offer or a solicitation of an offering to sell securities. An offering of securities is made by Private Placement Memorandum only.” The statement has a minimum size requirement. Font size: 10 pt. minimum.


To produce a “red herring” document to seek indications of interest, simply build your securities-offering document then make it a draft by including a watermark within the document that states the following: “Draft: Not an Official Offering” so it is on each and every page. Said tactic should protect you from inadvertently making an offering of securities, where none can or should be made.


Still, there may be peril associated with simply “testing the waters.” We cover it here, because although it won’t be germane to most entrepreneurs, it may be helpful to others. Although you may think you are saving money by holding off on creating a final draft copy securities-offering document—if indications of interest are positive—you should be prepared to sell the securities quickly. If your documents are not yet finalized, it might take too long to complete them— and investor interest often fades. We prefer to strike while the iron is hot. If you agree, have your securities-offering document almost completed and ready to make any final adjustments based on your testing the waters research then make those adjustments to finalize the securities-offering document for legal counsel review, then once reviewed and finalized by legal counsel send it those who show an interest. Otherwise, it may appear you do not really have your act together—a very bad thing when asking investors for money.


These “Testing the Waters” tactics to determine indications of interest are used by Wall Street firms, on a much larger scale through their in-house sales force, but you can avoid most of the formal research by shopping for high-yield investments. Act like an investor who just received $1 million in a 30-year, 12% tax-free municipal bond that just matured. On that $1 million Bond you were getting $10,000 a month in tax-free income, and now your job is to replace that income. You are smart enough to know you should never buy a ten-, twenty-, or certainly thirty-year bond in a low-interest-rate environment—as in the current environment. What is out there? Check on what the bank is offering for one-, two-, or five-year CDs. Call a stockbroker, or search the Internet and find out the rates that one- to five-year corporate notes or preferred stocks are trading—based on yield. Once you complete a cursory investigation, you will know how to price your Company’s securities. Just beat the yield and offer upside potential against the risk associated with your deal by designing securities that meet investor demand, and you will raise capital.                                                                                                


The R&D of Debt Capital

Traditional Debt


If debt will be part of the company’s capitalization plan, consider getting in touch with a few banks and/or leasing companies before you contact any potential equity or debt investors. Contact those institutions with a loan or lease proposal outlining your Company’s basic business plan, which should include the pro forma financial projections you will use for your securities offering. You will need to present a deal structure that uses equity and debt as the main components of your Company’s capitalization plan within the Company’s securities-offering document for raising equity.  This important step is for gaining “indications of interest” from the debt side of the capital equation.


Obtaining a conditional Letter of Commitment from a bank and adding that letter to your Company’s securities-offering document for raising equity capital —or “Red Herring” document—will carry significant weight in your prototype proposal. Incidentally, a “Red Herring” document is generally used by larger publicly traded companies to detect the market’s “indications of interests” of a potential type of securities offering. “Testing the Waters” is rarely used by younger companies, due to the impracticality of the time it takes, but a simple rendition may be helpful.


Let’s say the bank requires that you raise more equity as a percentage of total capital on the table—that’s fine. You simply rework the numbers to accommodate the bank’s request and resubmit that proposal. Let’s say you are looking for $1 million in total capital. If you go to the bank and ask, “If I raise $500,000 in equity capital, will you loan me the balance?” The banker may say, “Your Company or project would be considered generally un-bankable, but if you raise $700,000.00 in equity, we will loan you the $300,000 in debt.” Simply get the signed conditional Letter of Commitment in writing then rework your pro forma financial projections to reflect that 30/70 debt-to-equity (ratio) deal structure.


We cannot emphasize enough the importance of obtaining that written and signed Conditional Letter of Commitment. If bank debt will be a large part of your capitalization plan, do not proceed without one. In an equity investor’s mind, a Conditional Letter of Commitment from a bank generally gives the equity proposal increased validity and further assurance of a successful project. This will greatly increase the response rate from your equity investor pool and ultimately increase the probability of obtaining the full capitalization amount.


Note: We did not say you could not move forward without a Conditional Letter of Commitment. If you cannot get one, you may want to raise the equity capital first then deposit it into an escrow account held at the bank. When you have cash on deposit at the bank, ask for the loan. Remember, banks want to lend money to those who do not need it. By having a rather large deposit in the bank, they may perceive you as not needing any large amounts of additional debt capital. That is when you can start to negotiate from a relative position of strength. Remember, you must disclose the use of debt in any securities-offering document used to raise equity capital.


The key is most banks want to help you in your quest for debt capital, especially if you are successful in raising equity capital. Ask a commercial-loan officer to forward an SBA-loan application to you. Once your Company’s securities-offering (Red Herring) document is complete, you could use the existing financial-projections data to accommodate the information needed for the loan application. Be sure to fill out the application and supplement it with your securities-offering document. Why send along your securities-offering document? It may carry some major weight in the bank’s decision-making process. If, for some reason, you are unable to get any interest from any bank on your capitalization proposal, you may want to test the waters by adding a Note or Bond offering when marketing the “Red Herring” to gauge individual-investor interest.


Notes & Bonds


Maybe creating a securities-offering document with a four-year senior-secured convertible note at 12% interest would be attractive. If you file a qualification for an exemption from registration under: Regulation D, 506 (c) (IF you limit the 506 to accredited investors only); Regulation A with the SEC and the state(s); a SCOR offering in the states where solicitation will occur; or a CA (1001) for California companies, you can advertise the interest rate and maturity in the local newspaper, normally through a tombstone advertisement. Unless you’re a convicted felon involving securities or bank fraud, as a US Citizen, you have the legal right to go around financial institutions and directly solicit US investors for a direct investment, as opposed to using a financial intermediary.


If the bank sees you are advertising and competing for lenders—the bank’s depositors—they may lend you the money, especially if you are viewed as a threat to bankers’ deposit-raising efforts for the bank. We would use this tactic as a last resort, as you will want your banker to support all your efforts. Commercial bankers can become your friends, especially when you can raise equity capital or garner affluent co-signers.


Previously, we mentioned the maxim, “Banks will only lend money to you if you don’t need it.” In a perfect world, a banker would lend money only to the very wealthy or those who don’t need a loan. By doing so, the bank would eliminate repayment risk. However, in the real world, banks must lend money to those who need it because people don’t have enough capital to build their company. What if you could convince your banker to introduce or refer you to a few of the bank’s wealthy customers, to obtain a co-signer on a loan and receive some carried interest and/or an equity kicker/component for their co-signature? The banker gets what he/she wants, they get to loan money to those who don’t need it, and you get what you want—a loan—but more importantly, a relationship with one or more “angel” investors. We have done a few deals, in this manner, that involved the bank—the bank inadvertently became the primary investor-referral source. It is one of the most successful capital-raising strategies available for start-up, early stage, and seasoned companies.

Remember, in this phase of the process, your job is to research the different local and national avenues of debt capital.


The R&D of Equity Capital


This exercise should be considered the production and distribution of a “Red Herring” document to gain “indications of interest” from the equity side of the capital equation. A Red Herring document is an executive summary to test the waters for indications of interest for a securities offering. In other words, you are able to test investor interest in a particular company and its offering, prior to spending a fortune on producing the required securities-offering documents. Please realize this takes time and may not be appropriate for your Company’s situation, due to the nature of capital needs and the essence of time for most small companies—take all this with a “grain of salt.” It may take too much time, to “Test the Waters” considering that the construction time of a complete securities offering document (that’s ready to collect funds) takes only a little extra time than a Red Herring document, does.


The executive summary of a Red Herring would include:


  1. The industry in which your Company will engage and compete.
  2. The problems or changes within that industry that provide the opportunity to profit from selling your Company’s product and/or service line(s).
  3. The solutions your Company’s product and/or service line(s) shall provide to solve those problems or address those changes.
  4. The opportunity to profit from selling your Company’s product and/or service line(s) and for investors in terms of rate-of-return projections by investing in the securities to be offered by your Company.
  5. The exit strategy for the investors.


After securing a conditional-commitment letter from the bank—if appropriate—we would advise you send the Red Herring document to your management team’s personal-and-professional prospective, investor contacts that may have an interest in your Company. We would suggest you limit the number of securities-offering scenarios to one, maybe two—to limit any confusion. Be sure the scenarios are germane to the stage your Company is in (i.e., convertible note for seed capital).


Include any officers’ and/or directors’ professional biographies, with no more than 30–40 words for each team member. If you can, add an advisory board to strengthen the experience factor of your project or company. Certainly do what you can to develop real corp. Board-of-Directors or an LLC Executive Board, but you may find that most professionals will not want to sit on your company’s board-of-directors in the beginning because that position carries fiduciary responsibilities to your shareholder base, which could create a direct liability against their personal assets if the management’s actions breach that fiduciary duty. That is why an advisory board has no actual power to vote on any action of the company, as it relieves the advisory board members from a legal, fiduciary duty to the shareholders of the company. Therefore, being included on an advisory board is considered more attractive to most professionals at the early stages of a company’s existence. Your relative position of strength will elevate when surrounding yourself with those who have in-depth experience in your industry or in general management. Be sure to get written permission from each advisory board member before you add his/her biography to your Red Herring document.


Remember, only bona fide employees—primarily the officers and directors (managers for an LLC) of your Company—can legally solicit and sell securities in the company in a private offering if you cannot engage an investment bank to sell your Company’s securities. If you can engage an investment bank to sell your Company’s securities, the stockbrokers of their selling group and both your officers and directors (managers for an LLC) can sell. However, be careful to not directly or indirectly compensate any employee, officer, or director for the sales of privately placed securities. (In a private or public offering, it is against the law to do so.)


Request in the Red Herring “testing” letter that the prospective investor, if interested in a particular securities-offering scenario, simply ask the investor to contact you to set up a time when it would be convenient to discuss the investment opportunity.  Try a lunch meeting. Remember, there’s nothing like a face-to-face meeting to start building the trust relationship.


When approaching investors, always exude confidence and a subtle, professional attitude that you are going to move forward and succeed—with or without them.


Under Regulation D, 506(c) (with a self-limitation of accredited investors only) or Regulation A (a limited federal and state(s) qualification for an exemption from registration), or a SCOR offering or a CA (1001) for California companies, one can submit a tombstone advertisement publication in a local newspaper to gain indications of interest, only after the advertisement has been submitted to the SEC for review and comment for (Regulation A); to the states where registration will be made for (SCOR) or to the California Commissioner of Securities for CA (1001) for California companies, review and comment. The North American State Administrators’ Association (NASAA, the state regulators) has adopted a uniform offering exemption allowing companies that are soliciting and selling securities to accredited investors only, to advertise in the general media to seek indications of interest of a securities offering.


WARNING: SOME STATES DO NOT ALLOW A PUBLIC TESTING OF THE WATERS through the general media, even though Registrations A & A+ are “qualifications” of an exemption from federal registration.


For all practical purposes, testing of the waters should be done for the private placement of seed capital to pre-existing investor contacts (friends and family). Attempting to conduct a public testing of the waters can take a prohibitive amount of time. By contacting accredited investors in this manner, you are still starting from scratch. Just because you’re ready to sell them doesn’t mean they’re ready to buy. Your response rate is going to be 1%–2% if you’re lucky.


Throughout all your Company’s present and future capital-raising efforts, you must always deal from a relative position of strength if you are going to dictate the terms of the deal. Strength positioning begins with contacting your own personal and professional capital contacts in the early stages of the capital-raising effort. You should already have a relative position of strength when dealing with those who already know and trust your character and in your ability to build and run the business.


If you research any “Fortune 1,000” company, you will find the vast majority—over 95% of them—started raising capital from friends and family before they were able to raise capital from an institutional source or directly from a mass individual-investors scale. You may be thinking it is too politically sensitive to ask friends and family for capital. As investors, we would ask ourselves the question, “If you don’t have enough confidence in your Company’s ability to succeed, to raise capital from friends and family, why should we invest our money in your Company?”


By completing the production of your Company’s securities-offering document, you should increase your relative position of strength from your personal contacts’ perspective as well. Once they see your securities-offering document—realize you wrote it (within the Corporate Engineering Conservatory™) and that you’re serious about building a quality company, they should trust in your abilities even more. More importantly, they will further trust in your character in handling the tasks of building a profitable enterprise, because you’ll actually be the architectural engineer of it.


When your company has reached $5 million or more in annual sales, whether or not has sustained a profit, (considered early stage) you can approach strategic alliances (existing companies within your industry) to sell them securities in your Company. With that relative position of strength, you should receive a warm reception. This tactic does not necessarily work in the start-up phases though. More often than not, strategic alliances tend to take too long to make a decision. Some strategic alliances may want to dictate the terms of the deal if they do choose to move forward and invest. However, when you have $5 million or more in annual sales, to maintain a relative position of strength, you should be dealing with strategic alliances that are double or triple the size of your Company, not much larger. Be mindful when dealing with any larger strategic alliances—you will start to lose your relative position of strength the larger they are compared to your company. (It’s relative!) In addition, by letting these potential strategic alliances know you are shopping their competitors, it may increase your relative position of strength; they may move a lot quicker in their decision-making process than they otherwise would.

When searching for capital through strategic alliances, it’s best to approach businesses or professions that understand what your Company does to make money, especially if they would inherently benefit from your Company’s existence or expansion. So look for an “inherent benefit” opportunity for the capital contact of a strategic alliance. You should ask yourself, “Who or what company would inherently benefit from my project or company’s existence over and above the benefit of investing in the project or company?”


The Corporate Engineering Conservatory™ is geared specifically to enable the entrepreneur to raise capital and maintain control of their company. Many times, a strategic alliance will make a counter offer and fund their entire operation. However, they will most likely take control of the operation and give you some equity—maybe 10% and some cash—then build the company on their own terms and conditions. Depending of course on who the strategic alliance(s) is/are, you may want to accept the deal. If an acquiring company with worldwide-distribution channels, production facilities, and the marketing budget to turn your Company into a two-billion-dollar company within five years, and wants control of your Company, it may be wiser to take that deal than to compete as a potential competitor in the marketplace with them. In this case, it may be worth more by accepting less.


This inherent-benefit position goes further toward the “dealing with like minds” concept of solicitation and sales of securities. If you have a product or a service, like a real estate-agent-referral network driven by a special software program, real estate agents may be interested in investing in your Company. (The product would directly influence their day-to-day sales volume.) The agents can better relate to its value than other potential investors would, especially if they use and love the software.


In other words, by positioning your Company (its product, service lines, and your securities offering) to those who would inherently benefit from your Company’s existence—suppliers and customers—you build a network of investors and prospective customers with the securities-offering sales effort. For instance, you could design a multi-media presentation on a DVD or “housed” in a secured securities-offering portal on your Company’s website. Either method would include the company’s story, product or service segments, and an investment-opportunity presentation. This network may feed you leads for other investors. Trying to sell software-company securities to a farmer is the opposite of the “dealing-with-like-minds” concept unless the software increases milk production and you’re attempting to sell the securities to dairy farmers as investors. If they like your software—because it helps their profitability—they may want to invest in your Company. Ultimately, when prospecting for capital, approach and deal with those who at least understand and/or will directly benefit from your Company’s new project or product line.


This stage is about conducting a private testing of the waters to find indications of interest for a private offering of equity or debt securities. Why a private offering? It is easier, quicker, and less expensive than conducting a registered public offering. In the start-up or early stage phase of your Company, you will certainly have a difficult time raising it publicly if you can’t raise it privately—this is the general rule.


This is the very first step in the R&D-of-equity section of capitalization planning. Developing a securities offering is very much like creating a product offering. Research your private capital market before finalizing your securities-offering structure and document. Although the concept of R&D for a securities offering is homogeneous to R&D for a product or service launch, the approach and process of a securities offering is highly regulated on the federal level and in all 50 states. Financial Architect®, within the Corporate Engineering Conservatory™, has already streamlined the process.


Since much of the equity’s R&D involves actual indication-of-interest soliciting on a “Marketable” deal structure, and because you can produce an actual securities-offering document—quickly, easily, and inexpensively with Financial Architect®—you may choose to forget the Red Herring exercise. If so, simply put together a great deal structure with a generous IRR on the security and sell it the best you can. Sometimes a Red Herring can backfire; because if you do get positive indications of interest, you may take too long to produce the actual securities-offering document.


Be sure to follow up with these potential investors within 1–2 weeks of delivery to get indications of interest. If the deal structure prototype receives responses that are equally negative across the board, you may need to refine your deal structure prototype and either re-issue another Red Herring document (with another deal structure prototype) or just move directly to creating a securities offering document to solicit and sell securities with a new completed deal structure. To capitalize your Company, figure out what securities scenario to sell. You may also want to ask, “In a perfect world, what kind of investment would you be interested in?” In fact, from the very beginning of your capitalization plan’s research-and-development-of-the-equity process, you may want to tell a dozen or so wealthy individuals, whom you know personally, how you plan to proceed in your research and ask them for wise counsel. Why? If you allow them to help map out the deal structure in the beginning stages, they most often will feel they are the ones who will make your success happen. (They will be more inclined to invest and provide referrals from their friends.) Be sure to ask them, “What terms would you be interested in seeing in an investment? What stimulates your interest and why? Do you know anyone else who may be interested investing in the company?”


Consider an alternative scenario, where you get no response from your Red Herring test—even after you’ve reworked the deal structure. If you have done a comprehensive job of listing all personal and professional contacts of your management team—as well as sent them your Company’s Red Herring document, but your response was weak or nonexistent—you will need to consider registering your securities offering to conduct what is known as a “direct public offering” or simply do it under Regulation D, Rule 506(c). Under Regulation D, Rule 506(c) you can use the general media to solicit accredited investors only. Simply use Regulation D, Rule 506(c) as cover for your Red Herring to garner indications of interest from the general public.


Although there are other exemptions from registration that allow you to advertise, you actually must produce the final securities offering document and submit it to regulatory authorities prior to solicitation.  If you use other exemptions, to conduct a Red Herring Test using the media to benefit from general solicitation you run the risk of needing to re-file more than a few times, to test new prototype deal structures, which can get very expensive. For instance, a SCOR offering can cost $25–$50,000; CA (1001) for California exemption from state qualification under paragraph (n) of Section 25102, $45–$65,000; and a Regulation A offering can cost as high as $50,000 to $100,000—depending on the professionals you hire to produce the documentation and do the filings. That’s why it’s important to do all testing Under Regulation D, 506(c), as no pre-filings are required and you can advertise the securities in the local newspaper or any other form of general media.