Understanding Institutional Sources of Capital. Substantial amounts of equity or debt capital, from financial institutions, is generally not available for the vast majority of start-up and early stage companies. Institutional equity or debt capital means capital secured primarily through professional investors, such as venture-capital firms (“VCs” or “VC firms”), angel groups, family offices, private-equity investment firms, retirement or pension funds, insurance companies, and capital secured through the sale of securities offered through investment banks and broker-dealers. Corporations, unless they have a specific venture capital division or subsidiary, are not considered financial institutions by regulatory authorities and hence by the securities industry, as well. Commercial, merchant and import / export banks are another subject entirely and are lenders, not investors. Although debt financing is the least expensive form of capital and we want you to get to that level eventually, without sufficient equity capital raised externally, there never seems to be enough debt capital obtainable to provide for development or expansion at the start-up and early stage.
“According to the National Venture Capital Association, first financings, defined as the first round of equity funding [Seed Stage] in a startup by an institutional venture investor, also took a hit in 2016, with just 2,340 companies receiving their first round of funding, amounting to $6.6 billion in total invested capital or an average of $2.82 million per company.”
“Following the year 2016 that saw both capital invested and completed financings at the angel & seed stage drop around 20%, the market stabilized to some extent last year, 2017. What we continue to note, however, is the lower counts in completed financings. Today, more institutional investors are in the market looking to back early-stage startups. The number of companies competing for this capital has also grown considerably over the last few years. As a result, the bar has risen in terms of the Key Performance Indicators (KPIs) that investors will want to see before investing. This notion, along with the delayed entrance of companies into the traditional seed & angel space will continue to contain deal flow in the size bucket.
While such a large pool of capital is available to the industry, investors are working to stay disciplined in their approach, translating into overall fewer deals taking place, though more capital is being deployed at higher valuations.
In many ways, 2017 can be characterized by the record amount of activity we saw involving unicorns. More than $19 billion was invested into such companies across 73 completed financings, reflecting a year-to-year increase of over 10% and nearly 49%, respectively. Further, investments in companies valued over $1 billion amounted to more than a fifth of all VC invested last year, yet less than 1% of total deal flow.”
Stage of Development
A picture says a thousand words. VC interest in Seed Capital investing is and has always been anemic and Early Stage investing is not much better, unless of course your company is a hot software firm, on the east or west coast. Even then, you’ll most probably give up voting control to obtain all the capital you’ll eventually need.
The problem for start-up and early stage companies is there is more Venture Capital available and being invested but fewer deals are getting done. This is due to the drain of capital from a huge emphasis on financing larger ‘Unicorns.”
Even more revealing is where these deals are being funded. Silicon Valley leads the pack by a wide margin with NY Metro and New England coming in at a distant second, leaving all other areas of the U.S. virtually non-existent.
It is also a common misperception that 85% of small businesses fail within the first five years. The statistics indicate approximately 50% survive past five years and 30% survive past ten. The problem is that venture capital firms are not interested in simple survivors, but those who truly prosper. Now what’s the definition of prosper? One could use a “start-up to IPO” statistic to arrive at what a VC firm would consider a success, because IPOs or outright strategic sales are the primary exit strategy for a VC firm. “Out of approximately 17,500,000 employer companies, only 275 IPOs were conducted in 2014”. The acquisitions (outright strategic sales) number is skewed as the numbers are derived from large companies eating up other large companies ($10 billion or more in acquisition price) and the statistics are primarily based on the size of the deals not the number in the US. However, the number of total acquisitions in the US was approximately 2,254 and worldwide was 16,775 Therefore, based on those statistics one could surmise that very few small businesses actually prosper to the degree that warrants a venture capital investment.
The above figures show only a small relatively insignificant part of the equation. They only show the percentage of dollars received from the total dollars in venture capital actually invested. What’s missing is the percentage of all start-up or early stage companies seeking venture capital but not receiving it. These statistics vary and they’re hard to pin down, but according to the U.S. Small Business Administration the reality is that there are approximately 28,000,000 small businesses in the U.S. and 600,000 start-ups each year. We believe in the 80/20 rule, in that only 20% of those would be worthy of an outside venture capital investment, as 80% would be “mom and pop” type operations obtaining traditional bank and or lease financing to start and grow their companies. If that seems reasonable, then 120,000 of the start-up and 5,600,000 existing small businesses are those seeking venture capital from outside investors. If that seems reasonable, then we simply divide the total start-ups 2,340 plus early stage 2,065 companies, or the 4,405 that were funded last year, by the total amount of 5,720,000 qualified companies seeking venture capital to arrive at that percentage of 0.77% (3/4th of 1%) of those actually receiving it.
If the simple analysis of the above-mentioned statistics is correct, then 20% of small businesses are in need of a venture capital investment but only 0.77% are actually receiving it. Hence, there is a high probability that 19.22% of potentially great companies are being ignored. We believe with the proper corporate engineering, 30 to 35% start-up and early stage companies would be worthy of venture capital and we intend to see that they get it.
The bottom line is the overall probability of your start-up and early stage company being funded by venture capital (including angel groups and private equity) is becoming lower each year. Hence the absolute need to an alternative and effective method of raising substantial amounts of seed, development and expansion capital through the legal solicitation and sales of hybrid securities to individual investors.
However, no matter what route an entrepreneur may take, the capital-raising process takes time, money, and effort. Consider the cost of failing (e.g., the entrepreneur’s management team’s time and energy) to receive VC funding. It takes 3–5 months (on average for due diligence review) to be turned down.
One issue should be explained here. Venture capital is almost always provided in stages, and therefore the number of first-time financings, may mean a combination of both first time for serial entrepreneurs for that particular company not in their history and first time for those who have never received financing before. Therefore, the statistics also leads us to believe that most start-ups being funded by venture capital are high-end deals that serial entrepreneurs who have built and sold more than two successful start-ups in the last ten to fifteen years are the only ones being funded, because they’re matching venture capital funding internally. In other words, these entrepreneurs have $20,000,000 $50,000,000 of their own money and they want the VCs to simply match them based on their terms of the deal. These entrepreneurs deal with the VCs from a serious relative position of financial strength. That’s who getting the most venture capital for start-ups and because they not only have a successful track record of being serial entrepreneurs but more importantly they have the funds to command venture capital attention.
Becoming quality deal flow for professional capital is just as important to attract passive investors as it is for professional investors. Professional capital sources would include investment banks (e.g., broker-dealers), angel-investor groups, hedge funds, private equity firms, family offices, venture capital funds and registered investment advisors. From their perspective, quality deal flow typically refers to a company with positive cash flow, an experienced management team with a unique, high-demand product or service in a growing market. Unfortunately, identifying quality deal flow is often an overly simplified, quantitative assessment that does not fully recognize the distinctive benefit and potential value of investing in a start-up or early stage company.
We believe that the reason for direct or in-direct failure or stagnant growth for so many small businesses is not due to lack of entrepreneurial vision or product/service need or demand, but due to the lack proper market positioning and sales execution, organizational communication with action item checks and balances; capitalization planning, internal accounting controls and corporate governance. However, the cornerstone to these problems is the lack of capital—and therefore the inability to hire the right management team and outside legal, accounting and other professionals to executed the entire business plan through to fruition. Without adequate access to substantial amounts of capital to hire the necessary management team to design and implement the proper product and service production protocols; execute the proper marketing and sales strategy; implement the proper internal accounting controls; and standard corporate-governance practices; and to survive general economic down cycles, business failure isn’t assured, but prosperity becomes a rarity indeed.
In our experience and analysis, less than 0.77% of all new, non-serial entrepreneur driven start-up and early stage companies searching for capital receive their needed funding through any institutional source—on average annually, in good or bad times. In good times, generally more money is available and there is more quality deal flow. In bad times, less money is available and there is less quality deal flow. It’s all relative. If your start-up or early stage Company is within the lucky 0.77%, the institutional, equity-capital source will most likely control the terms of the deal and [often] demand voting control. You may have to give up substantial equity and upside participation to “seal the deal.” On average, VC firms typically fund two, three, or possibly four companies out of the 1,500 [or more] deals they review each year.
“Why do most VC firms operate this way?”
They operate this way because they have no real choice—it is a matter of survival. True, more venture-capital money is currently available than at any other time in history; however, the money is not being invested due to a lack of quality deal flow. In the VC industry, this reality is called “capital overhang.” The VCs cannot lower their investment criteria—to fund the majority of start-up and early stage companies—primarily because they raised capital through a prospectus to individual and institutional investors, which limits their flexibility. Specifically, they raised capital for their Funds by selling shares and setting criteria within the prospectus (their securities-offering document) that limits their ability to invest in prospect companies. For example, they may have stated, “…the Fund will only invest in portfolio companies that are engaged in the medical-supply-and-health-care industries, nanotech (as it relates to medical supplies), surgical application or other related technologies [sector-positioning limitation]; with a minimum of seven years of operating history [stage limitation]; annual sales of at least $15 million [size limitation]; and the average capital commitment of $20 million [capital-commitment limitation].” Essentially, they pin themselves into a corner through prospectus limitation. Granted, they believe this limitation protocol mitigates portfolio risk, which it does to one degree or another—depending, of course, on how one looks at it. More importantly, however, this limiting strategy mitigates capital-raising risk for the VCs. What do you think would happen if they took a prospectus with little or no limitation protocol to an institution looking to invest a couple hundred million dollars? They would be laughed out of the room.
“I only need $500,000. Why won’t a venture capitalist just cut me the check?”
Unless they make a radical departure from the “old school” position and protocol of investing and managing “portfolio companies” for their Funds, it is a mathematical certainty they will never be able to afford to simply “cut the check.” Not only is it commercial suicide for a VC firm to stray from investment-criteria protocol for attracting capital for their Funds, but they could not otherwise afford to manage the amounts invested in smaller companies.
For instance and as an example let’s run the numbers to discover why. Let’s say a VC firm was able to raise $10 million in a new Fund to invest only in start-up companies. Also assume the average amount to be invested is $500,000 per company, and the Fund plans on investing in twenty companies this year (for diversification) with the average holding period estimated to be five years. After making stated investments, the Fund has twenty portfolio companies it will then need to look after. The VC firm needs to employ professional managers (in-house within the VC firm) to look after these companies. How many companies can each manager reasonably look after—two, three, or possibly four? Remember, the VC firm has a fiduciary duty to its shareholders of the Fund, so it cannot skimp in this area. Let’s assume for this example that each manager looks after four companies (the high end of this estimate). In this scenario, the VC firm needs to employ five managers to look after all twenty portfolio companies. How much should the VC firm pay these managers in annual salaries? Should the VC pay $200,000, $250,000 or $300,000 each? Where is the line to further assure the Fund is hiring competent managers to protect the VC firm’s fiduciary duty? Let’s assume $200,000 is the line on salaries—the low end of the cost spectrum. That’s five managers at an annual cost of $200,000 each for a total annual cost of $1 million in salaries alone. Who is going to pay for these managers’ salaries? Typically, the portfolio companies need to provide immediate returns to the VC Fund to pay this cost. Most start-up companies would be hard-pressed to afford annual contributions to the VC Fund of $50,000 each year. However, let’s assume that each of these portfolio companies can make annual contributions to the Fund of $50,000 each year to enable the VC Fund to afford the managers to justify the capital invested. We do this to further define the next segment of this scenario.
After the average holding period of seven years, the total cost of managing the investments of the Fund in these start-ups is $7 million ($50,000.00 x 20 companies x 7 years) in salaries alone, which is now being funded by the companies within the investment portfolio. Add an extra $500,000 for other unforeseen costs, such as additional legal advisory, accounting services, etcetera, which will also be borne by the collective of all portfolio companies—for a total of $7.5 million over that seven-year period. That’s the VC Fund’s overhead commitment, whether or not these companies survive to the degree that they can cover these costs. Now the accepted truism in the industry is 50% of these portfolio companies will fail within the first five years, 30% will stagnate and or essentially breakeven, leaving 20% to succeed to a degree that should make up for the “capital losses” (and then some) of the other 80% (50% + 30%). Thus, we can assume that out of the twenty companies funded, ten companies (e.g., 50%) will fail—for a total capital loss of $5 million of the original total Fund value of $10 million and 6 companies (e.g. 30%) stagnate and breakeven for a $3,000,000 recapture. If we assume the 50% fail and the 30% are sold at breakeven during the 5th year, on average, the sixteen companies will not be able to cover 2 years of the $7,500,000 VC’s overhead commitment. This equates (16 x $50,000 x 2 = $1,600,000) to a VC overhead shortfall or loss. Let’s say the VC is willing to absorb the $1.6 million potential operating loss for the potential to offset those losses with capital gains. Note, if you knew any VCs, they would laugh at that last statement. Each of the four remaining portfolio companies with initial investments of $500,000 each ($2 million total) would need to be liquid—publicly traded or sold to a strategic buyer—with average values of at least $15.625 million per company (assuming an 80% ownership interest acquired in each portfolio company by the Fund, for a $12.5 million net value in each portfolio company to the Fund) to meet the “risk/return criteria” of five times the money in five years set by the Fund, e.g. $10 million dollars to $50 million—4 companies x $12,500,000 in Fund value each. That is a far reach. Furthermore, as an entrepreneur, if you had a company with the potential to be worth $15.125 million in five years, would you sell 80% of the ownership today for $500,000?
In the precious scenario, we’ve made some fairly unrealistic and aggressive assumptions to entice or motivate a VC firm to adopt a business model to fund start-up or early stage companies. First, we’ve asked the VC firm to demand $50,000 from each portfolio company for each year; we’ve asked the VC firm to shoulder an estimated $2 million in internal operating losses; and lastly, we expect the VC firm to grow 4 out of the 20 start-up or early stage companies with unproven business models, to grow and sell company for a minimum value of $15.125 million in five years with only $500,000 invested.
The point here is the math simply does not make sense for a VC firm when one assumes the traditional VC Fund model is employed by competent managers.
You may be thinking, “But I’ve read in all the trade magazines that venture capital groups are springing up all over the country and are funding deals left and right.” Frankly, you are reading about the rare cases. Remember, the publishers of these magazines need to sell “hopes and dreams” and, ultimately, their publications. Consider the source before you jump to conclusions. They produce good stories that motivate and do have value. However, if you want to raise substantial amounts of capital while maintaining the vast majority of equity ownership and voting control, consider producing and executing a series of successful securities offerings to be effective in your capital-raising efforts—this strategy has far more value than simply being motivated by stories.
There are two sides to the investment banking industry. Those two sides consist of: 1.) “Consumer Markets,” where financial advisors manage individual investment portfolios of their firm’s investor clients, and 2.) “Capital Markets,” where investment bankers raise capital for their firm’s issuer clients. We refer primarily to the Capital Markets side of the investment banking industry in the discussion below.
The investment banking industry is continuing to experience difficult times. Restrictive and suffocating laws have been passed, such as; the U.S. Patriot Act and Sarbanes Oxley, and the new FINRA replacing the NASD have put additional pressures on publicly traded companies and investment banks alike. What most people do not realize is that these laws have a negative effect on the ability of all companies, publicly, as well as privately held, to raise capital through a traditional investment-banking avenue. The attributes necessary for companies to qualify for an investment banking relationship, have always been high, but recently they have increased significantly due to the increase in regulations and the inherent general liability of compliance. Therefore, even companies that would have normally qualified for such investment banking relationships in the past, now find it difficult to qualify for the relationship, due to today’s regulatory environment.
The typical “boutique” investment bank – broker dealer must be extremely selective and protective of any capital raising effort they engage an issuer in. Broker dealers need investors more than they need quality companies to capitalize, aka quality deal flow. One would be wise to budget marketing dollars, from the use of proceeds from the securities offerings, to provide to broker dealers so the broker dealers can attract new investors for your securities offering. This further justifies taking on the additional risk of capitalizing an early stage company. This is a tactic we’ve used successfully since 1998.
Boutique investment banks and broker-dealers (specifically those with less than 50 sales representatives) are finding it far more difficult to engage companies, at any stage of the companies’ life cycles, in an investment-banking securities-brokerage effort. The difficulty arises in the increasing compliance burden of the SEC, Financial Industry National Regulatory Authority (FINRA), and North American Securities Administrators Association (NASAA). In the compliance session at a capital conference we recently attended, a former SEC-enforcement attorney—on a panel of six securities attorneys—made the statement that FINRA has indicated in their internal documents that these small broker-dealers are to be sought after as the primary targets for assessing fines, because these smaller firms are the cause of the vast majority of the complaints and regulatory violations within the securities industry. For these reasons, the securities regulators are set out to destroy this portion of the industry. What FINRA recognizes is the more rules they make and enforce the more difficult and cost prohibitive it is for compliance to be met by these firms. Thus, small-boutique broker-dealers may be going the way of the dinosaurs.
In addition, the amount of quality deal-flow—e.g., companies that qualify for the investment-banking relationship—is far less than it used to be. The profit margins are simply too small to make it worth it anymore. Sadly, this portion of the industry may be doomed. In conjunction with this evolution, entrepreneurs may have no choice but to capitalize themselves “in-house” by conducting one or more securities offerings themselves.
To hedge your position and increase the probability of success, you must compete directly with financial institutions to attract capital from individual passive investors. Keep in mind those financial institutions need to attract capital from individual investors as well. Banks need depositors and venture capitalists need shareholders in their Funds. No matter how it looks, it boils down to attracting individual investors, because ultimately they own and control the money. Business plans and executive summaries do not meet the stringent legal requirements to raise capital from individual investors—only securities-offering documents do.
As previously stated in Chapter 4, the Sub-Chapter “Denying Access,” the Crowdfunding Portals for regulated equity or debt offerings will become more and more like investment banks / broker dealers. They’re a good avenue for start-ups as long as you really know what you’re up against when dealing with the increasingly risk-averse environment of this new sub-industry of financial institutions. Change is inevitable and we’ll bet it moves toward risk aversion, and if your company is not properly engineered you simply will be denied access.