Four Key Strategies for a Successful Capital Raise

The Start-Up Perspective

Corporate Team of Warren Law Group

Warren Law Group - The Smart Choice

Managing a capital raise is like walking a tightrope – balance is the key to success. A growing business must strike a balance between its interests and its investors’ demands. The downside risk and the lure of a rewarding upside, all while ensuring the venture has the capital, control, and flexibility needed to reach the next level and beyond.

Warren Law Group’s corporate team has extensive experience handling every aspect of a private capital raise; we’ve represented companies seeking investment, private investors, and broker-dealers who profit when they align sophisticated parties for new endeavors. This diversity of experience gives us insight into what makes a start-up appealing and how start-up founders can protect themselves as they grow their business.

This blog is the first of two that will boil down critical strategies for capital raise success. First, from the start-up perspective, and second, from the investor perspective.  

Strategy One

Structure the Offering Before Approaching Investors

Before a company approaches potential investors, it should prepare a firm structure to build on. There are three major categories to consider: debt (usually unsecured), equity, and convertible notes.

A debt raise allows the current equity holders to maintain full control of their company in exchange for adding the liability of that debt to the company’s balance sheet. Conversely, selling equity dilutes the current shareholders’ control, while the funds used to purchase that equity becomes an asset on the balance sheet. What’s more, having sold equity at a given price provides a solid basis for your valuation in the next round of investment. Convertible notes are precisely what they sound like: debt instruments that can be converted into equity. Investors like these notes because they offer downside protection (i.e., priority in the event of liquidation) with the possibility of an upside. An intelligent investor can convert their debt into equity after a company has developed and is more likely to provide an upside to its equity holders.

Knowing the optimal structure for your capital raise frames the conversation with potential investors, projects strength, and empowers you to quickly filter out prospects who aren’t a good fit to partner with your company.

Strategy Two

Choose the Optimal Securities Exemption

All offers and sales of securities in the U.S. must be registered with the SEC or conducted pursuant to a federal exemption from registration. Unless you want to go public from the start, it’s essential to select the correct type of exempt offering to raise investment for your business. Determining the most suitable exemption depends on your business needs and the structure of your offering; you should consider the type of investors you want to reach, how you plan to conduct your offering (including advertising), and how much you are seeking to raise. We’ll discuss the most common exemptions: Reg D, Reg CF, and Reg A.

Regulation D (Reg D) is the exemption most utilized by start-ups, allowing a company to raise nearly unlimited funds from “accredited investors.” The two most useful Reg D exemptions are Rule 504 and Rule 506. Rule 504, the “seed capital exemption,” is favorable for companies conducting their initial funding round, allowing a raise of up to $5,000,000 (from accredited investors only). Rules 506(b) and (c) allow for a raise of an unlimited amount of private capital and are great for raises past Series A. Rule 506(c) is differentiated by an issuer’s ability to use general solicitation or advertising, so long as: (1) all involved purchasers are accredited investors, (2) the issuer takes reasonable steps to verify purchasers’ accredited investor status, and (3) certain other conditions in Regulation D are satisfied.

Regulation Crowd Funding (Reg CF) exempts capital raises conducted through online crowdfunding platforms. Reg CF offers issuer guidelines and regulates the funding portals and broker-dealers that facilitate crowdfunding offerings. In crowdfunding, “backers” commit funds in exchange for early access to products or other “rewards” offered by those platforms. The limit under Reg CF is $5 million, while the maximum offering under Rule 504 is $10 million.

Regulations A and A+ (Reg A) are two-tiered “mini-IPO” exemptions from registration for small and medium-sized companies. To sell securities pursuant to Reg A, you’ll need prior approval and “notice of qualification” from the SEC, after they’ve reviewed your company’s offering materials. Reg A has two tiers, each subject to different max offering rules: Tier 1 caps offerings at $20 million in a 12-month period, while the enhanced regulatory requirements of Tier 2 allow for offerings up to $50 million every 12 months.

Each of these exemptions presents its advantages and drawbacks. Further, they can be conducted in parallel, such as starting a Reg D round in the middle of a Reg CF offering. Each company’s situation is unique, and you should evaluate all possibilities with the advice of counsel.

Strategy Three

Use Your Resources Wisely & Avoid Costly Mistakes

Whether you’re selling widgets or providing services, the goal of any entrepreneur is to maximize the return on every dollar they’ve invested. To this end, cash flow is the most important determining factor between success and failure. When investors look at a company, they want to know it’s operating “lean,” keeping overhead low with no unnecessary expenses. Think of your company like a car; its operations are the engine, and capital is its fuel: investors like a car that can go fast and still get good gas mileage. Investors also know that, just like a car, companies need safety features: mechanisms to mitigate the risk of a catastrophic crash.

Managing business expenses that don’t immediately translate into revenue is challenging, but taking the long view is key to growth. Too many entrepreneurs neglect to account for wholly unexpected expenses. An unexpected tax bill, audit, regulatory enforcement lawsuit, fine, or penalty could all be unforeseen drains on your cash flow and reserves. To paraphrase Oscar Wilde, to expect the unexpected shows you’re ready for success.

Many entrepreneurs fail to invest in solid legal counsel and wind up paying excess taxes or expenses they’d otherwise avoid with proper legal guidance. An entrepreneur must have a well-informed understanding and custom-tailored legal strategy for the specific legal environments and obligations under which their business operates. A relatively small investment in sound legal counsel goes a long way towards preventing surprising and potentially devastating expenses in the future.

Strategy Four

Know the Rules of the Road

Every entrepreneur knows that they need to know their product/service, understand their target market, and stay informed of industry trends to succeed. What many entrepreneurs forget (and what sophisticated investors want to see) is knowledge of the “rules of the road” (i.e., the regulatory framework) that apply to their business and their customer base.

Knowing these rules, and keeping up as they change, gives a start-up two distinct advantages over their competitors. First, start-ups can proactively avoid costly compliance issues or other regulatory headaches. Investors might love your chocolate-covered bacon, but they might not be prepared for the cost of FDA compliance when you try to transition to a commercial kitchen. Second, knowing the rules enables a company to add value to its customers with innovative solutions. The key to a new recycling business might be making it easy for clients to meet constantly shifting municipal requirements without worry.

Start-ups with the wisdom to learn and apply the rules of the road are attractive to investors, especially those who invest in the long term, and not just because of costs avoided or value-added. Deep knowledge of your company’s regulatory context shows investors that you’re prepared for sustained growth, to mitigate your risk of capital loss, and adapt positively to changes in the market landscape.

The Corporate Team at Warren Law Group stands ready to thoroughly equip you and your business with the proper legal counsel, advice, direction, and strategies to help you raise the capital you need, and to mitigate your risk while doing so. We’ll share key strategies that any investor should employ to maximize their ROI and mitigate their risk in our next post. Stay tuned!  

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Todd P. Kulkin

Todd P. Kulkin, Partner