One of the primary reasons that small start-up companies fail is the lack of sufficient capital to carry them through the financial hurdles during their early formation and development. As a start-up gets launched, reaches new milestones, and expands, it’s likely the small business will need several rounds of capital to stay competitive, hire top-notch professionals, realize the potential of the venture, and properly plan for an exit for its shareholders.
There are many reasons a small business may fail to raise capital. Leaders may lack the knowledge or fail to leave sufficient time to raise the capital.
The entrepreneurs may pitch to the wrong investors or fail to speak to the investors’ interests, or the company may lack sufficient human resources and corporate governance to ensure proper stewardship and deployment of the capital raised. Or, finally, the deal structure offered to investors may be too dilutive on investor capital, thereby deterring investor interest.
A Forbes article by Dileep Rao said the number of start-ups funded by venture capitalists (VCs) is about 300 out of 600,000 new businesses started in the United States each year. The odds of your start-up receiving VC investment are approximately 0.05%. So, it may be wise to plan to raise capital and grow your business without counting on VC money.
The good news is there is much more money than ever before in the hands of individual investors. On January 31, 2021, the amount of investor capital was more than $26.16 trillion (M1+M2, nonseasonally adjusted) compared to $17.57 trillion on May 7, 2018. M1 and M2 are monetary indicators published by the U.S. Federal Reserve Economic Data. M1 and M2 combined are considered “cash available for investment” on Wall Street. Small businesses can compete directly with VCs for individual as well as institutional investor capital by creating securities offerings with an attractive deal structure.
SECURITIES OFFERINGS AS VC ALTERNATIVES
To further this effort and benefit start-up and early-stage companies, effective March 15, 2021, the U.S. Securities & Exchange Commission (SEC) published the Final Rules to modernize aspects of the private securities offering framework (click here for the summary table). These rule changes are extensive and will likely have a significant impact on the overall capital formation strategy of emerging companies across industries. Here are some key features:
- Allows certain test the-waters communications between the issuer and investors prior to filing a Form C for Regulation Crowdfunding and Regulation D, Rule 506(c) offerings.
- Revised accredited investor third-party verification under Regulation D, Rule 506(c).
- Overhaul of Regulation Crowdfunding:
- The maximum offering amount has increased from $1.07 million to $5 million per raise per a 12-month period.
- For offerings up to $250,000, the SEC has extended the current temporary exemption from certain financial statement requirements for offerings until August 28, 2022.
- Individual investment limitations have been removed for accredited investors (other than the $5 million aggregate limit applicable to the offering) and revised for nonaccredited investors.
- Offering limits have increased significantly in Regulation A, Tier 2, and Regulation D,Rule 504:
- Regulation A, Tier 2: The maximum offering amount has increased from $50 million to $75 million, and the secondary (or insider) sales have increased from $15 million to $22.5 million.
- Regulation D, Rule 504: The maximum offering amount has increased from $5 million to $10 million.
Crowdfunding has increasingly gained public awareness in the last few years, especially after the SEC’s Final Rules came into effect on March 15, 2021, which allows the increase of the maximum amount that can be raised through Regulation Crowdfunding offering by almost fivefold. This is a game changer for start-up and early-stage companies. Despite the initial optimism, caution is still warranted. For instance, on September 20, 2021, the SEC charged an issuer with committing fraud and conducting unregistered securities on a Regulated Crowdfunding portal. The SEC also charged the Crowdfunding portal and its CEO with failing to address red flags of the issuer and to reduce the risk of fraud to investors.
As the regulatory burdens of securities compliance have been considerably lifted for the issuer, Regulated Crowdfunding portals’ oversight roles seem to have taken on greater responsibilities to screen the deals that are raising capital through securities offerings on their online platforms. Of course, in the presence of violations of securities laws, rules, and regulations—whether discovered by the regulators or not—both the issuer and the Regulated Crowdfunding portal are at risk.
WHAT THIS MEANS
The regulatory amendments create a favorable landscape for small businesses seeking new ways to raise capital. These amendments significantly expand the investor pool for small securities offerings while lightening the compliance burdens for the issuer.
To legally raise capital through securities offerings, one must have the required securities-offering document in place in compliance with federal and state securities laws. To effectively raise capital through securities offerings, one is wise to provide an attractive deal structure that the investors find more appealing than other investment opportunities, relative to the risks involved. A securities offering is appealing when it maximizes investors’ return; maximizes investor safety by minimizing the operational, financial, and litigation risks of the business; and provides a clear exit strategy with available options for continued upside participation at the discretion of the investor.
There’s always a “sweet spot” between the entrepreneur’s goals and the investor’s goals when formulating a deal structure. Your job is to discover it. This means the investor is protected, to the highest degree possible given the risk involved, with the highest return potential, while the entrepreneur obtains the proper amount of capital without diluting their equity interests. This process can be further enhanced by engaging in a series of capital raises using hybrid securities, such as convertible notes and/or preferred stock.
A business plan or a pitch deck won’t comply with federal and state securities laws as these documents normally don’t provide sufficient disclosures required under securities laws, rules, and regulations. So, one would most likely violate securities laws when attempting to present a pitch deck to potential investors. Creating a marketable deal structure to attract individual investors requires the hard work of learning, planning, and producing pro forma financial projections to Generally Accepted Accounting Principles compliancy.
For a start-up or early-stage company, the burden of raising capital is mostly on you even when you pay professionals to handle the legal and accounting work. Done correctly, small securities offerings with marketable deal structures allow small businesses to raise substantial amounts of capital like never before.
NOTE: The article is in no way inclusive of all of the alternative ways to legally conduct an offering of securities.