by H. Randall Goldsmith, Ph.D.
Entrepreneurs often find themselves at a disadvantage in raising capital because they are not aware of the options available to them. The choice of method can determine the type of investor most likely to be attracted to the investment opportunity. Generally, passive investors will be more inclined toward a private placement memorandum while an active angel investor will be more attracted to a business plan proposal. It is also important for entrepreneurs to realize that investors will not write a check the first time they review the investment opportunity. A check follows an event called a term sheet and a period called due diligence. These terms are discussed below.
Accredited investors include a bank, insurance company, registered investment company, business development company, or small business investment company; an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million; a charitable organization, corporation or partnership with assets exceeding $5 million; a director, executive officer, or general partner of the company selling the securities; a business in which all the equity owners are accredited investors; a natural person with a net worth of at least $1 million; a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or a trust with assets of at least $5 million, not formed to acquire the securities offered, and whose purchases are directed by a sophisticated person
An angel investor (accredited investor) is a high net worth individual who provides capital for business start-up and early-stage companies, in exchange for ownership equity. Angels typically invest their own funds, unlike venture capitalists, who manage the pooled money of others in a professionally-managed fund. Increasingly angel investors are organizing themselves into angel networks (unfunded) and angel funds (funded) to share research and pool their investment capital.
Angel capital fills the gap in start-up financing between the initial founder, friends and family funding, and venture capital. While it is usually difficult to raise more than $100,000 from friends and family, most traditional venture capital funds are usually not able to consider investments under $2 million. Thus, angel investment is a common second round of financing for high-growth start-ups, and accounts in total for almost as much money invested annually as all venture capital funds combined. Compared with venture capital, angels invest about the same amount of funding in ten times as many companies.
Angel investments represent extremely high risk and require a high return on investment. Because a large and anticipated percentage of angel investments are complete failures, professional angel investors seek investments that have the potential to return at least 10 or more times their original investment within 5 years, through a defined exit strategy, such as plans for an initial public offering or an acquisition. This approach allows the few “winners” to offset the larger number of “losers.”
A term sheet is a document outlining the material terms and conditions of a business agreement subject to the investor’s satisfaction with the merits of the deal based upon the investor’s research. The Term Sheet provides the investor with an exclusive period of time to investigate the merits of the investment and restricts the entrepreneur from marketing the deal to other investors. Subject to the investor’s satisfaction with the investigation, the Term Sheet then guides the investor’s legal counsel in the preparation of a proposed "final agreement" which ultimately subject to negotiation between the investor and the entrepreneur.
Due diligence is a process of investigation using a standard of care to systematically analyze an investment opportunity. A private equity investment due diligence approach utilizes multiple levels of investigation beginning with an initial screening that simply identifies whether the investment opportunity meets fundamental requirements for a private equity investment. After an initial meeting between the investor and entrepreneur, a second more in depth level of due diligence researches the venture development strategies, claims and assumptions made in the business plan. Finally, execution of a term sheet results in a final, labor intensive, extensive, and costly investigation that considers all aspects of the execution, product, market, management, and financial risks and requirements associated with the venture investment.
A private placement memorandum (PPM) is the document that discloses all pertinent information to the investors about the company, proposed company operations, the transaction structure, the terms of the investment (share price, note amounts, maturity dates, etc.), risks the investors may face, and description of the investment opportunity. The Subscription Agreement sets forth the terms and conditions of the investment. It is the "sales contract" for purchasing the securities. It is the opposite of a public offering. Private placements can only be sold to certain sophisticated investors. These investors are called accredited investors and they are defined in the U.S. Securities and Exchange Commission’s requirements for a Regulation D offering. The procedure for conducting a private placement pursuant to the exemption is less stringent than for the public restrictions of Regulation D.
Issuers should cautiously approach offerings that have stated maximums and minimums. If the issuer elects to increase or decrease the size of the offering above the stated maximum and minimum size of the capital raised or to change the share price of the offering, the SEC requires that each of the investors who have signed subscription agreements must consent to the change in writing.
Do not confuse the detailed disclosures and transaction structure in a PPM with the general information a business plan provides - they are not the same. The advantage for the entrepreneurs raising capital through a PPM is the ability to offer a traditional format meeting generally accepted investment terms and conditions familiar to passive investors. PPM are generally unattractive to angel investors for the following reasons: 1) angel investors prefer a more active role in the venture, 2) angel investors to prefer the opportunity to influence the design of the business plan, 3) angel investors require the opportunity to negotiate the valuation and share purchase price of the venture. In addition, the PPM approach limits the entrepreneur’s ability to change content of the prospectus in response to changing market or business conditions.
Regulation D is a government program created under the Securities Act of 1933, instituted in 1982, that allows companies the ability to raise capital though the sale of equity or debt securities. The programs were designed to provide two main things - an exemption to sell securities in a private transaction without registering the securities (something that happens in any transaction involving investors) and the appropriate framework and documentation for doing so properly. Regulation D consists of three programs:
Understanding these terms and the process they represent gives the entrepreneur a greater understanding of what is required in ultimately securing an investment.