Where to Go When The Bank Says No

By 1997 I had written for Entrepreneur magazine for more than 7 years. In my Raising Money column, I had explored almost every nook and cranny of entrepreneurial finance, and had the idea to bring my separate columns together in a book. Ultimately, I was never able to come to terms with Entrepreneur magazine, but shopped the manuscript and found a much more eager publisher: Bloomberg LP, which was getting into the publishing business and anxiously signing up talent. They offered me a deal after our first meeting, and put a lot of resources into helping me put together a first class book. Where to Go earned rave reviews including a four and a half star rating from the Wall Street Journal.

David R. Evanson

Bloomberg, L.P., Fall, 1998

Raising Capital:
Where to Go When The Bank Says No

David R. Evanson

Introduction 2

Section 1 – Where to Go

Chapter 1 – Why You Need To Focus on Equity Capital 7
Chapter 2 – Locating and Securing Capital From Angel Investors 19
Chapter 3 – Initial Public Offerings 55
Chapter 4 – Alternative Routes To A Public Offering 92
Chapter 5 – Venture Capital 126

Section 2 – How To Go

Chapter 6 – Valuing Your Business For Equity Investors 141
Chapter 7 – Presenting Historical & Projected Financial Statements 160
Chapter 8 – Preparing & Presenting Business Plans 183

Conclusion 214

Resources 216

Appendix A – Overview of Securities Laws Influencing Private and Exempt Transactions 217

Appendix B – Sources You Might Not Have Considered 225

This book is written for entrepreneurs with small or new businesses seeking to raise between $250,000 and $15 million.

The cornerstone idea upon which this book was written is that simply knowing where to look for capital is only one of the ingredients required for success. In truth, many entrepreneurs fail in their search for capital simply because they are unprepared for the process.

This book is designed to attack both sides of the problem. That is, when you are done reading this book, you should know where to look and how [italicize how] to look for capital.

The first section is the one which gave the book itzzs name — Where To Go When The Bank Says No. Though this title implies that debt is not the proper source of financing for emerging growth companies, the first chapter goes into some detail about why this is so.

The reason this chapter is so long, is because my experience talking with thousands of entrepreneurs looking for capital has been that many are disappointed, or do not understand why banks will not lend them money. Worse, others are not aware of the serious drawbacks of debt financing. If you are one of these entrepreneurs, read this chapter. If not, skip this chapter.

Chapters Two, Three, Four and Five discuss the primary sources of equity capital. These are angel investors, initial public offerings, alternative routes to a public offering and institutional venture capital. Each of these chapters explains not just how to access these investors, but the sizes and shapes of the companies that should [italicize should] be trying to access them.

The second section of this book, chapters six, seven and eight, discuss financial analysis, valuation and business plans. The purpose of these chapters are to help entrepreneurs arm themselves with the tools they will need to raise capital. At the most fundamental level this section of the book is about planning.

The Resources section is unique. It contains a detailed listing of venture capital clubs and networks by region. These clubs and networks will provide every reader with a place to turn if they are interested in raising equity capital from angel investors. One of the underlying themes of this book is that raising capital requires making connections with other people. This directory represents a way for you to take the first step easily and painlessly.

Though buried deep in the back, Appendix B, The Sources You Might Not Have Considered is well worth looking at. I wish I could take credit for its creativity, but that rests with the entrepreneurs whose stories are told there.

This book covers a lot of ground in very few pages — a feat which is at once satisfying and a little bit frightening. This brevity places its trust in the ability of entrepreneurs to grasp concepts quickly, and to recognize that raising money is a lot selling their own products and services. If the readers of this book are anything like the many entrepreneurs I have met, or any of the now famous ones who have changed our landscape forever, Izzm certain this trust is well founded.

David R. Evanson

Conventions of this Manuscript

Each chapter of this manuscript is divided into distinct sections. These sections are designated by bold-faced, left-justified type. For example:

The Psychology of Angel Investors

Most sections of this manuscript are divided into
sub-sections. These subsections are designated by a dash “-” followed by a sub-head in the form of a phrase or action step.

For example: – Develop a Spreadsheet.

Sections and sub-sections frequently contain lists. Some lists contain several one line items. Other lists consist of paragraphs. Lists are designated by asterisks. For example:

* Seminars. Educational programs on everything from the importance of patent protection, to effective networking, to writing business plans.

* Fairs. Beauty contests where companies looking for capital can show their wares.

* Keynote Speakers. Notable successes or pundits address groups at breakfast, lunch and dinner on topics of interest.


* Wealthy individual investors
* Professional venture capital firms
* Individual investors via initial public offerings.

Throughout the text there are important action steps and summary ideas. These are designated by a dot: “•”. For example:

• To add credibility to projected gross profits, build in a fudge factor of two to three percent.

Chapter 1 – Why You Need To Focus on Equity Capital

Banks Arenzzt Built For Risk
If you really want to understand why your bank behaves the way it does, simply visit the lobby where the tellers are.

There you will see people putting money in the bank, and other people taking it back out again. The people waiting in line to take money out have every expectation their funds will be there when they ask the teller for them.

And that in a nutshell is the problem.

The bank canzzt lend your fledgling business money because itzzs not theirs to begin with. Itzzs deposited with the understanding nothing too exotic is going to be done with it after they drop it off. After all, itzzs a deposit. It is not [italicize not] a contribution to a hedge fund, venture capital partnership or buyout group. In fact, if youzzre a real purist, the deposit is a loan [italicize loan] to the bank. If someone lent you [italicize you] funds that had to be repaid upon demand, would you then lend them to a company that was developing a product but had no sales?

This arrangement leads bankers down a very narrow and predictable path. They can only make loans in situations of absolute certainty and safety. So who qualifies for a loan? Established companies which can repay it from cashflow, and if that dries up, then from the liquidation of its assets. And even if a company has the assets, or collateral, to cover a loan, it still might not be worth the risk. After all, if the deal goes south, the bank has to sell the assets to get its money back. These assets might be difficult to sell, they might not fetch as much as the bank thinks. Meanwhile there are carrying costs . . . Rapidly, the situation gets messy. Too messy anyway for the bank to have an interest in companies other than the ones that can pay them back easily.

These facts notwithstanding, untold numbers of entrepreneurs go knocking on the door of their local bank looking for capital. When the entrepreneur tells the banker that he or she has a cutting edge new media content business, the bankerzzs eyes might start to glaze; he or she might start thinking zzhow do I get out of this gracefully?zz The internal dialog the banker is having with him or herself might go something like this:

* Is the companyzzs product or service complete or do they need funding to develop it?
(We donzzt fund R&D, because there is no source of repayment associated with it.)

* If so, can the product be successfully developed or will it die in the lab?
(Even if we did fund product development, which we donzzt, I donzzt think that what would be left, in terms of a patent, or equipment would be worth nearly the loan value. The last time we tried to sell the rights we had to technology, it was a disaster.)

* Are there any assets or inventory here to collateralize the loan?
(By the time we enforce our lien, their Pentium desktops will be paperweights and doorstops.)

* If itzzs a new product or service, will the market buy it?
(Hmmm, I donzzt know a single person with an Apple Newton. And itzzs not just technology that flops, the other day I asked for New Coke with my Arch Deluxe and was told they donzzt make New Coke anymore.)

* Will customers pay for the product or service? What percent of sales will be bad debts?
(It makes me nervous when there is not an established pool of buyers with a payment history. Plus, if the service or product is unproven, will buyers withhold payment until it works according to their expectations?)

* Will this company grow too fast for its own good?
(Our rate of return has no bearing on how fast the company grows. If it grows too fast, we may even have to write off the entire loan because the company de stabilizes itself.)

Not that debt is completely out of the picture for small business. In several instances itzzs vital. Itzzs important to note some distinctions about debt. There is term debt, which companies use to finance equipment purchases. Then there is so called asset-based debt, which is used to finance cashflows, such as accounts receivable. In general, cashflow lending is easier than term lending for most lending institutions. A good company, even a good small company with proven sales, should be able to secure loans against their accounts receivable or for inventory purchases. On the other hand, for all of reasons mentioned above, term loans are almost never feasible. Even if they are made feasible by virtue of rock solid guarantees, then they are almost never a good idea, as will be explained in more detail in the following sections of this chapter.

• The needs of a lender are directly at odds with the needs of an emerging business.

The Government Canzzt Help You
When entrepreneurs come face to face with the fact that they canzzt get a loan, many of them turn to the federal governmentzzs Small Business Administration (SBA). This can be a good idea. But it can also be a bad idea if the entrepreneur believes he or she has a god given right to a loan. Entitlements, a concept with significant currency among those which hold the purse strings in the federal government, have absolutely no currency inside the SBA.

A popular myth is that through the SBA, the federal government hands out grants to businesses that canzzt find financing. Except for the Small Business Innovation Research Program, which awards funds to companies for highly specific research and development projects that meet the needs of certain government agencies such as NASA, the Department of Defense and the Department of Energy, among others, the SBA is not in the grant business.

The SBA is mostly about lending. Itzzs cornerstone effort is the so called 7(a) loan guarantee program. In a nutshell the SBA will guarantee up to $750,000 of a private sector loan. The reasoning goes that if a private sector lender, i.e., a bank, sees a guarantee on as much as 75% of the principal (in some cases 80%), it will be induced to make loans that otherwise would be too risky. And just to clear up one other misconception, SBA-guaranteed loans arenzzt subsidized low rate loans either. Rates are competitive, but capped at no more than the prime rate plus 2.75%.

While the 7(a) program is a good idea, itzzs not a panacea for small business. Why? Because when deciding whether or not to issue a guarantee for a loan, the SBA will conduct exactly the same credit analysis that a banking officer would. According to Michael Dowd, director of the SBAzzs office of loan programs the SBA actually turns down guarantees on some loans that banks have already approved.

You Canzzt Grow On Debt
Whether it comes from the government or a commercial bank, one central, irrefutable truth remains: emerging businesses will never truly emerge if they are financed with debt. Investment banker Jim Twaddell of Providence, Rhode Island, with more than 30 years experience financing emerging companies puts it: debt is like ice water running through a companyzzs veins, while equity is like warm red blood.

At the most basic level, a company cannot grow unless itzzs able to plow all of its cashflow back into the business. Diverting cash from the business in the form of monthly interest and principal payments can be debilitating — even when the rate of interest is well below the margins which a company earns.

Consider for a moment a secured loan for $300,000 with a five year term and 12% annual interest for, say a financial services company. The monthly nut for the company will be $6,700. But since the lender will need comfort above and beyond $6,700, it may require covenants in the loan that the company maintain average cashflow of 125% of the interest payments, or in this case some $8,400. According to banking trade group Robert Morris Associates, Philadelphia, PA, which produces financial statement studies so lenders can understand industry norms for financial performance, financial services firms like the one in this example, with sales between $1 million and $3 million, have, on average, a net operating margin of 7%. Assuming operating income equals cashflow, how much business must the company do on a monthly basis just to break even after debt service? $96,000. And what annual revenues will the company have to generate to ensure that itzzs maintaining the net cashflow the bank requires? $1.7 million. For unsecured loans, which are loans that are guaranteed by the borrower, rather than collateralized by the underlying assets, the hurdles will be even higher.

But stepping back and looking at the situation in the aggregate shows just how steep the hill is for companies that are financed with debt. The $300,000 loan proceeds will have to generate nearly six times their value just to keep the bank happy. They will have to generate about four times their value for the company to break even. If the new business happened to be a bookbinding manufacturer, instead of a commercial finance company, with average net operating margins of 2.3% according to Robert Morris Associates financial statement studies, the challenge would be even greater. In that case the company would have to generate $3.5 million from the loan proceeds to break after paying interest.

Therezzs no doubt that savvy American businessmen and women can turn $300,000 of capital, even debt capital, into $3 million, or perhaps even $300 million given one essential ingredient: time. However, in the same way that sources and uses of funds can sometimes get mismatched, so too can the sources and uses of time. Unfortunately banks provide emerging companies a very limited source of time, while growing the business, hence the revenues and earnings, requires unreasonable amounts of time.

Advertising agencies generate a lot of marketing juice by suggesting that business moves at the speed of light. Some do. In truth though, most business moves at the speed of cold tar. For many companies, the sales cycles takes months and months.

Itzzs not hard to see why. They get caught the middle of a Fortune 500 company spending half a year trying to figure out if it wants to test database marketing through an outside vendor, and then waiting another half a year to get the project budgeted. Or a retailer who will wait four months for a site to open up, and then spend three months on leasehold improvements. Or a state or local government that will wait until the next committee meeting before deciding whether or not to put a proposal on the agenda of the next committee meeting. And so it goes . . .

All this is fine. Except that it is at odds with the demands of a commercial loan. The emerging company financed with debt, or the established company financing a new product or service with debt, will quickly find themselves and their bankers ill at ease because although the loan payment is due each and every month or every quarter, new business is occurring at a much more random pace.

Debt Isnzzt Permanent Capital
Another reason debt financing is inappropriate for growth companies is because itzzs not permanent. It has to be paid back. But this understates the true dynamics of the situation. Itzzs not like the inability to make a loan payment keeps entrepreneurs up at night because they feel a sense of obligation to the lender.

No, what keeps people awake is that their inability to make a loan payment may cause the lender to recoil and force [italicize force] the company to repay the loan when they are not ready to do so and in a way that may destroy their business. How is this so? Remember, all of a companyzzs assets, including its accounts receivable and inventory, and most likely all of the personal assets of the entrepreneur are backing the loan, because the bank as a middleman, is not built to take risks and lose money.

According to borrowerzzs rights attorney Barry Cappello of the Santa Barbara law firm of Cappello and McCann, borrowers, most notably small business borrowers, are in a particularly precarious position as the banking industry consolidates via acquisitions. Cappello says that when one bank acquires another, the borrower faces two possible and unpleasant side effects. First, new management makes the decision that entire industries or loans sizes are no longer the focus of the bank. Second, as personnel shifts in tune with new ownership, or changes in policy, the borrowerzzs point of contact begins to change rapidly, with each new lending professional trying to ratchet up the terms of the loan.

One anonymous Cappello client who is suing his bank over the termination of a line of credit reported that, “During my 10 year relationship with the bank, there were seven different branch managers, eight commercial loan officers, two regional vice presidents and four assistant regional vice presidents. “Itzzs scary,” he went on to say. “Herezzs an institution that holds the destiny of your company in its hand, that has a lien on all of your corporate and personal assets, and every time you walk in therezzs a different person that wants to play by a new set of rules.”

A Case In Point: How Debt Killed One Company
Consider the following true story. Unfortunately many of the people involved have now passed away. But investment banker Ed Culverwell, of Culverwell & Company in Boston, MA, remembers it well, since it resulted in perhaps one of the most amazing deals in his lifetime.

The tale dates back to 1927, when salesman Homer E. Capehart formed Capehart Automatic Phonograph Company. So aggressive and relentless was Capehart that Fortune magazine was compelled to write of him in 1941, “One of the highest powered, highest pressure salesman this country has ever produced.” But Capehartzzs drive paid off. His name became synonymous with sound quality and high fidelity, long after he became a United States senator in 1944.

The Capehart name was still in tact during the early 70s. In fact, demographics may have given it even more cache. As baby boomers reached their teenage years, they began to clamor for stereo equipment. Their parents, shopping among the foreign looking gadgetry on the shelves of “hi-fi” stores immediately identified with the name Capehart [italicize Capehart].

Recognizing this, the late entrepreneur and businessman Leonard Kaye bought the rights to the name and began selling Capehart stereos though Zayres and other discount department store chains. Culverwell underwrote a $1 million equity offering in 1971 to help finance the company. Sales mushroomed from $4 million to $12 million the next year, to $30 million. The stock soared from $5 to $30 recalls Culverwell. Demand was piping hot, and in anticipation of hitting $60 million in sales during 1974, Capehart bulked up on bank-financed inventory.

Then interest rates took off. The prime rate hit 12%, two points higher than Capehartzzs 10% margin. As rates increased, sales slowed because consumers were less willing to purchase major appliances on credit. The companyzzs bank got nervous, says Culverwell. “They took possession of the inventory and liquidated it at bargain basement prices to pay of the companyzzs line.” Suddenly, high flying Capehart Electronics was out of business.

Lenders Versus Equity Investors
To understand why you need to focus all of your energy on finding equity capital, consider the following differences between a lenderzzs orientation, and an equity investor’s orientation. Note how the equity investorzzs focus matches an entrepreneurzzs while the lenderzzs focus tends to be at odds with the entrepreneurzzs

Lender Orientation Equity Investor Orientation
A lender wants to see plenty of hard An equity investor could care
assets on the balance sheet to less about hard assets.
collateralize a loan. If the company ever liquidates,
theyzzll know theyzzll never see a

A lender is not concerned with An equity investor will
intangibles such as trademarks, zero in on intangible assets
copyrights and goodwill because because they represent a
they have no liquidation value. competitive edge that can drive sales. Intangible assets are
also a concern however because their depreciation will deliver a hit to earnings.

Most lenders donzzt care about Equity investors are concerned other liabilities because their about liabilities because they
debt gets paid off first in a want their capital to build
liquidation. the business, not bail out creditors.

Meteoric growth scares lenders Equity investors want to see
because it can de stabilize meteoric growth.
the company and impair its
ability to repay loans.

Lenders would prefer to finance Equity investors like companies
companies that need more debt with operating leverage because
as they grow. it increase profitability.

Lenders like big loans. Equity investors are careful to avoid companies that will outrun the amount of capital they can provide.

Lenders like proven markets with Equity investors like proven
proven receivables. markets too, but the also like new markets too where there is
an opportunity to establish a
dominant position.

Lenders want to structure their Equity investors structure their
deals so that the company or its deals so that other investors
founders pay back what they borrowed. [italicize other investors] can pay them back more than they put in.

A lender will liquidate a company An equity investor will try to in order to get their money back. save a company in order to get his or her money back.

A lenderzzs capital is temporary, and Equity capital is permanent,
can be taken away against the wishes and is not taken away, but
of the borrower more accurately, get replaced
and or replenished as a
company grows.

• When the bank says no, as it surely will, focus all of your energy on locating and raising equity capital.

Chapter 2 – Locating and Securing Capital From Angel Investors

Although equity financing is the proper mode of financing for any growing business, it comes in different forms. An entrepreneur must decide which kind is right for their business.

This chapter is dedicated to the notion that for the vast majority of businesses, perhaps as many as 90%, equity capital from individual investors, called angels, is the [italicize the] optimal form of financing. Some of the reasons for this:

* Capital from angel investors is the most abundant source of capital.
* The amount of capital sought for early stage businesses,
$250,000 to $5 million matches the commitments which angels typically make.
* Angel investors often invest in businesses for reasons other than pure economics.
* Angel investors can provide the kind of value in strategic planning, and access to other investors that growing companies typically need.

To understand just how many angel investors are out there consider this thumbnail estimate from Jeffrey Sohl, director of the Center for Venture Research at the University of New Hampshire. Sohl, who is one of the leading national authorities on the topic of angel investors and the related public policy issues says there is some 250,000 of them in the United States. And each year, Sohl says, these investors fund approximately 30,000 growing businesses to the tune of $20 billion to $30 billion. This figure, incidentally, dwarfs the $5 to $7 billion invested each year by institutional venture capitalists.

Semantics have often stood in the way of business owners pursuing this option. That is, entrepreneurs seek venture capital from professional venture capitalists chiefly because the names of these investors are easily located in any number of readily found source books. Unfortunately, the six to nine months it takes them to recognize this as an extremely limited source of funding often proves fatal to their fledgling enterprise.

In truth, the concept of venture capital must be understood generically, as money invested in risky young companies, while its source must be considered quite specifically. The sources of generic venture capital are:

* Wealthy individual investors
* Professional venture capital firms
* Individual investors via initial public offerings.

To define terms:

* wealthy individual investors are referred to as angels [italicize angels]

* professional venture capital partnerships are referred to as institutional venture capital firms [italicize institutional venture capital]

* venture capital raised through initial public offerings is often called public venture capital [italicize public venture capital]

• Pursue venture capital, not venture capitalists.

Getting Started
To get angel investors to fund your business your strategy at the broad brush level must be to:

* Generate leads. You must find the kind of people who typically invest in early stage deals. Once you learn where they are, you must qualify them.
* Plan. A big part of planning means writing a business plan. This is important, because you canzzt answer the kinds of questions investors ask until you write a plan, and you canzzt set appointments until would-be investors have had a chance to look over your business plan. (See Chapter 7)
* Set appointments. The angel investor/entrepreneur relationship is consummated equally on the basis of personal chemistry and economics. Therefore, without face to face meetings, there canzzt be a sale.
*. Follow-up, follow-up, follow-up.
*. Close

Generating Leads
Investor angels tend to hover around easily identified, and in many cases easily accessed, centers of activity. Here are they place you need to go to find them and start generating leads.

– Venture Capital Forums. The term venture capital forum is general in nature, referring to the manifold venture financing, education and networking opportunities that are sponsored by chambers of commerce, economic development coalitions, publishers, as well as professional services organizations such as law and accounting firms. For instance, the MIT Enterprise Forum now runs in 16 cities in the Unites States. In these forums, a panel of professional venture capitalists who have all read a business plan several days in advance evaluate the company and the deal in front of the entrepreneur with audience participation, feedback, questions and answers. But this is just one format. Others include:

* Seminars. Educational programs on everything from the importance of patent protection, to effective networking, to writing business plans.

* Fairs. Beauty contests where companies looking for capital can show their wares.

* Clinics. Same as seminars, but more intensive. Donzzt go unless you want to get touchy feely and do a lot of work.

* Keynote Speakers. Notable successes or pundits address groups at breakfast, lunch and dinner on topics of interest.

• Some venture capital forums cater only to institutional venture capital firms. You need to qualify these organizations, and weed them out to make the best use of your limited time.

• Attend meetings in your area, and ask people there for the names of investors you can contact. For a detailed list of venture capital organizations which sponsor symposia and other programs, refer to the resources section of this book.

– Venture Capital Clubs. So-called clubs or consortiums are groups of individual private investors, which meet on a regular basis to hear formal presentations from entrepreneurs seeking capital. For the most part, these investors have other, full time businesses.

Typically, clubs solicit business plans, which are reviewed by a screening committee. The screening committee will frequently have some university or economic development council affiliation. Entrepreneurs whose plans are selected by the review committee are given anywhere between 10 and 30 minutes to make a formal presentation before the membership of the club. Interested members follow-up on their own. While members tend to invest independently, they will also team up on deals as well.

• Send your business plan to venture capital organizations which review them for presentation opportunities. For a detailed list of venture capital forums that offer presentation activities, refer to the Resources section of this book.

• Venture capital clubs may or may not select your company for presentation before their investors. Even if you are rejected, the people who reviewed your plan can point you toward investors.

– Private Capital Networks. Networks are essentially electronic matching services that put entrepreneurs and investors together based upon a similarity of needs and preferences. Almost all networks have a university or economic development council affiliation because as stand alone ventures, they have not proven to be profitable. Perhaps one of the reasons for this is because private capital networks tend to work best in the context of face to face networking, and educational programs for entrepreneurs and [italicize and] investors. According to Peter Bechtel, who runs the North Carolina Investors Network, an electronic matching service affiliated with the North Carolina Small Business and Technology Development Center, investment activity is positively correlated to these kinds of activities.

The brass tacks of a venture capital network is as follows.

1) Investors register with a network and provide detailed information about their investment preferences on items such as preferred industries or technologies, minimum and maximum deal sizes, geographic restrictions, willingness to co-invest with other investors, stage of development, and level of hands-on involvement in the company, among others items.

2) Entrepreneurs, on the other hand pay a fee, typically $100 to $500, to register with the network and provide a detailed summary of their company, financing needs, as well as the executive summary of their business plan. A custom software program then matches companies with investors in the network based upon similarities.

3) The network administrator then sends investors identified as likely candidates for investment the executive summary of the companyzzs business plan and the name of entrepreneur. Some networks also send the entrepreneur the list of investors that received the companyzzs executive summary. After this, the network steps back from the process in deference to the independent nature its investors, and in consideration of the securities laws it invokes by going any further.

Rather than a one shot deal, entrepreneurs keep their company on the network for a period of six months to a year and periodically update the listing. Hopefully, entrepreneurs realize a flow of leads and inquiries over a prolonged period of time. And again, generally speaking, networks are regional in nature, contain 100 to 500 investors who are outnumbered by entrepreneurs looking for capital by a ratio of three to one.

• Consider listing your company on a venture capital exchange. Many networks charge a fee from $100 to $500 to list your deal on their network. Pay these fees if you are provided a list of possible investors to call, or they pre-qualify you for at least 25 “matches”.

• For a detailed list of venture capital networks refer to the Resources section.

– Ace-Net: The Mother of All Networks. Ace-Net is a national private angel capital network designed to match entrepreneurs seeking capital with accredited [italicize accredited] individual investors, and was developed by several private venture capital networks, the Small Business Administration, with assistance from the Securities and Exchange Commission as well as state securities regulators.

Ace-Net is not for the feint of heart. To “list” on the network a company must complete a SCOR (Small Company Offering Registration) form, also referred to as a U-7, which when complete, looks suspiciously like a prospectus. In addition, once filed, state securities regulators can raise some thorny and difficult issues.

• See Appendix A for a brief overview of securities regulation.

Ace-Net relies upon existing private capital networks to act as “nodes” or feeders. The system went operational at the end of 1996, and today there are seven nodes which entrepreneurs can contact to get a registered offering on Ace-Net. Though still in its formative stages, Ace-Net is perhaps one of the most promising capital formation tools ever to emerge in the United States.

Chart: Ace-Net “Feeder” Nodes

The Capital Network (TCN)
University of Texas at Austin
Austin, TX
(512) 305-0826
Contact: David Gerhardt

Technology Capital Network at MIT
Cambridge, MA
(617) 253-7163
Contacts: Bard Salmon, or Betty Kadis (617) 253-8214

Accelerate Technology SBDC, at University of California, Irvine
Irvine, CA (714) 509-2990
Contact: Greg Collia

University of California, San Diego
La Jolla, CA
(619) 534-6114
Contact: Bob Leach

Advanced Technology Development Center
Georgia Institute of Technology
Atlanta, GA
(404) 894-3575
Contact: Gary Troutman

Kansas Technology Enterprise Corporation (KTEC)
Topeka, KS
(913) 296-5272
Contact: David Day

Ben Franklin Technology Center
Philadelphia, PA
(215) 382-0380
Contact: Earl Sissel

• Visit Ace-Net at https:acenet.sr.unh.edu which also contain hyperlinks several of the feeder nodes.

– Tap the Academics. Another way into the vein of angel investors which inhabit a region is through business schools with well developed entrepreneurship programs. Bard Salmon of Netropolis, Inc., Cambridge, MA, one of the architects of Ace-Net, a board member of the Technology Capital Network at MIT, and a recognized authority on venture capital networks says that universities with good entrepreneurship programs are teeming new business venture activity. More importantly, the professors there are closely connected to angel investors who are anxious to get a crack at the businesses which are being nurtured within academiazzs cloistered environment.

“The relationships between professors, the businesses they are helping to create, and investors is not widely promoted, or obvious, but it is very definitely there. Outreach and telephone calls to these professors, who are often sympathetic to any kind of entrepreneurial activity is an effective way to get connected to the schoolzzs venture forums, educational programs and networking events, which in turn leads to contact with angel investors.”

Listed below are some of the top university entrepreneurship programs which are also members of the Council of Entrepreneurship Chairs, a non profit group located at the University of the University of South Dakota, Vermillion, SD. According to Bob Tosterud, executive director of the Council, even schools with relatively new entrepreneurship programs attract top drawer professors with significant contacts in business and finance. “My advice would be to get the catalog of any university nearby to see if they have entrepreneurship programs. If so, call the professor and schedule a meeting.”

Universities With Leading Entrepreneurship Programs

Babson College
Babson Park, MA
Contact: Paul D. Reynolds

Ball State University
College of Business
Muncie, IN
Contact: Donald F. Kuratko

University of Baltimore
The Merick School of Business
Baltimore, MD
Contact: Zoliun J. Acs

Beloit College
Beloit, WI
Contact: Jerry Gustafson

California State University-Fresno
Sid Craig School of Business
Fresno, CA
Contact: Timothy M. Stearns

Carnegie Mellon University
Graduate School of Industrial Administration
Pittsburgh, PA
Contact: John R. Thorne

Case Western Reserve University
Weatherhead School of Management
Cleveland, OH
Contact: Robert D. Hisrich

University of Colorado
College of Business Administration
Boulder, CO
Contact: G. Dale Meyer

DePaul University
College of Commerce
Chicago, IL
Contact: Harold P. Welsch

Georgia State University
College of Business Administration
Atlanta, GA
Contact: Francis W. Rushing

University of Georgia
Terry College of Business
Athens, GA
Contact: Charles W. Hafer

University of Illinois-Chicago
College of Business Administration
Chicago, IL
Contact: Gerald E. Hills

Kennesaw State University
Michael J. Coles School of Business
Kennesaw, GA
Contact: Timothy S. Mescon

St. Thomas University
Fredericton, New Brunswick, Canada
Contact: Nancy M. Carter

University of Maryland
School of Business & Management
College Park, MD
Contact: Charles O. Heller

Miami University of Ohio
Richard T. Farmer School of Business
Contact: John W. Altman

University of Minnesota
Carlson School of Management
Minneapolis, MN
Contact: Richard N. Cardozo

University of the Pacific
Eberhardt School of Business
Stockton, CA
Contact: James O. Fiet

Saint Louis University
School of Business & Administration
Contact: Robert H. Brockhous

St. Maryzzs University-San Antonio
School of Business Administration
San Antonio, TX
Contact: Wayne Ferguson

Sierra Nevada College
School of Business
Contact: Gary Valiere

University of South Dakota
School of Business
Vermillion, SD
Contact: Robert J. Tosterud

University of Tennessee-Chattanooga
School of Business & Administration
Contact: J.R. Clarke

University of Tulsa
College of Business Administration
Tulsa, OK
Contact: George S. Vozikis

Wilkes University
School of Business, Society & Public Policy
Wilkes Barre, PA
Contact: Jeffrey Alves

University of Wisconsin-Madison
School of Business
Contact: Jon G. Udell

• Buy the September issue of Success magazine for their annual survey of the “The Best Business Schools for Entrepreneurs” To order back issues call 800-967-2083. Editorial offices: 212-883-7100.

– Work The Professional Services Firms. There are two things just about every venture capital deal requires: legal services and accounting services. Because of this, law and accounting firms have intimate knowledge of who the private investors are in their market. More importantly, professional service firms are selling access to these investors either implicitly or explicitly as part of their fees.

• If your attorney or accountant cannot provide access or introductions to individual investors, consider finding new professionals.

This sounds like harsh advice, especially if your attorney or accountant has been a loyal and competent adviser over the long haul. But, if bringing in outside investors is totally outside the sphere of their practice, your decision to raise money means you may have outgrown them. Thus, the entire relationship may require re-evaluation, and sadly perhaps, a parting of the ways.

Converting Leads Into Investors
The job of converting leads into investors is the most difficult, challenging and time consuming part of the process. But just throwing time at the task wonzzt carry the day. To prevail, you must plan and work smart. The following algorithm for converting leads into investors blends the techniques of two of the best in the business, Paul Rosenbaum, managing director of Wayland Partners, Wayland, MA, and Miles Spencer, creator of Money Hunt, a show about raising money which airs on public television stations around the country.

Rosenbaum, who has started and ran three high octane companies was also one of the general partners of American Research and Development, the oldest venture partnership in the United Stated that almost single-handedly institutionalized the concept early stage technology investing by backing Digital early on and earning billions [italicize billions] for its investors.

Spencer, on the other hand, a young venture capitalist, is now building a media empire catering to the needs of Americazzs fast growing companies. Here is their recommended approach.

– Form an advisory board. You need to clearly define the business and industry you are in. Armed with this information, reach out to those who have succeeded on a grand scale in the business, and ask for their help in the form of serving on an advisory board. Rosenbaum says therezzs a lot of psychology in why people readily agree to such a proposition. Among them are an appreciation for being recognized as a success, a desire to re-live success vicariously, and an altruistic urge to provide the kind of support they wish they had during the early days of their venture.

But the true purpose of forming an advisory board, is to generate leads (and to a lesser extent, to increase the confidence that would-be investors have in your team). When you start asking advisory board members who might be a likely source of financing, Rosenbaum says, “youzzll find itzzs a very natural process for them to open up their Rolodex. You might even find one of them will to take the lead on getting you in front of people they know.”

– Focus On Getting A “Lead” Investor. If you are raising $1 million, you might just run into the one investor that will write the whole check, but the odds are against it. In most cases, you will find an investor who will take half or a quarter of the deal. You want to find this person first, because they will serve as the magnet to draw in other investors.

When Katherine Hammer and Robin Curle, co-founders of data management firm Evolutionary Technologies, Austin, TX, were looking for capital, they landed Admiral Bobby Inman as a lead investor who committed $250,000 — 20 percent of what they were looking for — which in turned helped the pair secure another $1 million from other investors.

– Plan The Details Before You Contact Anyone. There are a myriad of details that need to be in place for the sales effort to succeed.

* Seek Legal Counsel. You do not want to start soliciting securities without first having consulted with a securities attorney experienced in venture capital transactions. Why? The act of raising money may invoke several state and federal securities laws. Even though many private transactions are exempt from state and federal securities laws, there can still be a myriad of requirements regarding notification, offering memoranda, and the number of investors that can participate in the offering. The task of raising capital is difficult enough. Donzzt add to your burden by unknowingly running afoul of securities laws.

• Read Appendix A of this book which provides an overview regulations influencing exempt transactions.

* Have a Deal Summary. Spencer said that you must have a one page summary of the company that is to be sent to investors before they receive your telephone call. This summary must, in one page, describe: the company, the product or service, the market, competition, key personnel, funding required, use of proceeds, and historical and projected financial snapshot. If youzzre stumped by this exercise, write a paragraph about each of the above categories.

* Have a Business Plan. You must also have a business plan for two very good reasons. First, if the initial contact is successful, the investor will request one. Says Spencer, “You definitely donzzt want to try writing a business plan after the request is made. When an investor asks for your plan, it needs to be on his or her desk the next morning.”

Second, itzzs only by writing a business plan that you can possibly hope to answer the kinds of questions which an investor will ask. Flip ahead to Chapter Seven of this book which discusses writing a business plan. At the end of the chapter are 50 questions a well-written plan should answer. If you cannot answer these questions, you are not ready to call investors.

* Figure Out Your Sizzle. The business plan is your steak says Rosenbaum. “But you will need some sizzle in you oral pitch to make an emotional mark on the investor. This sizzle is your unfair advantage which can also be a focus of your discussions.” For instance, computer products manufacturer Xyplex, Inc, Boxborough, MA raised a lot of money privately before it went public and was acquired. Rosenbaum says that rather than trying to drag investors through a tortuous technical explanation about front end processing and terminal servers from the get-go, the principals of the company said, “We are the company that turbocharges your DEC Vax computer.”

Another Rosenbaum client, Active Control Experts, Cambridge, MA, developed and manufactured so-called smart materials. But rather than confusing investors with the underlying concepts of piezo electronics, the company piqued investors with the positioning statement “We are the company that puts the brains in the skis.”

Even Wall Street uses this trick. When venerable motorcycle maker Harley-Davidson went public, the pitch to investors was “own a piece of an American icon.”

* Line Up References. You will also need to line up allies who the investor can talk to. These might be customers, potential customers who have said they will buy your product or service when itzzs available, the executive director of your trade association, members of your advisory board, or other investors. One of the keys to successfully reeling investors in is to get them committed to ever larger and more important actions. Having them call someone else about your deal can be the first step in that process.

* Get Warm Body Introductions. If you get the names of investors that you donzzt know, Spencer says itzzs vital to get what he calls a “warm body” introduction. “Avoid contacting someone out of the blue at all possible costs,” he counsels. Former employees, trade associations, accountants, lawyers, or the person who supplied you the lead in the first place, all represent viable candidates to prepare the investor for your initial contact.

* Meeting Locations and Times. If you work in a hovel, it may not be a good idea to let the investor look under the skirt so to speak. If this is the case, tell the investor if he or she asks to meet at your offices zzTherezzs not much to see here,zz and suggest neutral territory such as a restaurant, hotel, or your accountantzzs or attorneyzzs office.

– Initiating Contact. Now itzzs dial for dollars time. Prior to calling that first number you should have 1) written a business plan; 2) gotten a “warm body” referral and 3) sent the investor a one page deal summary. Now you need to:

* Qualify The Investor. The investor will ask you very early on in your initial conversation who you are and what your company does. In response, you need to deliver your positioning statement with a tight description of what youzzre looking for and why. For example “Well, our firm makes computer products that turbocharge Vax computers, and wezzre raising $1 million to rollout the products which we just beta-tested.” But according to Money Huntzzs Spencer, you also need to assume leadership of the dialog at this juncture to qualify the investor. “Unlike investment bankers and institutional venture capitalists, whose criteria and preferences are published in numerous references, angels are largely unknown.”

As a result, Spencer says, itzzs important to qualify the investor early on to see if he or she invests in companies like yours. If the person you are talking to doesnzzt qualify, Spencer says, “You need to give that investor a kiss goodbye. But before you do, ask for the names of three investors that would like your deal. ”

Top 10 Responses From Angel Investors Which Mean They May Not Qualify For Your Deal
I donzzt invest in technology companies.
I donzzt invest in low technology companies.
I only invest in companies with revenues.
I only invest in companies with positive net income.
I only invest in foreign companies doing business in the U.S.
My investments are restricted to an industry that you are not in.
My investments require your personal guarantee.
I only invest in companies where I have influence over product development.
I only invest in situations where the company has a strategic alliance with my company.
I only invest in private offerings of public companies.

* Handle Questions. If the investor wants to talk, theyzzll ask a lot of questions. Some of these questions will be about incredibly minute details — zzWhy do you use a P.O. Box instead of an address?zz — while others will be more global in nature, such as zzDoes the Internet represent a threat to you, or does it represent a viable new distribution channel?zz

Whatever the question, your answer must be persuasive and exude confidence. The reason is, the investor is evaluating you from the moment the conversation begins. Remember, unlike a lender who relies on cashflows to get their money back, the angel relies on the ability of the entrepreneur to sell the company again and again to other equity investors, and ultimately to investment bankers for a public offering, or to a corporation that will buy the company outright. The upshot is, if you canzzt be convincing to this investor, he or she is thinking you probably canzzt convince the next investor down the road, and that ultimately, their investment will remain trapped inside the company.

Another reason that all of your answers must sound confident during the initial phone conversation is that the investor wants to get the feeling that if he or she invested, their capital would go to work right away, and not lie fallow while you figure out fundamental aspects of the business. According to Rosenbaum, this is where all of the pain and suffering of putting together a good business plan, as well as the planning of the sales effort, pays off. “If you started calling investors with out being prepared like this, you would be wasting your time,” he says.

• Rehearse questions with a colleague or friend so that you can answer the investorzzs with confidence.

* Get A Commitment to Meet. Ultimately, your objective during the initial contact is to get a meeting with the investor. Rosenbaum says that if you are working with a well qualified list of investors, that are or were involved in your industry, you should get a meeting 50% of the time. If your initial target list was less focused, then he says you might expect to generate a meeting with just 25% of those which whom you initially contact.

• Use the request for your business plan as a tool to get a meeting with the investor.

If the investor is interested, they will need more information in the form of a business plan. However, according to Rosenbaum, simply agreeing to send out the plan cedes control of the process to the investor. Far better, he says, is to make a face to face meeting a condition of sending out the business plan. “You want the investor to agree to meet at a specific future date after they have received and reviewed the business plan.”

• Send your plan express mail, and include a sample of your product or service.

Spencer says that the business plan needs to arrive on the investorzzs desk the next morning by overnight mail. In addition, as practical, you want to include some kind of sample or tangible evidence of your product or service. In some cases this is simple — such as when you are distributing toys — and in some cases, this is difficult, such as when you are building mobile homes. Even in difficult situations, itzzs worth considering creative solutions because as Spencer says, “Papers pile up on peoplezzs desks get lost, whereas objects and samples get played with, looked at and talked about.”

• Donzzt simply take no for an answer, find out why your prospect isnzzt interested, and use this information to turn the situation around.

* Manage Objections. Most experts, Rosenbaum and Spencer included, counsel that if the investor is reasonably qualified to participate in the deal, you should never take no for an answer during the initial contact over the telephone. Spencer says that many investors will purposely be evasive and difficult either to get on the phone, or to talk to, just to see how committed and aggressive the entrepreneur is. “They want to get an idea of how hard you would work with their money if they funded the business.”

Rosenbaum, on the other hand suggests that 60% to 70% of the time, when investors decline an opportunity, itzzs because they donzzt understand a certain aspect of the product, or the market or the technology, or your vision for the company. “When somebody says no, you canzzt accept it,” he says. “Youzzve got to ask them why, and then educate them, teach them, and try to show them where their thinking is off.”

– The Initial Meeting. Entrepreneurs must have two objectives for their initial meeting with the investor. First, get the investor to like you. Second, get the investor to commit to doing some kind of action step.

* Get the Investor To Like You. For the deal to happen, the investor must like the entrepreneur — not truly, madly, deeply, but fundamentally — because personal chemistry is the cornerstone of the relationship between angel investor and entrepreneur. For many angel investors, the motivations to invest are psychological as well as economic. Accordingly, entrepreneurs would do well to review the concepts outlined in Part Two of the legendary book How to Win Friends an Influence People by the late Dale Carnegie. Naturally, making these concepts part of your fiber takes a lifetime of practice; but simply committing yourself to them the morning of a meeting with a private investor could spell the difference between success and failure. Here they are, as spelled out originally in 1937.

* Become genuinely interested in other people.
* Smile [!].
* Remember that a personzzs name is to that person is the sweetest and most important sound in any language.
* Be a good listener. Encourage others to talk about themselves.
* Talk in terms of the other personzzs interests.
* Make the other person feel important — and do it sincerely.

* Have A Formal Presentation Prepared. In every area of the capital markets, whether itzzs global equity deals, institutional venture capital, or the private capital market, the 20 minute pitch is standard operating procedure. Accordingly, you should walk into the meeting prepared to deliver one.

• For a primer on how and what to present to angel investors, look ahead to Chapter 7, in the section titled Presenting Your Business Plan.

Most meetings with angel investors are one-on-one, or perhaps three on one, if they ask some friends to join in. As a result, the best way to present to angel investors is to walk them through a set of 10 to 12 slides which punctuate the highlights of the company, the market and the deal.

• For a template of a successful slide presentation look ahead to Chapter 7, in the section titled in the section titled Presenting Your Business Plan.

During your presentation, investors may interrupt to ask questions. This is fine. The presence of the slides will continuously allow you, and the presentation to get back on track instead of diffusing into a dead end.

Itzzs entirely possible the investor will want to run the meetings and that no presentation is necessary. But again, the angelzzs payday comes when other equity investors buy out their stake. So itzzs not unreasonable to expect that the investor will want to see if youzzre capable of selling yourself and your company in conventional fashion.

* Create An Action Step. Unless you are totally bereft of human intuition, you will know whether or not to try to seal the investorzzs commitment during that first meeting. In general though first meetings, like most first dates, do not result in a commitment.

As a result, your objective for the first meeting is to get the investor to commit to some kind of action step.

Recommended Actions Steps For Close Of Initial Meeting
Get the investor to call your references
Get the investor to conduct due diligence about your industry, technology, products or service
Get the investor to try your product or service
Get the investor to have his or her accountant look at your historical or projected financials
Get the investor to read your business plan
Get your investor to interview some of your key personnel, vendors or advisors over the telephone
Get the investor to look at competitive product or service offerings.

The reason that you want to get the investor committed to an action step, is that it sets the stage for the second, and in theory, closing meeting. But the close for the first meeting goes something like: “O.K., youzzre going to try our product, and talk to some of our customers. That will probably take two weeks. Letzzs agree to meet then on this date, and discuss what you found out, and your reactions to it.”

• Never leave the initial meeting without letting the investor know that you are actively talking with other investors.

Money Huntzzs Spencer says that nothing motivates investors so much as the thought that they might get left out of a deal that other investors are in. “Youzzve got to walk a very fine line here,” says Spencer “Youzzve got to let the investor know youzzre on a fast track, but that you will not shut them out of the deal if they are genuinely interested in investing.”

– The Second Meeting. According to Selling 101, the date for the second meeting should have been set during the first meeting. If it wasnzzt getting the second meeting might take quite a few phone calls. Remember, the investor might be playing hard to get, simply to see how aggressive you might be if your were working with their [italicize their] money.

Regardless of how you get there however, the second meeting is deal time. Itzzs best to have some good news to start things off with, such as other investors who are interested in the deal, or progress on any operational front. But after that, itzzs time to get down to brass tacks.

• The second meeting is the opportunity to get the investor involved in the decision making process.

According to Rosenbaum, one approach that often proves successful in “popping the question” is to get the investor involved in the decision making process. “If you can do that,” says Rosenbaum, youzzre almost home.” Herezzs how a hypothetical closing might go according to Rosenbaumzzs recommended approach:

Entrepreneur: Wezzve met twice now, and youzzve had a chance to think about our situation a little bit more, read our business plan and to me, you have a real firm grasp on what we are trying accomplish. For all these reasons Izzd like to ask your advice on something. How much capital do [italicize you] you think we should be raising?

Investor: Well, your plan says that your are looking for $1 million. But I think that ramping up for demand, and accounts receivable are going to eat a lot more cash than you anticipate. I think you would do better with $1.5 million.

Entrepreneur: Well thatzzs one of the reasons Izzm trying to bring experienced investors like yourself to the table, because I think in the long run good advice is as important as capital. . . . (Resist the urge to breath in) O.K., of that amount, how much can you commit to?

Itzzs a very difficult position for an investor to get out of if they are genuinely interested in the deal. And if they wonzzt commit, well, thatzzs a small victory too, since it will save you from wasting any more time. But if they are interested, and respond with a material number, such as $250,000 or $500,000, then you have accomplished your objective of securing a lead investor.

• Solidify the investorzzs commitment with a term sheet.

If the investor commits to the entire funding, then the deal is highly negotiable. But if itzzs less — and it probably will be because most angel investors dislike being in a deal alone — then theyzzll need to be led through some sort of deal structure. Spencer says that a term sheet is the most effective mechanism. First, it focuses the investor on highly specific issues which must be understood for the deal to close.

Second, he says, a term sheet has almost incalculable value when it comes to getting other investors into the deal, because there is often a herd mentality among angel investors. “With one term sheet,” says Spencer, “you can get five more.”

Sidebar: How One Company Did It
Management at Burlington, MA-based Lahey Hitchcock Clinic, one of the largest physician group practices in the country, saw a massive opportunity in providing total automation solutions for home care agencies. The non profit group even spun out a for-profit affiliate, CrystalView, Inc., Waltham, MA to fully capitalize on the situation, says Bruce Nappi, who left his post as director of advanced technology at the clinic to become president of CrystalView.

Nappizzs first task was to raise the required funding for the venture. Though he had never raised capital before, Nappi had a critical advantage which would give him the stamina the task would surely require: he remained on the cliniczzs payroll while getting the job of fundraising done. This gave Nappi the freedom to do what must often be done to successfully raise money: treat it like a full time job.

After a brief and unrequited stint looking for institutional venture capital, then a corporate investor, Nappi targeted individual investors and structured a $2 million offering which was exempt from federal securities laws, and which allowed him to sell securities to an unlimited number of accredited (read wealthy) and non accredited (read pretty wealthy) investors. Technically, he did a “506 deal.”

Starting in the first quarter of 1997, Nappi spent the first two months laying the required groundwork. He wrote a business plan, formed an advisory board, created a positioning statement (“We provide turnkey solutions for home care automation . . . .”), and lined up would-be customers to talk to would-be investors. He even sought legal counsel. Boston powerhouse Testa Hurwitz stepped up to the plate with deferred fees and a list of contacts.

Thus armed, Nappi went about generating leads with textbook grace. His first stop was nearly 20 years of business cards he collected from people he had worked for or with, hired or bought things from. “I selected 400 people for letters and got a great response.” In fact, Nappi got the dealzzs first lead investor, an old acquaintance who simply called Nappi upon receipt of the letter and said “Izzll get my family together and put some money in.” This investor put up $160,000, and gave Nappi 40 more names which generated three more investors. Meanwhile his original 400 letters turned up five more investors.

Another one of Nappizzs original contacts led him to a professor at Boston University Medical Schoolzzs entrepreneurship program. This investor made a material commitment to the deal, and then gave Nappi 40 more names to work with. These forty names brought in five more investors. By now, Nappi had some $250,000 sitting in an escrow account and 15 investors.

The third vein came from one of the cliniczzs physicians, who recommended that Nappi meet a neighbor of his who frequently got involved with early stage companies. This person promptly joined CrystalViewzzs board of directors. “He didnzzt invest pre se,” says Nappi, “But he helped refine our business plan, and with the refinements in place, gave us a good list of investors to send the plan to under his name.” Nappi says this pulled in five more investors. By now, Nappi had 20 investors in the deal.

The fourth big break came through a venture capital forum sponsored The Technology Capital Network at MIT, though it happened in an unexpected way. Nappi made a 15 minute pitch before 100 or so investors. He said the response from the audience was enthusiastic, but that the presentation itself did not generate any investors. “The funny thing was, after the meeting, there were four of us who had presented and, all being pretty much in the same boat, we swapped leads. That list which I took away from the meeting, brought in the rest of the investors I needed to close on the dealzzs $625,000 minimum.”

Nappi says that during the process, he kept his goals very focused and very limited. “The objective of my first phone call was simply not to let my initial letter go unanswered. If the investors were talkative, I tried to qualify them. If they qualified, I simply tried to get them to look at a business plan.” Nappi estimates that just 5% of all contacts agreed to look at a business plan. The good news was that 50% of investors that looked at a plan, agreed to a meeting.”

Though these were daunting numbers to work with, Nappi says that he wasnzzt too aggressive with anyone on the phone. “The experts tell you not to take no for an answer, but my feeling was, all these leads came from personal relationships, and I wasnzzt going to burn any bridges by being overbearing or a hard sell on the telephone.”

During the first meeting, Nappizzs objectives were again simple and focused. “I went in simply trying to build stature with the investors and to give them a sense of confidence in what we were doing.” He says that he generally closed meetings by making a commitment that he would get back to the investors. “None of them seemed ready for me to contact them at a specific date a time. They had some undefined process they had to go through to think things over.”

The task of getting back in touch was a big one, requiring between two and 10 calls each. Once back in touch, the decision rule for stopping pursuit of any single investor kicked in when their objections became unconnected. “When they said, zzIf you can get me a letter from one of your clients that says they will do business with you when youzzre funded . . . .zz and then when that was done, they said zzI need some kind of primary market research . . .zz I knew I was wasting my time, and would be better off cutting this investor loose.”

“The funny thing was, people who were genuinely interested, moved pretty quickly. The ones I leaned on, or spent a lot of time with, they rarely turned out so good.”

The Psychology of Angel Investors
• To be successful in your search for capital you must understand the mindset of your would-be angel investor.

Ultimately personal chemistry and economics will carry the day, and if pressed, personal chemistry might even have an edge over pure economics. After all, as mentioned earlier in this book, a commercial banker may completely trust a business owner, but still wonzzt make a loan if itzzs too risky. By contrast, an equity investor will alter his or her investment criteria and standards if they develop a strong, trusting bond with the entrepreneur.

Because of this phenomena, Rich Bendis, president of the Kansas Technology Enterprise Corporation, says that entrepreneurs must understand the basic investor personality types because it will help them forge the bond which is so vital to closing the deal. Bendis speaks from experience; a former venture capitalist, he took a company public, and with the proceeds from the eventual sale of the company, became an angel investor himself. Bendis says that while private investors come in many different shades, they can be broken down into five basic types. These are

* Corporate angels
* Entrepreneurial angels
* Enthusiast angels
* Micro management angels
* Professional angels

– Corporate Angels. Typically, so-called corporate angels are upper to senior management at Fortune 1000 corporations who have been outplaced or taken early retirement. For instance, in Bendiszzs Kansas City, Marion Labs and Sprint created an entire new generation of wealthy, or at least wealthier, corporate executives. Corporate angels may say they are looking for investment opportunities, but in reality, they are looking for another job. This doesnzzt mean they wonzzt invest. Bendis says these investors typically have about $1 million in cash and may invest as mush as $200,000 into a deal.

But in addition to cash, the entrepreneur gets the investor too, filling in some senior management position, such as business development. While corporate angels will work for free, after about six months they tend to get nervous, watching their remaining nest egg, which took them a lifetime to build, stop growing, or worse yet, go backwards. Psychologically, corporate angels can make for a poor fit because after a lengthy and successful corporate career, the reality of a truly entrepreneurial organization can be a shock to the system. This drawback notwithstanding, corporate angels can help an organization evolve from seat of the pants entrepreneurial management to professional management.

Corporate angels typically make just one investment, unless their last one didnzzt work out, and therezzs still enough cash and gumption left to have another go. And with respect to the one investment they make, corporate angels tend to invest everything at once. That is, they invest all the cash they are ever going to invest up front, and tend get nervous when the hat gets passed their way again.

• Evaluate corporate angels early. How much personal risk will they take? Do they want to exchange equity for work (sweat equity)? Is their investment linked to a job?

– Entrepreneurial Angels. These are the most prevalent investors. Most of them own and operate highly successful businesses. Since these investors have another source of income, and perhaps significant wealth from an IPO or partial buyout, they will take bigger risks and invest more capital. Whereas the corporate angel is looking for a job the entrepreneurial angel is looking for 1) synergy with their current business 2) a way to diversify their portfolio or in rarer instances, 3) a way to prepare for life after their current business no longer requires their attention. As a result of this orientation, these investors seldom look at businesses outside of their area of expertise, and will participate in no more than a handful of investments at any one time. Because of their rather narrow focus in certain industries in which they have expertise, entrepreneurial angels can be value added investors in terms of industry contacts, sales leads, technical expertise, corporate resources and contacts among institutional sources of capital.

Entrepreneurial angels almost always take a seat on the board of directors but hardly ever take on any kind of management duties. They will make fair-sized investments, $200,000 to $500,000 and invest more as the company progresses. However, because of their agenda, when the synergy or the potential they initially perceived disappears, often times so do they.

• Package your deal to entrepreneurial investors as a synergistic opportunity.

– Enthusiast Angels. While entrepreneurial angels tend to be somewhat calculating, enthusiasts simply like to be involved in deals. Bendis says that most enthusiast angles are 65 or older, independently wealthy from success in a business they started, and have abbreviated work schedules. For them, investing is a hobby, and as a result, they typically play no role in management and rarely ever seek board representation. Since enthusiast angels are hobbyists, they tend not invest so much in technologies or industries as they do in people and ideas. But because they spread themselves across so many companies the size of their investments tends to be small — from as little as $10,000 to perhaps a couple of hundred thousand dollars. On the plus side however, enthusiasts tend to have a difficult time saying no, and often will bring their friends into a deal. While they do not need the high profile return often required by entrepreneurial investors, the enthusiast is in continual search of the one company that will go public.

• Create ways that the enthusiast angel can benefit from the product or service which you are offering. Free equipment, service for friends and relatives, product trial and testing opportunities.

– Micro Management Angels. Micro managers are very serious investors. Some of them are born wealthy, but by far the vast majority attained wealth through their on efforts. Unfortunately, this heritage makes them dangerous. Since they have successfully built a company, micro managers attempt to impose the same tactics they used on their portfolio companies. Though they do not seek an active management role, micro managers usually demand a board seat. If the business is not going well, they will try to bring in new managers. Itzzs possible to exploit the behavior patterns of micro managers, but at a cost. Specifically, they enjoy having as much control as possible, and will pay for it by putting more capital in the business. Because they micro manage the companies they fund, these investors limit their efforts to perhaps four companies at one time. Like entrepreneurial angels, micro-managers can be valued added investors but the expertise they bring to the table can quickly become a burden as well.

• Establish “rules of engagement” up front to see and see if the investor is willing to live by them.

• Structure the deal so that one party can buyout the other if fatal incompatibilities arise.

– Professional Angels. The term professional in this context refers to the investorzzs occupation such as doctor, lawyer, and in some very rare instances, accountant. Professional angels like to invest in companies which offer a product or service with which they have some experience: a doctor will look at medical instrumentation companies, a franchise attorney will look at franchise deals, and so on. These investors tend not to have the need to know whatzzs going on in the business day to day and they do not micro manage their portfolio companies. In fact professionals rarely ever seek board representation. However, they can be unpleasant to deal with when the going gets rough, and may believe that a company is in trouble before it actually is. They are good for initial investments, but are less likely to make follow-on investments.

Professional angels will invest in several companies at one time, and their capital contributions range from $25,000 to $200,000. Perhaps more than any other category of investor, professionals operate within loosely defined, but clear networks, and they tend to have more comfort investing along side their peers. Thus, the first professional investor which an entrepreneur finds will likely offer a pathway to others. Finally, professionals can also offer additional value, when they bring to bear legal, accounting or financial expertise for which the company would otherwise have to pay hefty fees.

• Determine with the professional investor up front if they are expecting to provide professional services for a fee before or after making an investment.

• Accommodate the herd mentality of the professional investor by offering to make a presentation before several of his or her friends as well so that they can provide input to the investor afterwards.

Chapter 3 – Initial Public Offerings

The search for private equity capital among angel investors is a numbers game. The more investors an entrepreneur contacts, the greater their chances of success. But there are other numbers too, which suggest that private equity capital from angel investors, though plentiful, is not plentiful enough.

In the same way that insurance companies and pension funds allocate just a tiny fraction of their assets under management, perhaps just 50 basis points, to venture capital partnerships, so to do angel investors allocate just a small portion of their wealth to venture investments. The angel investor who puts $250,000 in a deal, but is trying to keep illiquid, high risk investments to just 5% of the total portfolio, may have in the neighborhood of $5 million in assets.

For the entrepreneur seeking capital, these numbers present a significant challenge. How many multi-millionaires can they get in front of? If their close rate is 10%, the required number of contacts among wealthy individuals can be large.

This challenge is one of the main reasons that public offerings are a viable option for smaller companies. Though public investors tend to invest much smaller amounts than angel investors, there are many, many more public investors. In addition, their investment standards are not nearly as rarefied as the ones held by angel investors.

This chapter will explore conventional initial public offerings, which are defined as deals underwritten by an investment banker and which trade on a recognized stock market. This technique, though popular, and often achieved by underwhelming companies, is difficult and unrealistic for many companies. As a result, readers are urged to carefully read the section on this chapter about the pitfalls of IPOs and the next chapter which shows alternative approaches to tapping public investors for growth capital.

• Conventional IPOs are viable, but most companies must explore alternative approaches to the public equity markets to get the capital they need.

The Top 10 Reasons to Go Public
Going public usually seems like a pretty good idea. There are several aspects to recommend it. Here are the oft-cited 10 commandments:


First, proceeds from a public offering are permanent. Unlike a loan, the funds do not have to be paid back.

Second, lots of capital can be raised at one time. Rather than raising say $1 million in a “Reg D” offering, companies can raise $5, $10, $15 million, or more, all in one shot.

Third, once public, a company gains direct access to the capital markets and can raise more capital by issuing additional stock in a secondary offering.

Fourth, a public company can use its common stock as a currency to acquire other companies. “Growth through acquisition” is frequently cited by companies as the primary expansion strategy in their IPO prospectus.

Fifth, public companies can more easily attract and retain skilled employees by using their common stock as a carrot, and later, should they decide to leave, as a stick.

Sixth, public ownership delivers a certain level of prestige that private companies do not have.

Seventh, going public provides owners and founders liquidity for their holdings in the business. For entrepreneurs approaching retirement, an IPO makes estate planning dramatically easier, and a lot more fun.

Eighth, public companies enjoy a higher valuation than private enterprises. Consider that at the dawning of 1997, the companies comprising the S&P 500 were, on average, valued at 17.5 times their earnings, while most business brokers will tell you that your private businesses may sell for somewhere one to five times cashflow.

Ninth, public companies are more attractive acquisition candidates. While some companies donzzt want to be acquired, others do. In fact for some companies, the [italicize the] strategy is to grow themselves to the point where they become an attractive middle market acquisition candidate and sell out.

Tenth, going public usually makes you a millionaire. Even if you donzzt get the price you want out of the starting gate, playing the waiting game can be profitable. The late An Wang, founder of Wang Labs, once asked if he was upset that investment bankers priced his company at $15 per share in the initial offering, replied: zzWhatever for? I didnzzt sell any of my stock until it hit $80.zz

• If you will realize less than half of the standard benefits associated with an initial public offering, consider alternative approaches to the public equity markets.

Apparently, more and more companies think they will get the value from an initial public offering as the number of issues and the dollars raised continues to trend upward.

Charts of Graph:
Number and Dollar Volume of Initial Public Offerings by Year

Amount Number
Raised of
Year $Billions Offerings

1990 10.1 213
1991 25.1 403
1992 39.9 605
1993 57.9 820
1994 33.8 647
1995 30.2 584
1996 50.0 874
1997 YTD @ 8/22/97 23.4 373 [OPTIONAL]
Source: Securities Data Company, Newark, NJ

Forget for a moment that even in a great year, like 1996, just 876 companies made it through the IPO gauntlet. Later on this chapter will explain not just the difficulties associated with the process of going public, but some of the structural flaws associated with being a small public company. For now however, if you want to raise more than $5 million and you want to take your company public in the conventional fashion, your first and most important task is to find an investment banker who can do the job.

The Universe of IPO Underwriters
The world of investment banking is regulated by professional conventions that border on a caste system. To see it at work, look closely at a “tombstone” advertisement. Notice how the members of the syndicate — that is the listing of securities firms which participated in the offering — appear in alphabetical order from left to right and how there are several groups of alphabetical listings in the tombstone advertisement. Each group is known as a “bracket.” By and large the song and dance of deal syndication is played out on these brackets. However, brackets also offer handy nomenclature for helping entrepreneurs understand whozzs who and whatzzs what among investment bankers in terms of candidates for an IPO. Below is a listing of brackets and the kinds of deals which they typically become involved in.

Underwriting Brackets & Corresponding
Financing Characteristics

The Majors. These are sometimes IPOs ranging from a
called “bulge bracket” firms referring low of $25 million
to their dominance in underwriting to over $250
syndicates. Household names such million. Typically,
as Merrill Lynch, Smith Barney, Majors focus on com-
Prudential Securities, Goldman Sachs, panies that can
have elaborate investment banking dominate niche.
operations, but court Fortune 1000 For these firms, IPOs
and international business. represent a small segment
This is not to say these firms donzzt of their overall
like IPOs for “emerging” businesses. business.
They do. But for them the term
emerging tends to mean a relatively
young company that is shooting for
dominance of a developing market,
such as cellular service in eastern
Europe, or Internet services via cable.
If a business needs $50 million, and may
someday need a $1 billion, itzzs a perfect
candidate for a bulge bracket underwriter.

Regional Powerhouses. There are a IPOs ranging from a low
select few regional powerhouses that $15 million to as much
often share space with the buldge as $75 million. Typic-
bracket firms in underwriting syndicates. ally the companies they
These firms include Montgomery take public have been
Securities, Hambrecht & Quist, through several round of
Robertson Stephens, Alex. Brown & Sons, institutional venture
and on a good year, Cowen & Company, capital. For regional
to name a few. These underwriters raise powerhouses, IPOs
capital for leading edge and represent a major portion
bleeding edge technology companies at of their business focus.
early stages of development. They also
frequently have some sort of specialty
in a non technology business as well.
For instance, Montgomery is strong in
banking and finance, while Alex.
Brown tends to be a Mecca for
emerging trucking and transportation
companies, due to the firmzzs early
and ongoing success with J.B. Hunt.
While firms such as Alex. Brown,
appear to rival the majors because
significant IPO activity — in reality
they are dwarfed by the majors.
Consider that while Alex. Brown boasted
capital of more than $350 million
prior to the acquisition by Bankers Trust
according to the Securities Industry Association
handbook, Merrill Lynch boasts capital
of more than $20 billion [italicize billion].
Regional powerhouses tend to serve
institutional investors,
and accordingly these firms
are hard pressed to underwrite companies
that will have market capitalizations of
less than $100 million after the
offering is complete.

Regionals. Every major IPOs ranging in size from
metropolitan region has one a low of $12 million to
or two zzregionalzz investment banking $50 million. Typically
firms. These firms by definition take regionals look at comp-
a high interest in local panies in their own
companies. Though they are further back yard — which can be
down on the investment banking food defined as a state or an
chain, most regionals are surprisingly area the size of the eas- large, owing to the fact that many were tern seaboard — that are capable of becoming solid
started and weaned on the rich municipal middle market companies
and corporate bond businesses that with revenues ranging
sprouted up in their back yards. from $50 million to $500
They also have vast retail networks million. Overall, IPOs
— some with more than 1,000 represent a small part
brokers — and in many instances, a of a regionalzzs focus.
muscular institutional business as well. The more active firms
Unfortunately, the size and scale of do three to five IPOs a
regional firms sometimes makes them a year, while others will
poor fit for smaller, emerging companies. do perhaps one deal
In addition, regional firms are culturally every other year, and
conservative, typically with older brokers, only then because of
who may not like small companies. Sometimes, some special or long-
regionals will get serious about standing obligation to
investment banking fees, or a gunslinger the issuer.
with lots of deal making experience will
talk him or herself into corporate finance
job, making the firm temporarily —
or if things work out, permanently —
hungry for new deals.

Boutiques. Boutique brokerages IPOs ranging in size
as they are sometimes called defy from $5 million to
accurate generalization. Some can as high as $20 million
be quite powerful. For instance, with a preference for
New York City-based Allen & Company, deals in the $8 million
headed by uber media and to $10 million range.
entertainment advisor Herbert Allen, For many boutiques, IPOs
is considered by many to be a represent the central
boutique. By some accounts, focus of the firm, with
Wasserstein, Perella & Co. is merger a secondary emphasis
and acquisition boutique. By and on market making for
large however, boutique firms are Nasdaq-traded stocks
small, relatively unknown outside and so-called “special
of the trade and concentrate either situations,” a loosely
on a particular industry, or a defined term in the
particular kind of transaction. brokerage business
Many boutiques concentrate on which seems to center
initial public offerings. on making a lot of
While the skill and expertise of money fast from the
the regional powerhouses is creation or repair of
uniformly high, there is wide an abberation in a
variance among the boutques. particular publicly-
Some are quietly making untold traded security.
millions for investors
on a select group of
carefully screened deals,
while others are pumping
out IPOs, and keeping the
securities regulators

With the above primer on IPO investment bankers in mind, consider the following tables of leading IPO underwriters for 1996 and the first half of 1997, tallied by Securities Data Company. These charts, though informative, are also misleading because they can leave entrepreneurs with the mistaken impression that the underwriters on them are the only game in town. In fact, nothing could be further from the truth.

Initial Pubic Offering Underwriter Totals for
The First Half of 1997

Amount Number
Raised of
Underwriter $ Millions IPOs

Goldman, Sachs & Co. 3,653 17
Merrill Lynch & Co. 2,236 16
Morgan Stanley Dean Witter 2,060 17
Credit Suisse First Boston 1,072 12
JP Morgan & Company 719 4
Donaldson, Lufkin & Jenrette 612 9
Friedman, Billings, Ramsey & Co. 490 5
Bear, Stearns & Co. 432 6
Montgomery Securities 428 13
Lehman Brothers 387 6
Salomon Brothers 386 5
Alex. Brown & Sons 362 10
Prudential Securities 352 4
Dillon, Read 284 1
ABN AMRO Hoare Govett 259 1
Smith Barney Inc. 248 5
ING Barings 187 2
Cowen & Co. 181 6
Hambrecht & Quist 162 6
Robertson, Stephens 136 3
PaineWebber 135 1
A.G. Edwards & Sons 124 5
Robert W. Baird & Co. 120 2
Wheat First Butcher & Singer 117 2
UBS Securities 114 5

Top 25 Totals 15,255 163
Market Totals 16,962 279

Source: Securities Data Company, Newark, NJ

Initial Pubic Offering Underwriter Totals for 1996

Amount Number
Raised of
Underwriter $Millions IPOs

Goldman, Sachs & Co. 9,888 51
Morgan Stanley Dean Witter 7,237 47
Merrill Lynch & Co. 3,624 38
Smith Barney Inc. 2,991 34
Donaldson, Lufkin & Jenrette 2,497 29
Alex. Brown & Sons 2,472 51
Lehman Brothers 2,415 29
Credit Suisse First Boston 1,906 14
Salomon Brothers 1,644 19
Montgomery Securities 1,303 34
Robertson, Stephens 1,204 28
JP Morgan & Company 1003 13
Hambrecht & Quist 964 30
Bear, Stearns & Co. 846 14
Cowen & Co. 608 17
William Blair 560 11
NatWest Markets 522 11
Dillon, Read 510 14
PaineWebber 438 10
Oppenheimer & Company 399 14
Prudential Securities 377 7
Friedman, Billings, Ramsey & Co. 327 13
Furman Selz 317 7
UBS Securities 314 9
Nesbitt Burns Securities 262 1

Top 25 Totals 44,629 545
Market Totals 50,013 874
Source: Securities Data Company, Newark, NJ

During the first half of 1997, the average-sized offering for the 163 deals done by the dominant firms was $93 million ($15.2 billion/163). For 1996, the average size of the 545 deals done by the larger and national firms was $81 million ($44.6 billion/545 offerings). Both of these averages, though high, are illustrative. They mean most of the house hold names in investment banking donzzt look at IPOs between $5 million and $15 million. In truth, they canzzt because the deal isnzzt big enough to make the required fees and aftermarket trading profits.

What the rankings donzzt say is who is doing all the other deals. Itzzs important to find out since, in 1996, these other deals represented 40% of the market and their average size, $16 million, represents a scale which opens up possibilities to many more companies looking for capital. The answer is that the lionzzs share of these offerings were done by the boutique brokerage firms many of which specialize in public offerings for smaller but established as well as embryonic companies. These boutique brokerage firms often espouse, (but do not always practice) the concept of public venture capital.

• If your company is a shooting star, and you envision that after an IPO it can reasonably be company valued at more than $100 million (total shares outstanding times price) aim for the Majors, the regional powerhouses, or to be a big fish in a little pond, the regional underwriters.

• If your company is a shooting star, and you envision that after an IPO it will be valued at less than $100 million (total shares outstanding times price), target the boutiques and regionals in your search for an investment banker.

Finding IPO Underwriters
There are a number of directories which publish lists of investment bankers. For entrepreneurs these can be confusing to the point of stifling progress. The complexity of investment banking often conspires with the inherent pitfalls of directory publishing and the result is lists of would-be investment bankers that have little or nothing to do with initial public offerings. Unfortunately, entrepreneurs looking for capital that donzzt know any better pursue these bankers anyway, and end up running down blind alleys.

• Avoid financing directories in your search for an underwriter.

If you cold call an investment banking firm, the likelihood they will take you public is almost nil. Sure, it happens, but the odds are against it. According to Cliff McFarland, a principal with Houston, Texas-based investment banking firm McFarland, Grossman & Company, “There are very few underwriters I know that will seriously consider even looking [italicize looking] at a business plan, that they do not have at least some connection with.”

While cold calling is generally unproductive, mass distribution of a business plan to potential investment bankers can be downright damaging. The ploy works well with angel investors, who, as a practical matter, donzzt talk with one another, and derive comfort from having others in the deal. But in the investment banking world, there is a lot of communication between deal makers. When a company is heavily [italicize heavily] shopped, investment bankers tend to find out and recoil. Worse yet, when discussing such a company with their contemporaries, they frequently miscommunicate important concepts and actually undermine an entrepreneurzzs chances of success of getting an audience with an underwriter.

• If you want to go public, donzzt cold call investment bankers and donzzt overshop your deal.

The appropriate channel to investment bankers who can take your company public are professional advisors including attorneys, accountants and in rare instances, financing consultants.

– Use Accountants. The “big six” accounting firms — Price Waterhouse, Arthur Anderson, Ernst & Young, Coopers & Lybrand, Peat Marwick and Touche Ross — are the dominant players when it comes to initial public offerings. Since accounting issues are often the largest and most time consuming in an initial public offering, these firms have intimate and longstanding relationships with investment bankers. As a result, referrals from big six accountants almost always result face to face meetings with investment bankers.

According to Bob Fish, a partner with Coopers & Lybrand in New York City, “connections with, and referrals to investment banking firms is part of what we are selling. Itzzs the value added component that we can bring to the table.”

Chances are, your accountant will recommend a firm that you didnzzt consider. Your research will pay off however, since you will have a framework to evaluate the quality of the firm your accountant is recommending. Incidentally, this is where the choice of a “big six” accounting firm will pay off. Since they are national in stature, these firms can make referrals in all 50 states.

Herezzs how it works according Coopers & Lybrandzzs Fish. “If you are in New York, and want to meet with underwriters in San Francisco, you have the partner in charge of your account call the west coast and find out who worked on the last five IPOs there. Your partner simply requests that the San Francisco staff make the required introductions.” If your chosen big six accounting firm is active in a region, the conversation on your behalf should go something like this:

zzHello Bill? Hi how are ya? Listen, I wanted to alert you to something. Wezzre having one of our clients back east send you their business plan . . . We just thought it was a situation you might be interested in . . . Yes, we do the audit work for them . . . No I talked to our partner there. He says the guy who runs it is a very solid guy . . . .So, listen, keep a heads up for this business plan . . . Izzll follow-up with a call . . .zz

Fish, who works in Cooperzzs New York High Tech/Venture Capital practice, says he makes similar calls on behalf of clients all the time. Hezzs quick to warn opening a door doesnzzt mean a deal will get done. It simply means the banker will take the call. But sometimes, thatzzs the hardest part.

• Hire a “Big Six” accounting firm if you want to go public.

Top Accounting Firms Ranked By IPO Proceeds

1996 Proceeds # of 1995 1994
Rank Company $ Billions Issues Rank # Deals Rank # Deals
1 Coopers & Lybrand $9,992 107 5 74 4 69
2 Arthur Andersen $8,728 154 1 91 2 91
3 Ernst & Young $8,364 168 3 107 3 118
4 KPMG Peat Marwick $7,635 118 4 68 6 85
5 Price Waterhouse $5,825 90 6 69 1 78
6 Deloitte & Touche $5,076 81 2 44 5 65
7 Grant Thornton $270 18 10 8 11 16
8 McGladrey & Pullen $240 1 9 4 9 10
9 Anjin Accounting Corp.* $203 1 N/A N/A N/A N/A
10 BDO Seidman $163 12 7 12 13 17
Industry Totals $50,027 873 674 846

* Based in Korea.
Sources: Public Accounting Report, April 15, 1995; Securities Data Company; PAR Research.

– Use Attorneys. Another path to an investment banker is through attorneys. Every initial public offering has at least two sets of lawyers: one for the company and one for the underwriter. When therezzs more than one underwriter on a deal — as there frequently is — then therezzs even more lawyers. Like accountants, attorneys have close, and in many instances longstanding relationships with investment bankers. In most cases, but not all, the underwriters genuinely trust the attorneys, and pay close attention to deals which they refer.

The following chart, compiled by SEC New Registrations Report, Washington, D.C., shows the top IPO underwriters during the first half 1997 by the number of deals they had in registration.

Top 15 Issuerzzs Counsel During The First Half of 1997

Value of IPOs in
Registration # of IPOs in
Firm (in $ Millions) Registration

Shearman & Sterling 1,950 5
New York, NY

OzzMelveny & Myers 1,602 7
Los Angeles, CA

Sullivan & Cromwell 1,288 5
New York, NY

Latham & Watkins 992 7
Los Angeles, CA

Paul, Weiss, Rifkind,
Wharton & Garrison 955 2
New York, NY

Goodwin, Proctor & Hoar 944 2
Washington, DC

Cravath, Swaine & Moore 847 2
New York, NY

McGuire, Woods, Battle & Boothe 789 3
Richmond, VA

White & Case 689 2
New York, NY

Simpson, Thachter & Barlett 631 2
New York, NY

LeBoeuf, Lamb, Greene & McRae 613 2
New York, NY

Weil, Gotshal & Manges 609 4
New York, NY

Rosenberg & Liebentritt 603 1
Chicago, IL

Cleary, Gotlieb, Stein &
Hamilton 577 2
New York, NY

Cahill, Gordon & Reindel 515 2
New York, NY

Source: SEC New Registrations Report

Top 15 Underwriterzzs Counsel During The First Half of 1997

Value of IPOs in
Firm (in $ Millions) # of IPOs

Davis Polk & Wardwell 2,517 10
New York, NY

Sullivan & Cromwell 2.476 5
New York, NY

Skadden, Arps, Slate,
Meagher & Flom 1,953 9
New York, NY

Shearman & Sterling 1,891 9
New York, NY

Simpson, Thachter & Barlett 1,551 11
New York, NY

Fried, Frank, Harris,
Shriver & Jacobson 1,358 4
New York, NY

Cleary, Gottlieb, Stein &
Hamilton 890 3
New York, NY

Dewey Ballantine 793 3
New York, NY

Hogan & Hartson 679 2
Washington, D.C.

Brobeck, Phleger & Harrison 589 16
San Francisco, CA

Wilson, Sonsini, Goodrich
& Roasti 491 12
Palo Alto, CA

Cahill, Gordon & Reindel 459 2
New York, NY

Bass, Berry & Sims 447 1
Nashville, TN

Rogers & Wells 404 4
New York, NY

Latham & Watkins 385 4
Los Angeles, CA

Source: SEC New Registrations Report

In the same way that lists of leading IPO underwriters can be misleading, so too can lists of professional advisors. There are a number of highly active law firms that donzzt make the charts. To find the firms that can lead to investment bankers, entrepreneurs or their consultants need to dig a little deeper.

• To find attorneys with IPO experience visit www.ipocentral.com or a professional or trade library which subscribes to the SEC New Registrations Report, published by The Washington Service Bureau, 655 15th Street, NW, Washington, DC. 800-955-5219.

– Use Financing Consultants, But With Caution. Another route to an investment banker which can do your deal is through financing consultants. The use of consultants is controversial and at times risky. Some consultants are not qualified. Some overshop a company and actually undermine its chances of success. Some are prohibitively expensive.

For example, financing consultant Ytzik Grossman of Target Capital, New York City takes an equity position of two to nine percent in client companies. In addition, if he is successful in getting a company public, Grossman gets an annual retainer of $100,000. “Therezzs no doubt about it,” says Grossman, “Izzm expensive. But I get results. The underwriters I work with trust me and my deals go to the head of the line.”

Is hiring a consultant a good idea? For entrepreneurs that are sophisticated, know what they are doing and have the time to see the effort through, the answer is probably no. But for entrepreneurs that do not know what they are doing, have never raised a dime, and do not have a lot of time, the answer is qualified yes.

The advantage a consultant offers can be likened to value an insurance agent brings to the table. With intimate knowledge of several carriers, an agent can often do a better job of finding someone insurance than they can on their own.

But just like a bad insurance agent will get you bad insurance, a bad financing consultant will likely get you undesirable financing. So, herezzs what to look for and do.

* Structure Fees Carefully. Contingency arrangements may save fees, but several things can go wrong. First, if prolonged effort is required, they may run out of steam. Second, if they donzzt run out of steam, they might push a certain transaction, not because itzzs in the best interest of their client, but because itzzs the fastest route the closing table and their back end fee. Third, and this may sound odd, but entrepreneurs tend not to take the advice, or respond to the needs of professionals whom they are not paying. This can cause the consultant to become prematurely discouraged and often leads to the collapse of the relationship.

The ideal fee structure is often a modest monthly retainer with a success fee, usually a percentage of the capital raised, or more often for smaller deals, an equity stake in the company, on the back end.

• While an equity makes for a good working relationship between entrepreneur and consultant, the contingency payment can get in the way of closing a transaction.

In the case of public offering, investment bankers sometimes refuse to pay intermediaries because it reduces the amount of compensation which they are able to earn from a deal per National Association of Securities Dealers regulations. And sometimes in private transactions, the investor wants all [italicize all] of the proceeds in the company and working, instead of paying off a financial intermediary.

Experienced consultants know this of course and shop their deals to sources of capital that protect their fees. But as often occurs in financings, the outcome comes down to random events, with investors the consultant has never worked with. Situations can get sticky with the entrepreneur actually mediating between the would-be investors and their own consultants.

• You can avoid many of the problems of equity compensations by having consultants buy their equity cheaply before the search for capital begins.

Of course if the consultants donzzt produce, the entrepreneur has unwanted, and sometimes cantankerous minority shareholders. The whole process is structurally imperfect and as a result, plain old fees are sometimes the best way to go.

* Have a 60 day out-clause in the contract. If you arenzzt in front of sources of capital within this time frame something is wrong and your deal is probably.

* Check references. Itzzs amazing how many entrepreneurs hire consultants without looking into their past. To do this speak to the principals of three firms the consultant has worked for. Did they add value? Did they do what they said they would? Did they act professional? Most importantly, did they raise the money? [italicize did they raise the money?]

The complete absence of codified professional standards when it comes to raising money probably accounts for the voluminous number of financing consultants. In truth, anybody can hang out a shingle and do it. This doesnzzt mean financing consultants arenzzt qualified, but it does mean that not all of them are.

• The first rule when considering whether or not to hire someone to help you raise money is buyer beware.

Evaluating Investment Bankers
The quality of investment banking services varies significantly from bracket to bracket and firm to firm. The endpoints run from superior to scandalous. Even professional advisors who recommend and or open doors to investment banking firms are not always aware of how good the firm really is. Since the costs of filing, to say nothing of consummating, an initial public offering are in the neighborhood of $200,000, entrepreneurs must be able to critically evaluate underwriters. Can the underwriter get the company to the closing table? Can they do it with a minimum amount of trauma?

Below is a technique for evaluating the skill of an investment banking firm and the likelihood that they will be interested in your deal,

Collect the following information on each deal put into registration by an underwriter over the past year (past two years is possible): 1) initial offering price range; 2) IPO price; 3) percent difference between range and actual price; 4) number of days in registration; 5) the earnings per share of the company at the time the underwriter took it public and associated price earnings ratio; 6) the price of the shares or units two to three months after the offering and 7) the auditor, company counsel and underwriterzzs counsel. To get this information:

• Visit www.ipocentral.com.

• Review Going Public: The IPO Reporter published by IDD Enterprises, L.P., New York City.

* Underwriters which have done just one IPO over two years are probably not candidates. There are many possible reasons for their low IPO count. They may have gone out of business, their one offering may have been a disaster, if not in the market, then perhaps internally, or in many instances, they donzzt do IPOs as a general rule, but underwrote this one offering because of unique circumstances.

* Underwriters Which Have Done Just Two IPOs Over The Past Two Years Are Good Candidates. From a qualitative standpoint anyway. New issues are hard to do, and a one deal per year clip is a respectable pace. It also means the underwriter is in a position to devote a substantial portion of their resources to supporting deals in the aftermarket. But at the same time, firms which do just one initial public offering per year are pretty choosy about the company they eventually commit themselves to.

* Boutique Underwriters Which Have Done Four To Eight Offerings Over The Past Two Years Are Good Candidates Too. While this firm clearly knows itzzs craft, the fact they bring one offering to market each quarter has several implications, so, caution is required. First, the corporate finance personnel or principals at these firms are on overload all of the time, and, as a result, are very difficult to reach and sell to. Second, new offerings they commit to may get short shrift while other deals get done. Third, with so many offerings in the aftermarket, they may not have the capital to provide any meaningful support. For these underwriters, check to see how many offerings they put in registration but never completed, the number of days their issues spent in registration (more than 135 days on a consistent basis spells trouble), and how many of their offerings are trading above their offering price.

* Disregard Geography. Unlike private investors whose radius of interest is generally confined to no more than a three hour drive, east-west coast connections are common.

* Look At Earnings Per Share Of The Underwriterzzs IPO Candidates. If every one of an underwriterzzs offerings have been done for companies with positive earnings, and your company has no or negative earnings, therezzs probably not a match.

* Look At The Aftermarket Performance For Each Of The Underwriterzzs Deals. If they are all way up, say more than 50%, itzzs an indication the firm prices deals too cheaply. Remember, if you sell 60% of the company for $10 million, and the price more than doubles in the aftermarket, it means the same amount of capital might have been raised by selling only 30% [italicize 30%] of the company. An underwriterzzs miscalculation costs company founders precious points of equity. If the deals are way [italicize way] up, it could indicate irregularities in the underwriterzzs trading practices. Finally, on the other side of the coin, if the underwriterzzs deals show a pattern of dipping below their IPO price three months after the offer, it indicates an inability to support their issues in the aftermarket. The ideal aftermarket performance would be a 10% to 15% premium in the share price during the first three months after the offering commences trading.

* Look At The Difference Between The Filing Range And The Eventual Price Of The Initial Public Offering. The filing range is just that, the range of prices at which the issue may come to market according to the preliminary [italicize preliminary] prospectus, and is generally expressed as something like zz$9 to $11zz or zz$5.50 to $7.50zz. Does the underwriter show a pattern of filing at $6 to $8 per share or unit and bringing their deals to market at $5? Sure, market conditions may have played a role in the price reductions. But a pattern such as this may also mean the underwriter plays hardball by threatening to pull the plug on the deal at the last minute unless the company accepts a lower price.

* Try To Spot Industry Preferences. Itzzs unlikely that among boutique brokerage firms youzzll find any. But if a brokerage firm seems to favor a particular business or type of company — say consumer products, services, technology, manufacturing — that matches your own, itzzs more likely theyzzll to want to talk.

* Look At The Number Of Days The Underwriterzzs Companies Spent In Registration. If they are, on average more than 90 days, itzzs a sign the underwriter is not skilled in initial public offerings.

* Look At How Many Offerings The Underwriter Took Into Registration But Never Completed. The costs of filing are too high to risk on an underwriter that leaves them at the alter. In addition, investment bankers resist completing someone elsezzs broken deal, so if you file but donzzt make it, your company is damaged goods.

Courting the Underwriter
there are several conventions of the initial courtship which should be followed to avoid immediate and inappropriate rejection. And make no mistake, it is a courtship that takes time, money and patience. Take note:

* Inspire Confidence That You Can Pull It Off. Given all the hurdles it takes to go public, itzzs a miracle that any firms ever do. Investment bankers know this. So theyzzre not only looking for solid businesses, theyzzre looking for entrepreneurs that can move mountains. According to investment banker John Lane, “A mediocre company with can do management will more often go public than a great company with naive management.”

* Donzzt Try To Negotiate The Investment Bankerzzs Fees. Compensation is regulated by the National Association of Securities Dealers (NASD), and for deals under $15 million, the bankers take the maximum allowable compensation, period.

* Disclose Problems You Have Up Front. Even though you might be putting up $250,000 to $500,000 to get the deal done, by the latter stages of the offering, the underwriter is in just as deep. Therefore, as a matter of practice, most investment bankers commission a detailed background check before they issue a letter of intent. If it turns up irregularities that you tried to conceal, kiss your offering good-bye. Besides showing your wart voluntarily, makes you more human, an in some instances, actually helps forge a bond.

* Show you can sell. Your underwriter will depend on other underwriters to get the deal done. If the investment bankers senses you canzzt get other underwriters excited about your offering, itzzs over. And the selling doesnzzt stop when the deal is over. Youzzve got to inspire confidence that you can keep selling the company once it starts trading. If not, then the underwriter knows when the shares start to come back, it will be all his or her burden alone to either take them back in or resell them again. In fact, given all of the structural inefficiencies in the market and the downward pressure they place on the shares of newly public companies, itzzs when the IPO is done that the selling really [italicize really] begins.

* Donzzt attempt to hide the fact that you want to get rich. Itzzs a turn off because the underwriter knows thatzzs exactly why you want to go public. By trying to obscure this fact you demonstrate a less than candid demeanor. Even if your motivations are not purely monetary, keep them in check because it will cause the underwriter question whether or not you are driven by the proper set of motivations. Which racecar driver would you like to back, the one who wanted to win or the one that simply liked driving fast?

* Donzzt argue about the value they place on your company. Your choices here are pretty limited. Swallow hard, or walk.

* Show you are in it for the long haul. The underwriter canzzt sell a deal where the management isnzzt going to be there in 18 months, so they donzzt bother trying. If during the initial conversation with the investment banker you say zzmy idea was to flip this deal to the public, and then move on to something else,zz then moving on is exactly what you will end up doing.

* Donzzt tell tall tales. If your sales are zero today, but will be $350 million next year, the underwriter will probably let you get off the phone, in light of all the work you have to do.

* Donzzt attempt to negotiate the sale of your own shares in the initial public offering. It happens all the time, in larger, more developed companies. But for smaller IPOs, itzzs rare. Sure it never hurts to ask, but if you make the sale of your own shares a condition of the negotiations, then there likely wonzzt be any negotiations.

* Never burn a bridge. No means no. But it also means maybe. The fact is, most IPOs take so long to shop, that when all is said and done, investment bankers who said no when you first started may say yes a year later when you are still looking. Many times, their objections such as no earnings, incomplete management team or unproven products will be overcome in the intervening time, and therezzs good reason to call the banker back and rekindle discussions.

Regrettably, how to move from the initial contact with an investment banker, to a letter of intent, to a deal and a six to eight figure check is beyond the scope of this work. Companies that are in serious discussions with underwriters should have a team of advisors that includes the board of directors, as well as counsel and auditors with IPO experience, to help guide them through the process.

In fact, if these advisors are truly doing their jobs, they should have already filled company founders in on all the reasons an IPO may be a bad idea. For some companies, the IPO is, as Winston Churchill so elegantly put it, not the beginning, nor the end of the beginning, but the beginning of the end.

Donzzt Go Public
Perhaps the best reason not to go public is that so very few companies successfully negotiate the process.

One reason is that the investment bankers who typically underwrite earlier stage companies to the tune of $5 to $15 million, have almost the same growth hurdles as institutional venture capitalists — that is, compound annual increases in earnings of at least 25%. Many investment bankers even refer to IPOs for emerging companies as “public venture capital,” though their investment horizon tends to shorten dramatically once the issue starts trading.

Another reason that so few deals get done is that most investment bankers who underwrite initial public offerings are unwilling to take risks on perfect strangers. Therezzs plenty of legal exposure even when they know where all the warts are. So, in the majority of cases, investment bankers end up working on deals that are in some way already wired into their own network of personal contacts. Incidentally, this goes a long way toward explaining why, if investment bankers are so choosy about the companies they finance, how so many incredibly unworthy companies get underwritten.

– Why Most Deals Die Before They Even File. “Market conditions,” wipe out a slew of deals that are in the pipeline and ready to go. But many, many more offerings topple in the negotiation stages or during the process of drafting a registration statement. In short, tens of thousands of deals never even see the light of day. According to Tony Petrelli, a Denver Colorado-based investment banker with 25 years experience, “There is a wide, but essentially predictable range of reasons that initial public offerings do not get past the negotiation or drafting stage.” Petrellizzs top 10 list:

* The investment banker insists that founders and other inside shareholders “lock-up” their shares, i.e., not sell them on the open market for a period of 2 years, and the founders refuse.

* The entrepreneur has legal problems, civil or criminal, not disclosed up front and the investment banker finds out on his or her own.

* The company is sporting a set of financial statements that, when restated in response to Securities and Exchange Commission “comments,” go from reporting profits to reporting losses.

* The company founders take a hard line on the fees the investment banker charges.

* The company and the underwriter cannot agree on the valuation of the company.

* The owners and senior management of the company prove they are unable to sell the deal to other underwriters that will be part of the selling group or syndicate.

* The industry or sector that the company is competing in, for one reason or another, falls out of bed with Wall Street.

* Some nuance of the offering prevents it from getting clearance in a state that is vital to the underwriter.

* The company cannot afford the $250,000 “dry hole” expenses for legal, audit and printing fees.

* The registration period becomes so long that the company must update their preliminary prospectus with new financials, and these figures show a marked decline in performance. Regrettably, the faltering financial performance is often directly attributable to the amount of time management has spent on the deal.

• To successfully complete an IPO in the range of $5 million to $15 million, most companies will have to give in on the underwriters demands regarding valuation, fees and lock up agreements.

– Many Completed Offerings Are a Disaster. In the most straightforward terms it comes down to this: there are several structural reasons why tiny companies that go public will see their share prices decline over time rather than rise. When this happens, all of the reasons to go public in the first place — such as easy access to capital, estate planning, a currency for acquisitions — become null and void.

Here are the primary zzstructuralzz challenges that place continuous downward pressure on so called micro capitalization stocks.

* Competition is intense. There are 3,300 stocks trading on the New York Stock Exchange, 750 on the American Exchange, 6,500 on Nasdaq (plus another 5,800 issues trading on NASDAQzzs Bulletin Board) and some 6,300 mutual funds.

Every security is competing for the attention and the investment dollars of investors. The upshot is that a newly public microcap stock is all but invisible to most of the individual investors who can buy it. And even when, per chance, they hear about the stock, the investorzzs thinking might run something like this: zzLetzzs see, I can buy Microsoft, which trades over 5 million shares a day, and whose biggest problem seems to be the threat of antitrust action from having cornered [italicize cornered] the market. On the other hand, I can take a flyer on this company I barely know, trading in the lower depths of the market with potentially revolutionary, but as yet unproven technology . . . .zz Under this regime, even if a company is doing well it can languish, itzzs price inching downward as investors, edgy over the lack of action, continue to put in sell orders.

As a case in point consider U.S. Transportation Systems Inc. (Nasdaq: USTS), which manages the transportation needs of corporations. With solid growth in earnings growth over the last three years, and the transition in earnings from a net loss in 1993 and 1994 to average net income of over $1 million per year in 1995 and 1996, USTS still canzzt get any respect from the market. With a price earnings ratio hovering just over 3 times trailing earnings, US Transportation stock seems cheap. In fact, considering that the average P/E ratio for a Dow transportation stock was 15.4 at the dawning of 1997, U.S. Transportation is getting just 20% of the valuation which the market offers similar companies.


The landmark work on valuing stocks called Security Analysis: Principles and Technique by the late Benjamin Graham and David Dodd postulates the market will always find value in a stock no matter how obscure the value or the issue may be. This notion still holds true today, and is the cornerstone idea for hundreds of billions of dollars under management. But old Graham and Dodd were canny. They never said when [italicize when] or how long [italicize how long] it would take the market to recognize the true value of a stock. For many tiny companies that are public, with their stock way under water, it seems to take forever.

* The investment bankerzzs capital is limited. Most entrepreneurs believe that once public, market forces will take over and naturally regulate the price of their stock. But once a chief executive comes face to face with the invisibility of their deal, they begin to see just how important, and in most cases, just how inadequate, their investment bankerzzs capital is.

Herezzs what happens. Three months after the initial offering, all of the shares so carefully placed with other brokerage firms, and with the leading underwriterzzs best customers start to come back on the market through sell orders. Because the deal is tiny, gets little attention, and has no major Wall Street research coverage, there are no buyers, except of course, the leading underwriter, which has a major stake in the offering, and a damaged reputation if the deal flounders. But how much stock can they take in? The amount depends on several factors, but most fundamentally, on the underwriterzzs willingness to tie up capital inventorying stock. [Italicize previous sentence]

The first key word in the above sentence is willingness. [italicize willing]. Spencer Marcum, an investment banker in Denver, CO, once remarked: “The problem with most brokerage firms is that they think they are in the moving business, when in reality, they are in the storage business.” Many underwriters, he says, are simply not willing to take in and hold stock for a prolonged period of time.

The second key word is amount [italicize amount]. Consider for a moment the numbers involved. The underwriter sells 1 million shares at $8 per share, and the issue trades up to $10. Now 200,000 shares come back. Does the underwriter have [italicize have] $2 million in capital they are willing [italicize willing] to tie up buying these shares? The answer is that most underwriters doing $8 million offerings donzzt have enough capital to support all of the deals they are involved in. In fact, of the 478 brokerage firms that are members of the Securities Industry Association — clearly not all brokerage firms, but definitely a good sample and one that supposedly represents the larger [italicize larger] firms — two thirds have less than $15 million in capital. And many of these have less [italicize less] than $1 million in capital.

So, the underwriterzzs likely response to the 200,000 “incoming” is to lower the bid at which they are willing to buy “loose” stock, and minimize the hit to their capital. This lowering of the bid is in fact, a decline in the price of the stock, which often sends a ripple of fear through the market causing still more shares to come onto the market. The new sell orders put further pressure on the bid, and the spiral begins.

* Institutionalization of the markets/Focus on larger capitalization stocks. One way to measure the change in scale of the U.S. stock markets is to look at the inflation of the word small capitalization [small capitalization] or smallcap companies. In the latter 80s, smallcap stocks were those with market capitalizations of less than $100 million. In the early 90s, the term came to mean those with market capitalizations of $100 million to $250 million. While there are still some investors that stick with the neoclassical definitions, today itzzs not uncommon to find money managers running small caps funds that are buying stocks with valuations of $500 million to $1 billion.

One of the primary reasons for this inflation has been the institutionalization of the capital markets. What does this mean? That individuals are investing more through mutual and pension funds, i.e. institutions, than they are on their own. According to the Investment Company Institute, Washington D.C., 36.8 million U.S. households own mutual funds — a 20% increase over mid-1994.

While individuals derive substantial benefits by investing this way, it has dramatically changed the character of the market. Specifically, when a mutual fund manager has say $500 million under management, they might take positions of $2 million to $10 million in portfolio companies. When these companies have market capitalizations of $300 million, the portfolio manager can easily trade in and out of positions without affecting the price.

But what about when the company has a market capitalization of $15 million? For the same portfolio manager with $500 million to manage, really [italicize really] small companies are no longer feasible investments. Itzzs like a formula one racer on a go-cart track: there simply isnzzt enough room for them to move in and out of the traffic — at least not without causing the kind of accident that might hurt themselves and a lot of other drivers on the track.

The damage wrought by this institutionalization, from a capital formation perspective, is twofold. First, itzzs taken a lot of individual investors out of the market. Second, it means that all of the liquidity (i.e. the ease with which shares can be bought and sold) in very small stocks is limited to the remaining few individual investors who donzzt have the muster to create an active trading market for all of the public companies out there.

• Company performance, market conditions, supply and demand can mean nothing when it comes to the price performance of a micro capitalization stock. What may ultimately determine the price is the amount of capital the underwriter has and is willing to put on the line.

– Living With Structural Defects. Prestige, quick access to capital, a currency for acquisitions, attracting skilled employees, growing the company into a successful venture and becoming a millionaire, are all achievable with a public offering. The huge risk is that if the stock doesnzzt perform well — and there are a whole lot of reasons unrelated to economics why it might not — these benefits may actually become more difficult to realize than if the company simply stayed private.

For some companies the structural inadequacies of the market are not a problem. After the capital is in their [italicize their] possession. Over time, if they can grow the company with that one discrete lump of funding, then a la Graham and Dodd, perhaps the stock will one day be fully and fairly valued.

As a case in point, consider once tiny Simula, Inc., which went public in April of 1992 by raising $5 million with a market valuation of just $11.9 million. Today the company trades on the New York Stock Exchange with a market valuation of more than $150 million. Simula manufactures crash worthy aircraft components with its core products in aircraft seating systems.

Since going public, Simula raised additional equity in private offerings and utilized its growing equity base to raise additional debt financing. In addition, as the stock responded the improving financial performance, Simula was able to use its common stock as a currency to consummate two acquisitions.

Founders and shareholders have been well rewarded in the process as well. Based on prices in early 1997, and adjusting for stock splits Simula common stock is trading at $25.50 per share, five times its initial public offering price. Founding shareholder Stanley Desjardins has seen his equity stake in the compete grow to more than $61 million.

Stories like Simulazzs continue to launch countless attempts at an IPO by starry-eyed entrepreneurs. The rewards are well known, but as the preceding analysis suggests, entrepreneurs should understand the considerable business risks involved in the process as well.

• Go public at your peril.

Chapter 4 – Alternative Routes To A Public Offering

The degree of difficulty associated with initial public offerings is unfortunate. It keeps many companies from accessing public investors. It also prevents public investors from cashing in on promising companies by financing them very early in their development the way professional venture capitalists do. (On a happier note however this barrier generally insulates public investors from the kinds of risks and losses institutional venture capitalists face.)

The real tragedy for entrepreneurs however is that there are other, often unused, ways to access public investors. In many respects these techniques are more appropriate than conventional offerings with all of their (lush as well as confining) trappings. Chief among these alternative techniques are 1) reverse mergers; 2) “exempt” public offerings and 3) direct public offerings.

Reverse mergers, and certain exempt offerings, are in some respects, indirect [italicize indirect] financing techniques. That is, they rely upon the idea that public companies, even ones without much of a trading market, can raise capital much easier than private companies with no market whatsoever for their shares.

• Create a public vehicle and the opportunities for raising capital become dramatically easier and more abundant.

The third technique, direct [italicize direct] public offerings, is, as the name implies, a way for companies to raise capital themselves without the aid of an investment banking firm. Direct public offerings are no easier than initial public offerings. However, company founders and senior management control the process, rather than a third party such as a brokerage firm. For many entrepreneurs, the degree of difficulty being equal, the comfort of being in charge is preferable to having to rely upon the competency of others.


Tiers of the OTC Market

Reverse Mergers
The idea behind a reverse merger is simple. A promising private business becomes public by acquiring or merging with an already public, though most often dormant, public company.

– A Case in Point
A textbook example of a successful reverse merger involves Cincinnati-based, LCA-Vision, Inc.

LCA founder Dr. Stephen Joffe already had a profitable hospital-based management business. But he saw a massive opportunity in establishing free standing centers offering laser refractive eye surgery, a procedure that corrects nearsightedness. There was just one hitch. The process was awaiting approval by the FDA. “The U.S. market,” according to Joffe, “might be as much as $10 billion, and grow as patient acceptance of the process increases.” While waiting for the approval, LCA-Vision laid plans for financing the huge roll-out of surgical centers in the United States and acquired an interest in a laser surgery center in Toronto, where the process had been approved.

Contemplating his options for financing alternatives, Joffe felt a straight IPO was doable, but highly unlikely for a new and untested concept. Itzzs not that he couldnzzt convince an underwriter of the potential. But could an underwriter convince other investors? What would happen if the FDA approval was delayed? With only one center under itzzs belt, wasnzzt the company really start-up?

But with a reverse merger, Joffe only had to convince the controlling shareholder of a public shell that the reward was worth the risk. And the controlling shareholder of a shell company which Joffe was talking with happened to agree.

In the ensuing transaction, Joffe acquired shares in the shell company in exchange for his contribution of the operating assets of LCA-Vision. At the end of the day Joffe had a majority position in the shell company, and the shell company had the operating assets of LCA-Vision. The public company then promptly changed itzzs name to LCA-Vision to reflect the new direction of the business.

The deal was completed in August of 1995. Sure enough in October, 1995 the FDA approved the laser refractive procedure used by LCA, and Joffe was off and running. Almost immediately after completing the reverse merger, Joffe raised $485,000 privately. Then he used his publicly traded common stock to purchase the remaining interest in the surgery center in Toronto. These funds, combined with favorable lease terms on surgical laser equipment helped Joffe roll out surgery centers in Cincinnati, New York City, Cleveland, Savannah, GA, Baltimore, Dayton and Toledo. After a brief honeymoon on Nasdaq’s Bulletin Board, LCA-Vision moved up to the SmallCap market in January 1996 under the symbol LCAV.

In a crowning transaction during latter 1997, LCA used its common stock to purchase Summit Technologyzzs Refractive Centers International subsidiary. In the deal, LCA issued 17 million shares of common stock and in return got Summitzzs 19 wholly owned and operated refractive surgery centers around the country. Of the 17 million shares issued to Summit, 9 million were the redistributed to Summit shareholders and significant broadened LCAzzs shareholder base. As an added sweetener, the subsidiary that LCA bought had a cash balance of $10 million at the time of the closing.

Today, LCA Vision is the largest provider of vision treatment procedures in the United States. Of the critics who sometimes downplay reverse mergers, (see Disadvantages below) Art Beroff, a New York City-based financier, the engineer of the LCA reverse merger transaction, and a nationally recognized expert on this kind of transaction says, “Itzzs not where you start that counts. Itzzs where you finish.”

– Advantages
* Reverse Mergers are Impervious to Market Conditions. Conventional IPOs derive a lot of their drama and tension from market conditions. That is, if the market is off, the underwriter may pull the plug on the deal. Or if an IPO candidate is in an industry thatzzs making unfavorable headlines, investors may shy away from the deal, causing it to implode. But not so with a reverse merger. The deal hinges on whether or not the people that control the shell believe in the operating private company and want to be acquired by it. Market conditions have little to do with the initial transaction.

* Shorter Timetable. A traditional public offering can drag on for months, sometimes more than a year. Unfortunately, the time it takes to do the deal is one of the most critical in a companyzzs life. The prolonged distraction of an IPO while the owners are trying to make the transition from an entrepreneurial to professional organization, can have disastrous effects, and even nullify the growth upon which the offering is predicated. In addition, during the many months it takes to put together an IPO, market conditions can deteriorate, closing the “window” on a company. By contrast, circumstances permitting, a reverse merger can be completed in as little as 45 days.

* Lower Costs. By most estimates, a traditional IPO requires a company ante up at least $200,000 in legal, audit and printing fees just to get a preliminary prospectus on the Street. To drive the deal to the closing table, the costs go even higher. A reverse merger, on the other hand, can be completed for $60,000 to $100,000 according to Beroff.

* Increased Financing Options. One of the primary reasons entrepreneurs should consider a reverse merger to begin with is to increase their options for raising additional capital. Some options that become viable are:

1) The issuance of additional shares in a secondary offering. Though theoretically possible, this approach is highly unlikely because there is very little, if any, trading market for the existing shares let alone new ones.

2) The issuance and exercise of warrants. Warrants are similar to options, which give the holder the right to purchase additional shares in a company at predetermined prices. When many warrant holders exercise their option to purchase additional shares, the company receives an influx of capital as in the diagram below.

Theoretical Exercise of Warrants to Raise
$2.5 million For a Newly Public Company

The exercise of warrants can be quick and easy, but itzzs not for everyone. First, the issuance of the additional shares may require a registration statement with the Securities and Exchange Commission — precisely the expensive and time consuming task that many companies are seeking to avoid with a reverse merger to begin with. Second, the exercise of warrants almost always requires the assistance of a brokerage firm. Finding the right firm can take a lot of time. More importantly, brokerage firms rarely cause warrants to be exercised according to the above model, but instead use a technique that is explained below in the section called “Disadvantages”.

3) Private Offerings. According to financier Beroff, perhaps the greatest impediment small private companies face when they are trying to raise capital is the liquidity issue. “If an investor likes a company, they tend to believe it will succeed. But their biggest fear is, even if the company does succeed, how will they get their investment back?”

Smart investors know that even a successful company may not be able to go public if the market conditions are off. But for a company that is already public, if it succeeds, the likelihood of developing a market for its common stock that accurately values the company and allows the investor to sell their shares, is much, much better. And for this reason says Beroff, “Private investors are much more likely to invest companies that are already public as opposed to those which still have that hurdle to leap.”

– Disadvantages. Reverse mergers are no panacea however. The technique has drawbacks as well. For some companies, the shortcomings of a reverse merger are negligible. For other companies, the shortcomings are insurmountable, making a reverse merger an inappropriate financing strategy. Among the disadvantages:

* Poor Image. Over the years, reverse mergers have gained their share of controversy. Itzzs easy to see why. To start with, the technique relies upon recycling, in most cases, a failed company. For instance, STN, Inc., the leading long distance reseller in Canada when that market deregulated at the beginning of the decade, was actively traded on Nasdaq as a promising up and comer. But STN became public through a reverse merger with Rawhide International, a dormant natural resources company trading on the Alberta Stock Exchange — all in all not the kind of pedigree that made Wall Street analysts and investors beat a path to the companyzzs door.

The poor image of reverse mergers is exacerbated by the way in which warrants are often exercised on their behalf. Firms that complete a reverse merger and hire a brokerage firm to exercise their warrants often see the process executed as follows:
Warrant Exercise When Brokers Sell Short

The problem is that at the end of the day, public investors are holding stock which they purchased for $7.00 per share. Note also the broker took in $3.5 million, but contractually only had to remit $2.5 million to the company. The broker made $1 million, less what it cost the firm to purchase the warrants. The company is capitalized, yes, but the brokerzzs pockets have been handsomely lined by public investors now holding expensive stock; management is under enormous pressure to make the company worth what investors paid for it.

All of this maneuvering is made possible by the unfortunate fact that, with the issue trading thinly, itzzs easy to create an arbitrage between the price of the common stock and the exercise price of the underlying warrants. The many implosions that have occurred on the heels of such financings have tarnished the reputation of reverse mergers.

* Interaction with the Unknown. In most cases, a reverse merger transaction leaves a company with a shareholder base that new management does not know. These shareholders can cause difficulties by continually selling their shares as a new trading market develops. In addition, creditors, and other parties injured by the predecessor company can step forward and make claims. Unfortunately, when there are new operating assets in the company, the incentive to make these claims is increased.

* Indirect Source of Financing. Reverse mergers are not an end in themselves, but most often a way to make a company financeable by some other transaction. Though reverse mergers are theoretically quick and easy, there is, as with any securities transaction, enough land mines to make the process tortuously long and complex. But in most instances, just doing the deal is the halfway point in the race. When itzzs done, capital still has to be raised.

As a case in point, consider San Diego-based PMR Corp. which merged with shell company Zaron Capital Corp. in 1988. PMR develops and manages psychiatric programs for hospitals. Though Zaron was a “clean” shell with no predecessor entities, the original reverse merger transaction took nearly a year [italicize year]. And when the deal was done, PMR didnzzt have any more capital than when it started the process. But the wait was worth it. PMR quickly raised additional capital and the company, which now trades on the Nasdaq market, was the highest percentage gainer on the American Stock Exchange in 1996, returning more than 450% to investors during the year.

* Difficulty in Developing a Market. Even though an exciting private company merges with a public company, it doesnzzt mean the markets will sit up an take notice. Continental American Transportation, near Atlanta, GA, merged with a shell corporation, and through a series of acquisitions, became one of the 20 largest trucking companies in the United States. Nonetheless, trading remained erratic, with the common stock barely responding the underlying growth being built by the new management team.

• Entrepreneurs seeking the benefits of a true public company will spend as much time and effort on the back end developing a market as they would have on the front end finding an investment banking firm.

– Strategies & Next Steps for a Reverse Merger
* Find A Shell. The sources are fairly predictable. Ask an attorney. Every metropolitan area — even if itzzs not a hub of finance — has a law firm with an active corporate securities practice. More than likely, the firm has a dormant public company literally sitting on itzzs shelves. If it doesnzzt, the firm has worked on a case that resulted in the operations of a public company closing down or ceasing altogether. Though it never hurts, you do not need a warm body introduction to call a securities lawyer about a shell corporation. They are obligated to field such overtures, because dormant or no, it is in the best interest of the public company which they represent to respond to inquiries which could have an influence on shareholder value.

An equally likely alternative is an accountant. Anyone that controls a dormant public company knows its value, and as a results keeps its financial statements, such as they are, current. If the shell is a “reporting” company, meaning it makes quarterly and annual filings as per the Securities and Exchange Act of 1934, then its financial statements must [italicize must] be audited. In either event, a good accountant can lead you to shell companies.

* Devise a Financing Strategy. Remember, the reverse merger is an indirect route to raising capital. Thought must be given first to how the creation of a public company will be utilized to bring capital in the front door.

If a warrant exercise is contemplated, then you must find a company to merge with which not only has warrants outstanding, but which also has registered the underlying shares with the Securities and Exchange Commission. In addition, companies which want to raise capital by exercising warrants, despite the potential pitfalls, must find a brokerage firm to assist with the transaction.

If a private offering will be sold after the company becomes public, i.e., a private placement, then the reverse merger must be very carefully structured. Specifically, the amount of “loose stock” — that is stock owned by investors that the new owners do not know, and cannot influence — must be minimized so that a stable bid and ask quote can be established. By doing so, the private investors can be offered a discount to the market price of the stock as an added incentive.

For example, if the quote on the stock is $5.00, private investors are offered the opportunity to purchase common stock at $3.00. This incentive will disappear however when sell orders flood the market, and the price of the common stock dips down to $2.00.

Not that any smart investor is going to think they can buy common stock in a private transaction for $3.00 and the turn around and sell it on the open market at the $5.00 bid. Itzzs simply easier to sell a private deal where there is some immediate upside to point to, and a clearly defined “exit” strategy for the investor if the company prospers.

* Lead A Path To The High Road. Dr. Stephen Joffe, chairman of LCA-Vision, who used the reverse merger technique to such brilliant effect, said that although it was the right path for his company, “therezzs definitely a stigma attached to them.” Largely, he believes, this is because the process is misunderstood.

Entrepreneurs can however take steps to elevate the profile of their deal. Specifically, consider taking one or all of the following steps:

• Hire a “big six” accounting firm. Nothing inspires confidence more than an unqualified opinion from one of the national firms.

• Hire a white-shoe law firm. While most financial professionals and intermediaries believe that lawyers are sharks, they still prefer to swim with the better ones.

• Look for merger candidates that do not have any predecessor entities. If a public company has failed operations in its recent past, or even distant past, some of the tarnish can rub off on you.

• Donzzt be greedy. Many reverse mergers are structured so that at the end of the day, the public owns as little as 5% of the company. Unfortunately, therezzs almost no incentive for any other investors to get involved if the only people who truly benefit are the insiders. If you are going to get the public involved with the intention of engaging in a truly symbiotic relationship, leave some value on the table.

In many ways the rap afforded reverse mergers is akin to the reputation of Junk Bonds (or High-Yield Debt, as they were referred to by the professionals which sold them) during the 80s. Sure, junk was used by corporate raiders to buy companies and break them up and that made them bad. But junk bonds also nurtured a whole tranche of exciting growth companies like Medco Containment, Calvin Klein, and Hovnanian that, prior to the advent of junk, had no access to the bond market for want of an “investment grade” rating.

Reverse mergers, like junk bonds are simply a technique. The character the technique, in the final analysis, depends on the character of the people behind the deal.

Exempt Public Offerings
One of the larger impediments to an initial public offering is the registration statement that companies must file with the Securities and Exchange Commission, which requires among other things a set of audited financial statements. Itzzs expensive, time consuming and difficult.

Fortunately, small public offerings of $1 million or less can be exempt from registration. Specifically, Rule 504, of Regulation D, of the Securities and Exchange Act of 1933, — whew! — offers this exemption. In addition, several states offer exemptions from state securities laws for small public offerings. By structuring deals so they take advantage of exemptions at both [italicize both] the state and federal level, companies gain direct access to public investors absent many of the barriers associated with initial public offerings.

Plus, if the offering is done correctly, the shares can trade on Nasdaqzzs Bulletin Board stock market. Although the Bulletin Board is one of the lowest tiers of the Nasdaq Market, it still offers quotation and trading information on terminals around the world. The significance of this feature cannot be underestimated. As with the reverse merger, the creation of a public vehicle has almost incalculable value, and can dramatically ease the process of raising additional capital.

– A Case in Point
To see this technique in action consider the case of tiny independent film producer Twilight Productions in Hollywood California. With several years of film making experience under his belt, Eric Galler wanted to make films for the obscure but thriving low-budget segment of the market.

Rather than Wall Street, Galler raised approximately $60,000 for his company through an exempt offering by selling units to investors consisting of common stock and warrants. The warrants gave the holders the right to purchase additional shares at pre determined prices. With the funding, Twilight was able to produce its first film.

Although the initial raise was small, it was still significant because the company was able to list its shares on the Bulletin Board under the symbol TWIP. Now, with the rudiments of a trading market for its shares in place, Twilight was able to raise additional growth capital by causing its warrants to be exercised. Through this effort, Twilight received an additional $900,000.

Galler says the structure of the offering was a success for the company. “We were able to raise start-up funds inexpensively, and as we proved our concept, were able to take advantage of the trading market to raise additional funds.”

– Pros
* Easier Financial Reporting. Exempt offerings (also known as “504 offerings”) do not require audited financial statements. This is important, because audited financials, which are de riguer for initial public offerings, as well as some exempt offerings, will add no less than $25,000 to the cost of raising funds, and in some cases several hundred thousand dollars.

* Speedier Transactions. By removing the need to complete a registration statement, the speed with which funds can be raised are increased. At the federal level, companies need only complete a fill-in-the-blanks form, popularly referred to as Form D. At the state level, things can get a little more complicated however. Some states require detailed filings, while others require a simple notification which can be completed in minutes. (See Strategies & Next Steps for an Exempt Public Offering Below.)

* Lower Costs. As mentioned earlier, absence of audited financial statements reduces accounting costs. In the same vein, the absence of a complex registration statement reduces legal fees. All totaled, the costs for Twilightzzs $960,000 financing were in the neighborhood of $20,000.

* Gateway to Upper Tiers of the Nasdaq Stock market. Exempt offerings can, with relative ease, trade on the Nasdaq Bulletin Board. But if a company grows, and meets certain quantitative requirements, it can “graduate” to the SmallCap or National Market tiers of the market. See the sidebar in this chapter titled “Tiers of the Over the Counter (OTC) Market.

– Cons
* Limited Size. The 504 offerings discussed here are limited to raising $1 million in any 12 month period. For some companies, such as a restaurant, $750,000 is all the equity capital they will ever need. For others, such as a pharmaceutical development company, $1 million does not even begin to make a dent in the amount of capital that will be required.

* Limited State Exemptions. In forty three states, companies that take advantage of Regulation D at the federal level will find they have to file what is known as a Form U-7 — if they plan sell to more than a certain number of investors in the state. The number ranges from 5 to 35 investors.

Form U-7 is also what is known as a SCOR (Small Company Offering Registration) form. Although SCOR deals represent an advance in equity capital formation for small businesses, and a quantum leap in unifying the myriad state regulations into one agreed upon filing, itzzs no day at the beach. In fact, when all 50 questions of Form U-7 are answered, the end result, known as an offering circular, looks suspiciously like a federal registration statement, which is the time consuming and complicating paperwork which most small businesses are seeking shelter from. In addition, many states add suitability requirements to an offering, which dictate minimum net worth requirements for investors.

Testimony to the degree of difficulty associated with traditional SCOR offerings comes from the large numbers of companies that never make it through the process. According to Tom Stewart-Gordon, publisher of The SCOR Report, Dallas, TX, 65 to 70% of companies that try a SCOR deal fail. And he says, that doesnzzt include the untold numbers who attempt the filing, but never complete it because of the complexity, legal or accounting costs involved.

– Strategies & Next Steps for an Exempt Public Offering
Therezzs lots of ways to approach and complete a 504 offering. Below is a methodology which takes maximum advantage of state and federal exemptions and the ability to create a public vehicle on the Bulletin Board stock market. Clearly, however each companyzzs circumstances and requirements differ.

* Structure a deal. How much capital do you want to raise, and what percentage of the company will it represent? Entrepreneurs contemplating a 504 offering must come up with fast answers about what their business is worth (See Chapter 6, Valuing Your Business), and as a consequence, how much of it they must sell to get the capital they need. Whereas the reverse merger, as an intermediate step to financing, does not always provoke hard questions about valuation, a 504 deal, with the immediate prospect of selling securities to investors, does.

* Hire a securities attorney with experience in exempt public offerings. Although the exemptions from federal and state securities laws are meant to simplify the process — no securities transaction is ever simple. Donzzt attempt the process without experienced securities counsel.

* Line Up A Brokerage Firm. To create a trading mechanism on the Nasdaqzzs Bulletin Board, two brokerage firms must elect to “make a market,” in your companyzzs stock by filing certain forms with the National Association of Securities Dealers (NASD). For most brokers, market making in unregistered securities is not the kind of business they are looking for; therezzs little money to be made, and perceived regulatory risks. The best bet is a small, local brokerage firm which can get to know you and your business, or a referral from counsel.

* Sell Shares in New York, Florida, Washington D.C. and Colorado first. In addition to exemptions from their Blue Sky (i.e. states securities) laws for selling to an unlimited number of investors, these states do not restrict the resale of shares by individual investors. This feature is critical, because it allows for unrestricted trading to occur on the Bulletin Board.

Obviously for many companies and entrepreneurs, this is a difficult tactic. One strategy for overcoming the challenge is to raise just a small amount of capital in these states — perhaps as little as $25,000 — and use the existence of these sales to establish a quotation on the Bulletin Board. Use the power of having a “public” company to raise capital with investors closer to home in a private, intrastate offering, which with very few exceptions, are always exempt from a state securities laws.

Sound convoluted? Perhaps. But not nearly as convoluted as satisfying the requirements of some state securities regulators. Jim Smith, founder of Triex Group, Ltd., a specialty lighting company in San Leandro California, spent almost $100,000 in legal, accounting and printing fees getting a never completed SCOR offering registered to the satisfaction of the statezzs securities regulators during 1995. “That whole episode was a period in my life that I would rather not remember, he says.

* Purchase Coverage in Corporation Records, published by Standard & Poorzzs Corporation. Once the issue is trading on a recognized stock market, such as the Bulletin Board, investors in almost all states can purchase shares — not from the company but in a secondary market — provided there is detailed information on the company that is generally available to the public. Corporation Records, because of its wide distribution, and its role as the primary source of information for many investment databases and quotation services, adequately fulfills this role in they eyes of some 40 state regulators.

The ability of investors to buy and sell shares nationally doesnzzt put any capital in the companyzzs coffers per se. It simply makes the process of raising additional funds as a company grows much, much easier.

– A Case in Point
The Electric Car Battery Company, Solana Beach, CA, developed a new battery which inventor George Carlsen felt gave it enormous opportunities for electric vehicles on golf courses and in retirement communities.

According to Electriczzs chief financial officer Don Hutton, when the company needed capital to finish development and fund a commercial roll-out of the product, they chose to do a 504 offering, because, says Hutton “it seemed to be the most straightforward path to the capital we needed.”

Initially, the company raised $200,000 by selling 100,000 units consisting of common stock and warrants at $2.00 per unit. The company used a broker to help sell the units to investors in New York, Washington D.C., Colorado, and Florida.

The deal was completed during the third quarter of 1997, and with the funds, Hutton says the company will finish development of its battery and enter the market during the fourth quarter. During this time period, Hutton will also work to get shares of Electric Car trading on the Bulletin Board.

“The thinking behind our strategy,” says Hutton, “is that the combination of starting product sales in a thriving market, with some kind of trading or resale mechanism will make the job of raising the additional funds much easier than if we were strictly a private company.”

Direct Public Offerings
The primary difference between direct public offerings (DPOs) as opposed to reverse mergers and exempt public offerings (as they are described above) is, do a degree, philosophical. The underlying idea of a reverse merger and exempt public offering is to create a public vehicle first, which in turn will increase financing options. By contrast, the underlying idea of a direct public offering is to raise capital from a companyzzs natural affinity groups such as customers, suppliers, and members of the surrounding community — with little or no concern for whether or not there is a trading market.

– A Case In Point
After 10 years in business, Michael Quinn wanted to go national. But his Hahnemann Laboratories, Inc., San Rafael, CA, which manufactures homeopathic medicines, needed to become an FDA-licensed pharmaceutical manufacturer if it was actively market product across state lines. Where would Quinn get the capital to outfit a new facility?

“I went to a commercial bank, and they said, zzNo way,zz” recalls Quinn. Investment bankers werenzzt offering much comfort either. But Quinn had an epiphany when he realized that if just 200 of his more than 28,000 customers invested about $2,000 each, his Hahnemann Labs would have the patient equity capital it needed. Intrigued by the prospect, and given little hope from conventional sources of capital, Quinn marketed common shares himself in a $467,000 direct public offering.

Quinn sent out more than 35,000 offering announcements. Typically, people interested in alternative medicine, are not those typically interested in the stock market says Quinn. But his deal, which in a way was an alternative public offering, seemed to have a unique appeal to these investors.

The announcements resulted in about 1,700 requests for prospectuses. There were another 400 requests for prospectuses from friends, family, associates, colleagues and contemporaries. Of the initial 2,100 investors which received a prospectus, Quinn says that ultimately about 240 invested.

None of this work was quick or easy. Quinn started drafting his prospectus in July of 1994, and twelve and a half months later, in August of 1995, closed his dealzzs $430,000 minimum. And of his 240 investors, Quinn estimates that just 15%, or 36 investors sent in a check after reading the prospectus. To get the other 200 or so, Quinn had to dial for dollars. In all, he figures, that he talked to 700 to 800 investors on the telephone. Nor was any of this cheap, either. Legal, audit, printing and marketing costs totaled $102,000 says Quinn.

Although the entire effort took valuable time and resources away from the business, Quinn says it was not without benefits above and beyond raising the money. “Sure there were days when I wished I would run into just one person who had $500,000.” But he says there was a tremendous benefit to talking to so many customers and finding out what there needs and attitudes were. “Reaching out to so many people and telling your story is never bad for a business if itzzs done if done with the right kind of heart and attitude.”

In fact, sales of $691,000 during Hahnemannzzs fiscal year 1996 (ended June 30, 1996), — the period when Quinn was most preoccupied with selling the deal — were about $100,000 higher [italicize higher] than fiscal 1995. And the momentum has spilled into fiscal 1997, with sales of some $400,000 at midyear.

Quinn has not been concerned with aftermarket trading. He has left that to a stockbroker who keeps a “book” matching buyers and sellers. Most of the investors are holding onto their shares, says Quinn. Upside potential seems to be the reason. “It would be nearly impossible for one of the major pharmaceutical companies to grow 10 times bigger. But we definitely can.”

– Direct Public Offering Limitations. Attorney, consultant and author Drew Field, who wrote the book titled Direct Public Offerings, astutely remarks that a direct public offering is no less complex or challenging than an underwritten offering, “But it is a more manageable way to go,” he says. The reason is, with a DPO, entrepreneurs do not have to accommodate or rely upon investment bankers, which can prove difficult and dangerous. “You can manage a direct public offering just like you would any other project.”

But he counsels, entrepreneurs contemplating a direct offering of shares to the public must be able to move the company forward despite the limitations intrinsic to this technique. Incidentally, many of these limitations apply to reverse mergers and exempt offerings that trade on the Bulletin Board.

* Absence of Liquidity. Companies which, in addition to raising capital, must provide an immediate exit for earlier investors or accurate valuation of the company for estate planning purposes, will find that DPOs fall short in helping them reach their ultimate objectives.

* Stock Has Little Value as Currency. Companies that need use their common stock as a currency to acquire other companies should not use a DPO. Without a trading market, therezzs little reason, except a great deal of faith, that would cause someone to accept a companyzzs stock in lieu of cash. In truth, even companies which trade on the upper tiers of the Nasdaq stock market, as well as those on the American, and even the New York Stock Exchanges, often have trouble accomplishing this feat.

* Little personal gain. It would be all but unheard of for the founder of a company to sell his or her shares to investors in a direct public offering. In addition, with no active trading market therezzs little hope of selling them on the market after the deal is done.

In summary, direct public offerings provide a solution for companies that, in the next three to five years, need patient equity capital, and not much else. Once the needs start to extend beyond this, the effectiveness of this approach becomes compromised. In truth, however this is all most companies need anyway, even though many entrepreneurs become romanced by the idea of a full-blown IPO. The truth is, maintaining an active aftermarket, one of the chief burdens of an IPO, is precisely what causes many entrepreneurs to run their company into the ground.

– DPO Candidates. But even for companies which can operate this framework, a DPO still may not be viable. Success requires certain traits, which not all businesses possess. Field says good candidates will fulfill the following criteria:

* The Business Is Easy To Understand. Individuals who participate in DPOs tend not to purchase shares in companies which they do not understand. And because they are individuals, the scope of what they understand is much narrower than brokerages or institutions with research departments behind them.

* The Company Is Established And Profitable. The DPO process, which involves little direct selling, but a lot of reading and evaluation on the part of would-be shareholders. As a result, DPOs tend to attract investors that are more cautious than speculative.

* The Business Is Exciting. Direct public offerings require a lot of motivation on the part of the investors because of the restrictions placed on the selling activities of company employees. As a general rule then, itzzs difficult for mundane enterprises to inspire the required level of action among investors.

* The Company Has Natural Affinity Groups. Customers, clients, and the community in which the company does business all have an affinity for the company. And itzzs through this relationship that much of the direct public offering will be sold. One of the fundamental questions entrepreneurs face in this regard is whether or not the affinity they perceive is mutual, and strong enough to motivate prospective investors to consider their offering. In addition, is it possible to uncover the names, telephone numbers and addresses so that these people can be made aware of the offering? Though this can sometimes prove to be a vexing problem, the success of the offering may rest with overcoming it.

Based on these criteria, a lot of companies are candidates, but some clearly are not. For instance a manufacturer of stained glass windows for homes is a likely candidate . . . A biotechnology company at the R&D stage is not . . . An agricultural cooperative is a candidate for a DPO . . . A manufacturer of industrial abrasives may not be . . . A lawn care company is a good prospect . . . While a business which operates prisons for governments is probably not.

– Regulatory Framework. From a regulatory perspective, direct public offerings can be conducted in accordance with the same securities laws which regulate conventional initial public offerings, or they can be conducted within the context of exemptions which are offered by the states and federal governments. The scale from hardest to easiest is offered below.

• For more insight into the securities laws discussed below see Appendix A, Overview of Securities Laws Influencing Private and Exempt Transactions.

* Full Registration. Companies seeking to raise more than $5 million, and/or that want to trade on a stock exchange or the top two tiers of the Nasdaq stock market (though this is highly unlikely without a brokerage firm leading the charge) must file a registration statement with the Securities and Exchange Commission. This is a major undertaking for any company, which is at once made easier and more difficult by the absence of an investment banker in the DPO process. Itzzs more difficult because an investment banker has lots of experience shepherding these registrations through the SEC that entrepreneurs donzzt. But itzzs easier because the company can make changes to the registration statement in response to SEC “comments” without worrying about how the investment banker will react to these changes.

* Regulation A Filings. Companies that want to raise more than $1 million but less than $5 million can take advantage of the exemption from federal registration by filing under what is known as Regulation A of the Securities Act of 1933.

* SCOR Forms. Companies that want to raise less than $1 million in a direct public offering may take advantage of the Small Company Offering Registration (popularly known a SCOR), which is accepted in 43 states and requires almost no filings with the SEC. The SCOR form, also known as Form U-7 is, as mentioned above complex and challenging.

* State & Federal Exemptions. Companies which want to avoid all filings can, at the federal level take advantage of the exemption offered by Regulation D, and at the state level, structure their offerings so as to qualify for exemption. In most cases, this means selling securities to no more than a specified number of investors, usually in the neighborhood of 5 to 35.

– Strategies & Next Steps For a DPO
* Evaluate Your Ability to Pull It Off. The DPO process takes time to execute. In addition, it requires leadership. Entrepreneurs must critically evaluate if they have enough of both to see the process through. Entrepreneur Quinn at Hahnemann Labs talked to more than 700 potential investors in the course of finishing his DPO.

* Consider Your Affinity Groups. Direct public offerings donzzt work well without a large group of investors that have some sort of connection with the company, its product or service. Some companies, such a publishers, have a large base of customers, and enough information on them to easily launch a direct marketing effort. Other companies, such as restaurants, also have a large base of customers, but often times, almost not information on them.

For companies such as this, the question becomes, can I buy lists of my customers or potential customers, and would they be effective? In the case of a restaurant, the answer yes, lists of restaurant customers can be bought, but no, the affinity they have for your company, simply because it operates a restaurant, is not strong enough to merit the effort of soliciting these lists for investment capital. On the other end of the spectrum however:

An environmental services company can rent membership lists of environmental groups, associations and institutions

A company making home care products can rent the membership list of the Visiting Nurses Association

A company making body-building products can get the names of consumers who read Fitness [italicize Fitness] magazine

* Purchase The Book, Direct Public Offerings. This book by author Drew Field, offers the most comprehensive step by step guide for how to structure a direct public offering from assembling the team of professionals to launching a direct marketing effort. Direct Public Offerings, Sourcebooks Inc. 121 North Washington Street. Naperville, IL 60540. 800-432-7444

The Limitations of Cyberspace
The impact of the Internet on the process of raising money for early stage companies is starting to be felt by entrepreneurs and financiers. One day, the Internet may well be the most practical and influential tool that entrepreneurs will have at their disposal for raising the capital they need to grow their businesses.

But not now. William Wetzel, professor emeritus of the University of New Hampshirezzs Whittemore School of Business, founder of the Center for Venture Economics, and one architects of the current public policy on angel investors, says “it is not, at the close of 1997, likely that companies will raise capital over the Internet.” Certainly, not with any measurable degree of ease over conventional capital formation techniques.

At present, raising money on the Internet is somewhere beyond the novelty stage but not quite at the utility stage. If anything, the ability to raise money over [italicize over] the Internet, has been hyped to the point where it is misleading. To understand why this is so, a little history is in order.

– A Case In Point. Perhaps the first person in the world to see the opportunities the Internet offered capital-hungry entrepreneurs was one Andrew Klein, a securities attorney turned brewer, turned investment banker.

The story dates back to late 1992, when Klein, then with the law firm Cravath, Swain & Moore, in New York City, took a few months off to travel. While in Holland, Klein was introduced to so-called wit beer which was brewed with wheat, and spiced with orange. When he learned that wit beer wasnzzt available anywhere outside of Belgium or Holland, Klein sensed opportunity.

It knocked on his door several months later, when back in the United States, Klein received a phone call from a Dutch brewer who had cashed out on the sale of his company. Was Klein interested in teaming up to brew wit beer in the United States? By January of 1993, just six months after his summer sabbatical, Klein had left his law firm (with 13 partners as investors) and established Spring Street Brewery, located in Manhattan.

Klein feels he had all the luck an entrepreneur could hope for starting out. Local bars could not get enough of his wit beer, there was lots of media hoopla, and distributors from across the country were calling offering to sell the product. “But when opportunity knocks,” says Klein, “It usually wants money. Our initial $800,000 of capital, which seemed like a lot when we started, quickly turned into a grossly inadequate amount.”

In the fall of 1993, Klein set out to raise $2 to $3 million from angels and venture capitalists. While the process was encouraging, it was too drawn out for Klein, with every investor or fund sending him away with zzhomeworkzz to report back on.

Realizing he needed an efficient mechanism to raise lots of money on a continuous basis Klein decided to sell stock directly to the public. In the midst of borrowing an idea from ice cream manufacturer Ben & Jerryzzs, who early on, says Klein, sold stock to the public by advertising their deal on product packaging, Klein struck upon the idea that launched a thousand ships: If exposure was the name of the game, why not put the prospectus on the Internet and open the company up to millions of potential investors?

The mechanics of Kleinzzs revolution were basic. Spring Street Brewery simply put the prospectus for its offering on the companyzzs web site (www.witbeer.com). Investors could visit the site, learn about the company, download subscription documents and if they were interested in investing, send a check to Spring Street.

Because it was the first deal of its kind ever, Kleinzzs single press release about an Internet initial public offering brought with it a windfall of publicity in the national news media. With the publicity came hits on the Web site, some 500,000 of them. Initially, the pace was furious and Klein recalls getting in as much as $85,000 a week. By the end of 1995, Spring Street Brewery raised $1.6 million from 3,500 investors over the course of 10 months.

While the Securities and Exchange Commission (SEC) quickly and easily gave its approval to Klein to post his prospectus and other offering documentation on the Internet, the regulators were not at all pleased when Klein designed a series of bulletin boards that would allow shareholders to trade Spring Street common stock among themselves. After news of Spring Streetzzs Internet trading hit the national business media, which had a field day because of the implications of bypassing established stock markets, Klein found himself on a conference call with 11 SEC attorneys.

Upon review of the situation, the SEC ultimately allowed Spring Street to continue to operate its Internet trading service, but under conditions that for Klein and Spring Street, carried too much liability. Rather than cave, and in the true spirit of an entrepreneur, Klein formed Wit Capital as an investment banking firm to use the power of the Internet to raise money for emerging companies, particularly those concentrating on new media and Internet content.

– Why The Internet Doesnzzt Work. When the history books are written, there will surely be a place in them for Andrew Klein, as the visionary entrepreneur who first tapped the power of the Internet to fund his fledgling brewery.

But visionaries have an advantage which none of their followers enjoy. They are first. [italicize first] In the case of Spring Street, being the first zzInternet IPOzz created what bordered on a self fulfilling prophecy because the Spring Street story was carried by just about every national print and broadcast media — twice in many cases — including such venerables as The Wall Street Journal, CNN and the CBS Evening News with Dan Rather.

Today however, companies canzzt generate the kind of publicity which Spring Street earned. Entrepreneurs now looking to raise money on the Internet come face to face with the reality that while the Internet offers a potent medium for distributing information to potential investors, it offers almost no mechanism for selling [italicize selling] to them.

• Internet or no, the old dictum still holds: stocks are not bought but sold [italicize sold].

So, whatzzs left is hope. Specifically, entrepreneurs raising money on the Internet hope that:

Investors find their website or the website where their offering is posted

Investors are intrigued enough to download their offering circular, memorandum or prospectus and subscription documents

Investors who do this reside in a state where the offering can be sold

Investors print out, carefully review the documents and are simultaneously excited and comforted by what they read

None of the millions of people on the Internet that now have access to delicate company information, including their compensation and the companyzzs financial statements, uses this information against them

Investors will respond to further entreaties from the company via e-mail, mail or telephone by sending in a check. If they are not so well organized, they hope the investor takes it upon him or herself to write out and mail a check to the companyzzs escrow agent

Enough investors do this so that the zzminimumzz on the offering can be closed

Enough additional investors do this so that the rest of the offering can be closed

That all of this happens quickly

• If you are doing a direct public offering or an exempt offering, use the power of Internet to distribute information to investors, but do not rely upon it to make lead you to capital.

Chapter 5 – Venture Capital

Venture capital is wonderful stuff.

The current windfall of wealth in the United States today was created in no small part by institutional venture capital firms. The development of the semiconductor was financed by venture capitalists. From this came minicomputers, microcomputers which were financed by venture capitalists. From the hardware came the software, the peripherals, and the networking equipment that ran them. All of these industries were also financed by venture capitalists. Entrepreneurs made billions. Venture capitalists made billions. Several individual venture capitalists and entrepreneurs became billionaires themselves.

But the influence didnzzt stop there. Venture capitalists shifted the tectonic plates beneath Wall Street, and made brokers, institutional investors and investment bankers pay attention to, and finance tiny, technology driven companies. With the liquidity of the public equity markets, the wealth spread to institutions, mutual funds, employees with ESOP holdings, and individual investors. An investor who purchased 1,000 shares of Microsoft common stock in the companyzzs 1986 initial public offering, for $21,000 now has 36,000 shares worth about $5 million.

These benefits comes with a price. And the price is selectivity. Consider some of the numbers involved. Dun and Bradstreet Corporation reports 600,000 to 700,000 new incorporations each year [italicize year]. By contrast, a 1995 survey conducted by zzbig sixzz accounting and consulting firm Price Waterhouse for the National Venture Capital Association (NVCA), Washington, DC, found venture firms comprising the NVCA invested about $7.5 billion in 1,586 deals that year. Comparing the two numbers suggests that institutional venture capital funds are financing 0.2% of the new businesses that are created each year. It also means that 99.8% of American businesses had to go somewhere else to find equity capital.

Is your company part of the 0.2%, or is it pat of the other 99.8% that should and must look elsewhere?

To find out, take the following test.

Finding Out If You Qualify
The following test will give you a good indication whether or not your company is a candidate for institutional venture capital investment.

1. Are you a technology company? About 80% of a venture capitalistzzs portfolio is in technology. Itzzs not that institutional VCs donzzt fund low or no tech companies. They do, but just not that often. So the reasoning goes, if your company is not technology driven itzzs behind the eight ball to begin with. In addition, the competition among non technology companies for the few institutional venture capital dollars that are available is even keener, meaning that if your company is low or no tech, itzzs got to be a truly spectacular performer. Why the relentless (and sometimes enervating) focus on technology? The answer to this question may lie in the answer to the next one.

2. Are you capable of being a market leader? Venture capitalists rarely finance a company that is going up against a market leader with a similar product or service. Reason? Itzzs too difficult and too expensive to succeed simply by stealing share from a well entrenched and larger company. Not that a company cannot succeed in large markets with large competitors. Look at all the hamburger restaurants. But few of them generate the kind of returns that an institutional venture capitalist requires. This is why technology is so attractive to venture capitalists. Advances and breakthroughs can shatter the established paradigm of existing markets, or create vast new ones. With low technology consumer products, such as injection molded plastic housewares, or ubiquitous services, such as restaurants, itzzs difficult to change the rules of the game.

3. Can your company be built inexpensively? Inexpensive is a relative term. In a venture capitalistzzs nomenclature, thatzzs about $10 million, or less. Sure, there are lots of companies that could make a billion, by say developing hydro-electric plants in China. The problem is they need $5 billion in investment capital.

4. Does your company require a material amount of capital? This is the flipside to building a business inexpensively. If a company needs just $500,000, for an institutional venture capitalists with $50 million to invest, itzzs usually a pass. The reason is cost. It takes a lot of time and money to research, negotiate and monitor a deal. So, in order to deliver the kind of hands-on approach institutional venture capital investing requires, the VC would rather make 15 to 20 $2 million investments than 100 or so $500,000 investments.

5. Can the company be acquired or go public? The payday for the institutional venture capital investor comes when the company is sold or goes public. If neither occurs, it doesnzzt matter what the VCzzs stake is worth. They canzzt deliver a tangible return to their [italicize their] investors. Itzzs not just a question or whether or not a company will generate the kind of performance that will allow it to be sold or go public either. Itzzs also a question of whether the founder is willing to go that route. If the business ownerzzs posture is zzI want to pass control and ownership of the business onto the next generation of my family,zz that generally stifles the venture capitalistszz interest on the spot.

6. Can the product or service generate gross margins of more than 50%? For business owners that are trying to carve out a salary and a living, gross margins of 30% are fine. But for institutional venture capital investors that need to make a significant return, 30% margins are too thin. Not only is there little room for error, but the prospects for an acquisition or IPO, the big event for institutional venture investors, dim significantly.

7. Can the company grow to $25 million in sales in five years, with the prospect of growing to $50 or $100 million?. It all gets back to the numbers eventually. At $25 million in sales, a company just begins to generate the kinds of profits which make the business worth enough so that a venture capitalist can get the kind of return they are looking for. Letzzs say for instance that a $25 million enterprise was bringing $5 million to the bottom line — a feat, by the way, that is difficult to accomplish when the gross [italicize gross] margin is 30%. If the company went public and was valued in the market at 20 times earnings, it would be worth $100 million. The venture capitalist who invested $10 million and owns 50% of the company, now has a stake valued at $50 million, or five times the initial investment in five years — a middle of the road target return for most institutional venture capital funds.

John Martinson, a general partner with Edison Venture Funds, Lawrenceville, NJ, a venture capital firm with some $200 million under management says that in all, “If a company canzzt pass the last hurdle on sales and earnings growth, they should not waste their time pursuing institutional sources of venture capital.”

More conservatively, a no to almost any of the preceding questions, with a possible but unlikely exception for questions two and six, makes the entire prospect of institutional venture capital dim at best.

• If you donzzt qualify for institutional venture capital, donzzt waste your time looking.

How to Search
If you do qualify however, then by all means start looking. As the chart below indicates, the supply of venture capital continues to rise.

Total Capital Raised by Institutional
Venture Capital Funds By Year

Amount Raised
Year (in $ Billions)
1990 1.8
1991 1.3
1992 2.5
1993 2.5
1994 3.8
1995 4.4
1996 5.2

Source: Venture Economics Investor Services

But donzzt be lulled by the above graph into thinking that your search is going to be made easier by the increasing supply. Institutional venture capital is probably more difficult to raise today because of the demand side of the equation. Yes, more and more companies are seeking venture funding. But far more challenging is that fact that companies already [italicize already] in a venture capitalistzzs portfolio demand more and more capital to reach fruition. So, supplicants must compete with the companies that have already been financed.

In addition, do not be misled into thinking the appropriate response to a growing number of venture capital “targets” is sending a business plan to as many venture firms as possible. According to Glen Bierman, a managing director with Tycon Equity Partners, a venture capital firm in New York City, there is a relatively high degree of communication among venture capitalists, and a deal that is intensively shopped, quickly becomes undesirable.

“Worse,” he says, “itzzs not unusual for a venture capitalist to inadvertently miscommunicate certain aspects of a deal by saying something like, zzWe didnzzt like that deal because we thought the management team was too thinzz, and causing the VC on the other end of the phone to sour on the deal before the entrepreneur has even knocked on their door.” Itzzs far, far better, says Bierman, “to pick off highly researched targets one by one than it is to throw as many business plans against the wall as you can and hope that one sticks.”

• When hunting for venture capital, use a rifle instead of a shotgun.

The way to narrow your search into the most likely pool of venture capital investors — assuming of course that your company qualifies in the first place — is to search by three variables. These are: geography, stage of development and industry preference, and in some instances, amount of capital required.

– Search By Stage of Development. Of the three criteria perhaps the most important is the stage of development at which a venture capitalist will fund companies. Generally speaking, while a venture capitalist will overcome distance, and industry preferences for what they perceive to be a hot deal, the stage of development criteria is generally quite rigid. One reason for this, according to David Freschman, president of the Delaware Innovation Fund, Wilmington, “is while almost anybody can travel, not everyone can master investing in companies at every stage in their lifecycle. There are huge differences between a company at the seed stage, versus one at the mezzanine stage.”

Below are the generally accepted stages of financing along with corresponding company characteristics. The percentage in the far right column represents the percentage of venture capitalists that reported a willingness to invest in companies at that stage of development. These percentages were developed from Prattzzs Guide to Venture Capital Sources, published by Venture Economics, a division of Securities Data Publishing, Newark, NJ.

Company % Venture Firms
Financing Characteristics Reporting Interest
Seed Financing Small amount of capital 12.8%
used to validate a business
concept or technology.

Start-Up Financing Generally ranges from $500,000 13.6%
to as much as $3 million for
companies that have completed
product development and are now
ready to commence initial marketing

First Stage Financing Generally ranges from $500,000 to 17.5%
$3 million. First stage financing
is for companies that successfully
negotiated the start-up phase and are
ready to commence full-scale

Second Stage Financing Generally ranges from $3 million to 23.2%
$8 million. Second stage financing is
for companies which are enjoying pro-
duct or service acceptance and have
growing working capital needs.

Mezzanine Financing Ranges from $5 million to $12 million. 32.7%
Mezzanine financing is for companies
that have demonstrated success and seek
to expand the scope of their operations
through new products, new capacity, or
intensified sales and marketing.

The bad news about searching out prospects by stage of development preference is that will eliminate a lot of potential leads. The good news is the elimination of so many firms from consideration will keep you from running down a lot of blind alleys. Says Delaware Innovation Fundzzs Freschman, “If you start cold calling venture capitalists that only invest in companies with revenues, and youzzre a year away from generating any, in most cases you are wasting your precious time.”

Parenthetically, the percentages on the chart at the right add more evidence to why institutional venture capital is so dear for early stage companies. Only 13% will look at companies with no revenues. Some 75% are looking for companies that are already successfully selling a product or service.

• Donzzt call venture capitalists which donzzt take an interest in companies at your stage of development.

– Search By Investment Size Preferences. Another criteria, strongly related to stage of development preferences, is preferred investment size. A fund with $100 million under management probably does not want to make a $500,000 investment in your company. Why? To be fully invested by making $500,000 investments, the fund would have to finance 200 companies. Thatzzs too many to monitor. A fund this size might prefer making investments in the neighborhood of $2 million to $6 million instead.

According to G. Jackson Tankersley, a general partner of The Centennial Funds, the largest institutional venture capital pool in the Rocky Mountain region, “preference for a certain sized investment is not always useful by itself, but when taken along with other criteria, can help in selecting venture capitalists that will most likely be interested in your company and its financing proposal.”

– Search By Geography. Playing the geography card can produce good results. There are several reasons for this, some related to the art and science of venture capital investing, and some related to human nature.

First, most people have some kind of bias for the hometown team. Second, most people do not like business travel. Therefore, situations closer to home have more appeal than ones 3,000 miles away. The third reason, and the most relevant to the proposition which a venture capitalist offers a company, is related to value. Simply put, itzzs difficult for a venture capitalist to be a value adding investor, when he or she is not even on the same time zone as the company.

• Even venture capitalists who have no geographic preferences, prefer to invest in their own back yard.

To find out the firms that are in your back yard, you first have to know what your back yard is. Draw a ring around your company with a 150 mile radius. Everything within the resulting circle is your back yard.

For some folks in Montana, such an area may still [italicize still] be in their back yard, literally. Therezzs hope though. Some venture firms operate in a region. For instance, Seattle-based Cable & Howse Ventures looks at deals in the Northwest. Charlotte-based Kitty Hawk Capital looks at deals in the southeast. And The Venture Capital Fund of New England in Boston looks at — no surprise here — deals in New England.

• Many states recognize the economic development potential venture capital and finance seed and development stage funds to invest in companies within the state. To find a fund in your state call or write the National Organization of State Venture Funds, 301 N.W. 63rd Street, Oklahoma City, OK, 73116. 405-848-8570.

– Search By Industry Preference. Therezzs a direct relationship between an investorzzs time horizon and their knowledge of a company, itszz operations and industry. Security traders, who may own shares in a company for about 10 minutes, probably donzzt know who runs it, where itzzs located, or how many employees it has. Venture capitalists, on the other end of the spectrum, with a five to seven year investment horizons, know everything about the companies they invest in.

Either because of this, or to prepare for this, most venture capitalists maintain industry preferences. These are certain business in which they prefer to invest, or in which they will invest exclusively. Industry preferences can be broad, such as zzcomputers and related equipmentzz, or quite narrow, such as zzpollution control systems.zz

For entrepreneurs, this specialization can be a blessing. At the most basic level, in very narrowly defined niches, venture capitalists are more likely to talk to companies, simply because they are interested in learning more about the companies in their industry. During these conversations, the venture capitalist, even if they are not interested in investing, may provide additional, well qualified leads.

But venture capitalists that specialize in an area are particularly valuable investors. According The Centennial Funds Tankersley, “other venture capitalists will acknowledge their expertise, and it will make your company a more attractive investment for later rounds of financing.”

He notes another reason these investors are important is because they can provide providing financing leadership over successful round of financing. “These firms can help you tap the funds of more passive venture capital investors who typically invest alongside others.”

• To find the data you will need to conduct a highly targeted search of venture capitalists purchase Prattzzs Guide to Venture Capital Sources. 40 West 57th Street, New York, NY 10019. 212-765-5311. The guide is offered in hardback, and on CD ROM. The CD ROM version makes searching by geographic preference, stage of development and industry preference quick and easy.

• VentureOne, San Francisco, offers custom searches of its venture capital database based on key criteria. In addition, VentureOne publishes VentureFocus Reports, which provide lists of top venture capitalists, contact information and aggregate valuations by industry group. Call or write VentureOne, 590 Fulsom, San Francisco, CA, 94105. 800-677-2082

• If you have received at least one round of outside financing visit www.ventureone.com to become part of VentureOnezzs company database. By doing so, you will put your company in front of the top tier venture funds which mine this database for investment opportunities. Free [Italicize Free] to entrepreneurs.

– Putting Your Research Together. Your research will lead likely lead you to too many potential venture capitalists to avoid the drawbacks associated with overshopping a deal. According to Centennialzzs Tankersley, the right number is somewhere between 10 and 50. Remember, every venture capitalist on your list can always be contacted. The purpose of your research is to find the best [italicize best] candidates where you have a chance of getting funded.

To isolate the top candidates from your research, Tankersley recommends scoring them on a matrix by your search criteria — namely preferences for stage of development, geography, deal size and industry. By assigning a score for each preference, (2=good match, 1=acceptable match and 0=poor match) you can get an overall score for each candidate to determine which are best. For example:

Fund A Fund B Fund C

Stage of Development 1 2 1
Investment Size 1 1 0
Geography 2 2 1
Industry 1 2 1

Score: 5 7 3

– Making Your Approach. Testimoney to the importance of selecting carefully researched targets is offered by this comment from Gordon Baty, a partner with Zero Stage Capital, a venture capital fund headquartered in Cambridge, MA, “Of every 100 plans that we get, ninety of them are completely irrelevant because they do not match our investment criteria regarding the industry, stage of development, geographic location, or the amount of capital we typically invest.” Of this misguided bunch, Baty reports “Our receptionist can weed out their business plans.”

Baty says the gravest tactical error an entrepreneur can commit is to start calling cold venture capitalists. A more likely path to success is to get a referral from one of the usual suspects: an accountant or attorney with attorneys being the more likely candidate.

• Never cold call a venture capitalist. If you expect them to take your call, get a warm-body introduction first.

But he says, the best possible introduction for an entrepreneur would come from the chief executive of a company that he or she has already invested in, or who is recognized as an authority in an industry where the fund is active. “To me, the most credible referrals come from people inside the industry,” Baty says.

• The best source of referrals comes from within your own industry.

To find the companies that a targeted venture firm has invested in, Baty recommends simply calling the firm, and asking for a brochure. This document, according to Baty, will contain an embarrassment of riches to help you with your search. First, it might name the areas of focus that each partner concentrates on, giving you, at the very least, the name of the person to send your plan to.

But he says this fact sheet may also contain the names of the fundzzs auditors, attorneys, and a listing of the companies it has invested in.

If you have truly targeted well, you will know many of the companies on this list. And if you are not direct competitors, itzzs reasonable to call the chief executives of these companies to ask them about their experience with the venture capitalist. If the conversation goes right, or if asked correctly, the executive of the peer company will volunteer or agree to make a introduction to the venture capitalist.

– The Final Step. In some ways, hunting for venture capital is like painting a room. All the prep work get done up front, and when itzzs done right, the actual painting is easy.

In the same vein, if the preparation of venture capital candidates has been done correctly, the actual calling is easy. To understand what you are trying to accomplish on these initial telephone calls, and the process by which you move from the initial call to the commencement of negotiations, revisit the section in this book called Initiating Contact, Chapter 2, Locating and Securing Capital From Angel Investors.

The principals are exactly [italicize exactly] the same. The only difference is that angel investors do not have to invest, and tend to be cagey about giving a straight yes or no answer. Venture capitalists on the other hand are most often fiduciaries, and therefore must [italicize must] invest the funds under their control. As a result, if well targeted, they are more likely to read a business plan, make a rapid decision whether or not they are interested, and quickly issue a yes or no answer. As the introduction to this chapter suggests however, entrepreneurs looking for institutional venture capital must be ready to hear no many more times than yes.

Chapter 6 – Valuing Your Business For Equity Investors

Before any of the equity investors mentioned in the preceding chapters can become your [italicize your] investors, there is one great divide which must be crossed: the price. While the entrepreneur and the investor may agree the business requires $1 million to jump start production and marketing, there is likely to be little agreement on just what percentage of ownership the investor will get for ante-ing this amount of capital. Ultimately, for the two to get a deal done, there must be agreement on the value [italicize value] of the enterprise. This single number is the anvil upon which the rest of the deal will be hammered out because it defines the ownership positions of investor and entrepreneur.

While equity investors have differing profiles, and entrepreneurs certainly come in every stripe, the dance around valuation is always the same.

On one side of the table, the entrepreneur is trying to protect his or her precious percentage points of equity. There is only 100 percentage points to start with, and over several rounds of financing, they disappear with alarming ease. For instance, modern Internet legends David Filo and Jerry Yang, who founded Yahoo! had sold 70% of their company to venture capitalists and public investors by the time their April, 1996 IPO was complete.

On the other side of the table, the equity investor is trying not to overpay. A business might be worth $5 million. But if a case can be made for a valuation of $3 million, the $1 million the investor is prepared to sink into the company can be 33% versus the 20%. Simply by arguing persuasively, the equity investor can increase his or her ownership position by more than 50%.

Entrepreneurs always tend to think their businesses are worth more than investors. Except for really stellar companies however, the investors tend to win the battle on valuation. Why? Because, the investor has the gold. In early stage finance, as in many other walks in life, he who has the gold makes the rules.

This chapter is about valuing your company the way an equity investor does. In addition, it provides readers with tools they will need to make the case for a premium valuation.

Why You Must Value Your Business
Before Talking With Investors
“Itzzs absolutely amazing,” remarks John Lane, an investment banker in Westport Connecticut who specializes in emerging growth companies, “how many companies are looking for capital that 1) have not done any fundamental analysis to determine what their business is worth or 2) are shopping deals with utterly ridiculous valuations.”

• You separate your deal from the pack with a well conceived valuation analysis.

Itzzs important to have a clearly defined and well delineated argument for your companyzzs valuation says Lane, because, except for those who specialize in one industry, “most equity investors have little concept of what a company is worth and need some guidance.” The situation is analogous to consumers making big ticket purchases. When therezzs a lot of money at stake, consumers carefully read product marketing literature to understand why the product costs as much as it does. Without this information, many will simply move onto another brand.

In the same vein, without a valuation on the table, many equity investors, particularly high strung and perennially overworked investment bankers, might not to take discussions with an entrepreneur to the next step. Itzzs not that they canzzt, therezzs just a greater likelihood that they wonzzt [italicize wonzzt]. With raising capital so difficult to begin with, why make the task even harder?

But entrepreneurs who look for equity capital without a valuation also give up the high ground, and may surrender more equity than they have to. “The advantage they lose,” says Lane, “is that rather than telling the investor how much their company is worth and why, the entrepreneur ends up listening to the investorzzs assessment of how little their company is worth and why.”

• By taking the lead on valuation, an entrepreneur has the opportunity mold the investorzzs thinking on what a company is worth as opposed changing an investorzzs thinking on what it is worth.

The degree of difficulty associated with changing an investorzzs thinking can be compounded when he or she goes so far as to do the kind of analytical research which the entrepreneur should have done in the first place. When doing this research, which quite naturally is skewed in their favor, investors often develop the kind of stubborn conviction to their opinions which can be hard to dislodge.

• Know what your company is worth and why.

A Framework For Measuring Value
While there are many ways to value a business, for the purposes of raising capital, it makes sense to develop a valuation analysis that answers the question thatzzs on the investorzzs mind. Specifically, what will this company be worth in three or five year? An if this is true, what is it worth today?

By far, the most widely used technique for doing this is the so called discounted cash flow [italicize discounted cash flow] method. In addition, it is the method most professional investors use to assess value, and therefore, the one you should have at your disposal to meet an investor on his or her turf.

The discounted cash flow method relies on two concepts, that when initially introduced, often prove slippery to grasp. The first, and easier of the two concepts to understand is that the value of an enterprise is some multiple of what it earns. The second concept is that all future cashflows are equal to some present day amount.

Regarding the first concept, for argumentzzs sake assume that by divine intervention it is known that businesses are worth 5 times their net income. Thus, the business earning $100,000 is worth $500,000 or simply 5 x $100,000. Thatzzs easy to understand. Whatzzs far more difficult to assess however, is just what the multiple ought to be, a topic which will be covered later on.

Parenthetically, itzzs worth noting the concept of a multiple probably has its roots in the bond market. After all, a bond paying 7.5% or $75 per year costs the investor $1,000. But another way of looking at this is that the bond returns to the investor 13.3 times the $75 cashflow it generates. Logic would dictate if the bond was higher risk they payment would be higher, and the multiple would be lower. If the bond had little risk, the payment would be lower and the multiple higher. Hmmm.

The second concept says that an investor whose required rate of return is 5% has no preference between receiving $1.00 today or receiving $1.05 one year from today. Why? Because if the investor gets $1.00 today, he or she will simply invest it at 5%, and end up with $1.05 a year from now. Therefore the present value [italicize present value] of $1.05 received one year from today, for this investor, is $1.00.

Note that the investor whose required rate of return is 25% has a different set of numbers to work with. This investor is indifferent between $1.00 today and $1.25 a year from now. If the second investor were to receive the first investorzzs $1.05 a year from now, what would they need to receive today in order to hit their required rate of return of 25%? Eighty four cents. Said differently, $0.84 invested at 25% per year will yield $1.05 a year from now, making the second investor indifferent between the two sums.

Applying this concept to a business suggests its future income can also be reduced to a present value. Thus the $1 million before taxes a business is expected to earn 3 years from now is equal to $657,000 today for the investor whose required rate of return is 15% ($1 million/[1.15]3).

Now add in the concept of a multiple. If the multiple remains at the above decreed 5 times earnings, the business earning $1 million in three years could arguably be worth $5 million at that time ($1 million x 5). The present value of this future value would be about $3.3 million [$5 million/(1 + 0.15)3 ]. If the owner of this hypothetical business was looking for $1 million in equity capital, they might consider giving up about 30% of the business ($1 million/$3.3 million) to the investor.

• Cashflow is the essence of value.

A Case In Point
The balance of this chapter will show how to develop a valuation that can be used to meet and negotiate with equity investors. To bring the example to life, it will reflect the experience of Philadelphia-based entrepreneur Rod Vahle.

Vahle has been in the pet supply business for 30 years. As of 1996, he had 9 pet supply and animal theme gift stores called Accent on Animals up and running. Originally, Vahlezzs shops offered supplies only. But by adding pet-related items such as cards, clothing, stationary and books, alongside traditional supplies, Vahle found that he could generate substantially higher margins than pet superstores or traditional gift shops.

Vahle put together a business plan to roll out 250 more stores and estimated he needed initial capital of $6 million to do it. For Vahle, equity capital was the only way to go. He spent 30 years building a nine store chain using debt. But with a nice, patient, $6 million dollop of equity, Vahle felt he could make a quantum leap in his roll out rate.

His first big question was, zzWhat is my business worth and how much equity will I have to give up for the $6 million which I need?zz To answer this, Vahle had to: 1) estimate his future earnings; 2) calculate their present value and 2) determine the appropriate multiple for these earnings.

Estimating The Present Value of Earnings
Creating financial projections is a discipline unto itself which is covered in this Chapter 7. Here, wezzll simply use Vahlezzs projected earnings verbatim, and focus more on the thinking behind calculating its present value.

– Selecting The Right Projected Earnings. The first question is, which of Vahlezzs five discrete years of future operating earnings should be used? Although five year projections are standard, the fifth year estimates are too unreliable to be used for estimating the value of the business. In truth, most investors ask for five year projections because they want to see, on an order of magnitude basis, just how big the entrepreneur wants to grow the business.

Use third year projected operating earnings for estimating value. Itzzs close enough so the investor can envision the time period in the context of what the entrepreneur says he or she will accomplish — but far enough away so that significant earnings, hence value, can be created. In Vahlezzs case, the projected operating earnings in the third year after funding three is $3 million.

• If projected operating earnings have significant non cash charges, such as depreciation, use annual cashflow instead.

– Selecting the Right Discount Rate.
To understand which discount rate should be used, consider the mathematical equation used to determine the present value of future earnings:

Present Value = [Future Earnings, Year 3] / (1 + Discount Rate)3

Notice that the smaller the denominator, i.e. the number on the bottom, the larger the present value. The larger the denominator, the smaller the present value. Translation: the present value of a company is inversely related to the discount rate. That is, the larger the discount rate used in the equation, the smaller the present value of the company. The smaller the discount used, the larger the present value of the company.

Intuitively then the business owner would use the lowest possible discount rate, say 5%, to calculate the present value of future earnings. If Vahle did this, he would arrive at a present value of $2.6 million for his future earnings of $3 million ($3 million / [1+ 0.05]3). Obviously, this is a much better figure than $1.2 million that he would get using a discount rate of 35% ($3 million / [1+ 0.35]3). But is 5% realistic?

No, because the discount rate is the investorzzs required rate of return, and no investor investing in early stage enterprises will settle for a return of 5% per year. To see why the discount rate is the investorzzs require rate of return, consider the following re-arrangement of the above present value formula. It goes like this:

Future Earnings, Year 3 = Present Earnings(1 + Discount Rate)3.

Thus, the discount rate is the factor by which present earnings are advanced so that they reach the desired future value.

So whatzzs the appropriate discount rate? Twenty-five percent.

This figure owes its origin to institutional venture funds, which strive to achieve this rate of return on successful investments. Even if you are negotiating with an angel, a smart one will realize he or she is taking on a great deal of risk and deserves a return comparable to those earned by institutional venture investors.

The 25% figure is also benchmarked by ongoing research conducted from Satya Pradhuman, manager of U.S. Quantitative Analysis for Merrill Lynch in New York City. According to Pradhuman, over the past 20 years, so called micro-capitalization companies (public companies stock price times total shares outstanding are valued at $100 million or less) outperformed the market at large with a compound annual rate of return of 19.54%. By comparison, over the past 20 years, the S&P 500 returned 15.51%. So, the argument goes, if high risk public [italicize public] companies return almost 20%, high risk companies that are not yet public must offer investors a premium. Ergo, 25%.

• Without extenuating circumstances present, utilize a discount rate of 25%.

Using this discount rate, plugging and chugging, means the $3 million that Vahlezzs Accent on Animals will earn in the third year after he has been funded, has a present value of $1.53 million to the investor willing to take on the kind of risk that Vahlezzs venture entails.

Selecting The Right Earnings Multiple
Now that Vahle knows the present value of his earnings are $1.53 million, he needs an earnings multiple to calculate a valuation for his business which he can present to, and defend before investors.

– Use Price/Earnings Multiples. The task of finding appropriate earnings multiple can be accomplished quite easily by looking at the price/earnings (P/E) ratios enjoyed by similar public companies.

What do the P/E ratios mean? In essence they are formulas for measuring the value of the price of a share of stock. A common stock that is trading at $15 per share, and which has earnings per share of $2.00, would have a P/E ratio of 7.5 ($15/$2.00). Another way to say this is that the common stock is valued [italicize valued] at seven and a half times its earnings. But since a share of stock is just a microcosm of the company, the same formula can be used to value the enterprise at large. Thus, Vahlezzs Accent on Animals can be valued at 7.5 times earnings too, less any debt he might have on the books.

But is 7.5 the right factor? Should it be higher? Or should it be lower? To answer this question, Vahle needs to look at public companies like his own, and find their multiples. After all, the price of publicly held common stock represents the consensus of informed buyers and sellers. Therefore, the multiple a particular group of companies trade at represents a tenable measure of value.

• Use the P/E ratios of comparable public companies as the basis for your earnings multiple.

In general, industry groups have different multiples, depending on the overall prospects for the segment. For instance here are some multiples from Standard & Poorzzs Analystszz Handbook.

Price Earnings Ratios of Selected Standard & Poorzzs
Industry Groups

Sector Ratio Sector Ratio
——————————————————————-Composite Index 19.7 Publishing, Newspapers 38.4
Auto Parts & Equipment 10.6 Restaurants 22.0
Diversified Chemicals 15.7 Retail (Dept. Stores) 18.2
Computer Hardware 31.4 Services (Adv./Mktng.) 24.7
Computer Software 50.4 Telephone 14.7
Electronics (Instrumentation) 31.3 Tobacco 12.8
Medical Products, Supplies 29.2 Trucks & Parts 11.1
Manufacturing, Diversified 18.4 Waste Management 15.9
Metals Mining 14.4 Banks 13.9
Photography, Imaging 23.9 Investment Banking/Brkg. 8.8

Note the wide variations. Investors are buying software companies high and banks low. Said differently, investors were willing fork over, on average, 50 times what a share of stock earns to be in software, but only 13.9 times (on average) earnings for banking companies. Individual equities bear this out. As 1997 came to a close, Microsoft (Nasdaq: MSFT) was trading at 53 times earnings, and Citicorp (NYSE: CCI) was trading at 17 times earnings.

– Use Projected Growth Rates for Your Earnings Multiple. In practice, this means if a company earns $10 million, and enjoys a compound annual growth in earnings of 20%, the business at large can be valued at $200 million ($10 million x 20), less any debt it has outstanding. With 10 million shares issued and outstanding, each one should be trading at $20 per share ($200 million/10 million shares). If this particular equity was trading at say, 18 times earnings [italicize earnings], security analysts might suggest that the company was undervalued because it was trading at a discount to its growth rate.

• Companies looking for capital can use their growth rate or comparable price earnings ratios as a valuation multiple. The higher of the two should be used because the investor that wants to haggle over valuation, will employ the lower.

– Develop a Spreadsheet. Vahle chooses to use comparable price earnings multiples. The average price earnings multiple for Standard & Poorzzs General Merchandise Retailers is 23.5, which offers a good starting point. But Vahle will have to dig deeper.

Happily, there are two publicly traded pet supply stores which represent excellent comparables. Therezzs Petco, which operates 275 pet food and supply stores in 14 states and trades on the Nasdaq National Market System under the symbol PETC. Then there is (presumably arch rival) PETsMART (Nasdaq NMS: PETM), based in Phoenix, Arizona, operating some 280 pet supply superstores in 32 states.

Three “comps” are pretty good, but Vahle might need a little more ammunition to make his case. Frequently, entrepreneurs can make their argument with companies that are similarly structured, but perhaps in a slightly different line of business. For instance, Fremont, CA-based Natural Wonders (Nasdaq NMS: NATW), operates a 146 store chain that sells nature and science products. Like Accent on Animals, Natural Wonders stores are smaller, sell to consumers with an interest in nature, and with 146 locations, is almost exactly the sized empire Vahle is trying to build — at least initially.

There is also Nashville, TN-based Dollar General (NYSE: DG) which owns and operates more than 2,500 general merchandise sores in midwestern and southeastern states. Like Accent on Animals, Dollar General is offering merchandise typically at $1, $5 and $10 price points.

Another comp might be Norfolk, VA-based Dollar Tree Stores (Nasdaq: DLTR) which operates 686 discount variety stores. Like Accent on Animals, Dollar Tree is concentrating on low price points. In addition, Dollar Tree, like Vahlezzs shops, operate primarily out of strip shopping centers.

In spreadsheet format, herezzs what it looks like:

3 Year 3 Year
12 Month 12 Month Compound Compound Market
Revenues Earnings Revenue Earnings Recent Capitaliztn P/E Price/ Price/
($millions) Per Share Growth Growth Price* ($millions) Ratio Sales Book

Petco $270 $0.71 32% 156% $23.75 $388 46 1.4 2.3
PETsMART $1,030 $0.22 55% N/A** $26.00 $2,743 46 2.7 9.4
Natural Wonders $138 $0.23 5% (32%) 5.12 $40 22 0.3 0.8
Dollar General Stores $1,764 $1.00 24% 35% $28.50 $2,467 28 1.4 5.5
Dollar Tree Stores $300 $0.76 35% 45% $39.25 $1,105 40 2.4 14.1
S&P Genzzl Merchandise
Retailers N/A N/A N/A N/A N/A N/A 23.5 N/A N/A

*During the fourth quarter of 1996
** PETsMART actually delivered a loss for the period under consideration. The companyzzs strategy of acquisitions produced a high volume of extraordinary and non recurring expenses. Wall Street analysts typically do not include these expenses in their calculation of earnings. Therefore the above earnings are calculated before extraordinary items.

What are the numbers saying? That investors are paying for growth. The companies that delivered the highest growth in earnings, Petco, Dollar Tree Stores and PETsMART (presumably) were afforded the highest multiples, 40 and beyond. While those that delivered slower growth, Dollar General and Natural Wonders appeared to be somewhat penalized, on a comparative basis. This analysis also shows just how ruthless the consensus opinion of investors can be. Even though Dollar Generalzzs earnings performance has achieved a remarkable 35% compound annual growth, investorzzs apparently arenzzt letting the company rest on past laurels.

How to Make the Case For Your Valuation
The average multiple is 23.5. What Vahle needs to do now is use this information, plus more he has unearthed about the financial performance of his comparables, to suggest why he should be valued the same or higher [italicize higher]. Vahlezzs analysis goes like this:

* Accent on Animals actual gross margins, at 45%, beat Petcozzs gross margin of 24% by 21 percentage points, and PETsMARTzzs 25% gross margin by 20 percentage points.

* Him companyzzs capital requirements to open new stores are dramatically lower than Petco and PETsMART. For instance, to open one of its superstores, PETsMART will spend between $680,000 to $1.2 million. By contrast, Vahle can open a new site for no more [italicize no more] than $120,000. The high capital requirements of opening new stores, which is a function of their gargantuan size, helps explain the lower gross margins at PETCO and PETsMART.

* Accent on Animalzzs sales per square foot, $258 is over 50% higher than Petcozzs $169 of sales per square foot and 61% higher than PETsMARTzzs $157 in sales per square foot.

* Accent on Animalzzs operating earnings [italicize earnings] per square foot of $39 are more than 10 times [italicize 10 times] the $3.42 per square foot of operating earnings Petco enjoys (before non-recurring expenses are taken into account).

* Accent on Animalzzs operating margin of 15% is more than 300% higher than either of its competitors in the pet supply industry.

• Earning a premium valuation rests with your ability to show how and why you make more money.

Understanding Why You Must
Leave Value on the Table
Obviously, Vahle is onto something here. Hezzs got a concept that works, and from a profitability standpoint, outperforms all the rocket science of the big boys. And because of this he can make the case that Accent on Animals ought to be valued just as richly as Petco and PETsMART. Theoretically Vahle could argue for a valuation using the average multiple of his comparables:

PV of Earnings x Multiple = Valuation
$1.53 million 23.5 $35.9 million

Or he could make an argument that Accent on Animals should be valued using the top multiple in the industry, that is, the price earnings ratio of 46 maintained by Petco and PETsMART:

PV of Earnings x Multiple = Valuation
$1.53 million 46 $70.3 million

Vahle has done his homework, and has a well honed argument that will help him in negotiations. But, according to Jim Twaddell, an investment banker in Providence Rhode Island, with more than 25 years experience financing emerging companies says, “These numbers simply represent a starting point. Entrepreneurs must them submit themselves to the reality of the situation, and leave lots of the theoretical value they find on the table.”

Herezzs how a private investor putting funds into Accent on Animals in a private transaction might pare down Vahlezzs numbers from the top industry multiple of 46.

* Risk, 33%. Although Vahle has an admirable track record, his companyzzs future earnings, upon which the entire valuation is built, is simply speculation. Therezzs a strong likelihood earnings will not occur as anticipated, and if they donzzt, the investor will have overpaid dearly. So, the earnings multiple of 46 is now 30.

* Liquidity, 50%. An investor can trade Petco and PETsMART all day long. But even if Vahle hits his projections, and merits his valuation, the investor still has little more than a perceived paper gain. So the earnings multiple of 30 gets adjusted down to 15.

* Market Pitch, another 33%. Just because the stock market has been on a tear for the last few years doesnzzt necessarily have an influence on what a private equity investor is willing to pay in a private transaction. After all the S&P 500 gained 37% in 1995 and more than 20% in 1996. If the entrepreneur and the investor had met two years earlier, with all other business factors being the same, the earnings multiples prevailing in the market at that time might have been 50% lower. zzSo I should overpay because Wall Street wants to have a good year?zz the investor begins to ask. Suddenly, Vahlezzs earnings multiple of 15 is now 10.

If Vahle presents this argument to the investor, and utilizes an earnings multiple of 10, then Accent on Animals will be valued at about $15 million, which is 10 times $1.53 million, the present value of the companyzzs earnings. Finally, the $6 million equity investment should represent 40% of Accent on Animals ($6 million/ $15 million).

Itzzs important to point out that without all of the comparative financial information showing how Accent on Animals can be a superior financial performer, then the starting [italicize starting] point could have been much lower [italicize lower] After all, if Accent on Animals canzzt beat the margins delivered by Petco and PETsMART, why should it be, at least initially, afforded the same multiple?

Investment banker Twaddell says that if Accent on Animals was contemplating an initial public offering, the multiple would be much higher, since the liquidity, and market pitch issues would disappear. “Still,” he says “the firm taking the company public would value the Accent on Animals below the market leaders because as a younger, smaller, and untested public company, investors would demand a discount to the companyzzs more seasoned peers. ”

• Private companies raising money privately are valued at a deep discount to the market. Private companies going public are generally valued at discounts to the market ranging from 10% to 30%.

If an investment was made at this level, would Vahle be getting whacked too hard on the valuation? Probably not. The fact that he is up and running, and can point to performance measures that actually exceed [italicize exceed] his competitorszz are strong arguments he can use to prevent the valuation from going any lower [italicize lower].

But one thing is for sure. Doing the investorzzs homework pays off in a big way. If the investor stuck a valuation of $10 million on the company more or less arbitrarily, Vahle would have too fight uphill to get the other $5 million in value his company is worth. The ultimate cost to him could be 20% more of the company than might have been otherwise.

A Word About Pre-Revenue Stage Companies
This analysis should beg a vital question for entrepreneurs that need funding for products or services that are not yet launched or developed. Specifically, zzHow can I make compelling arguments about what Izzm worth without any actual performance figures to point to?zz The answer is you canzzt. As venture capitalist John Martinson of the Edison Fund points out, “Valuations for companies at the pre-revenue stage, in their seed or first round financing, are almost always less than $2 million. Itzzs hard to make a return if itzzs any higher.”

Itzzs not that the above mathematical arguments donzzt hold for companies at the pre-revenue stage. They do. At early stages, the required rate of return, hence the discount rate is so large, that the present values get reduced to almost nothing.

An investor might not be quite so numerical in reaching this conclusion. Intuitively though, theyzzre thinking zzIf Izzm going to put this much money into the company at this stage of itzzs development, I need to own 60% of it, period.zz By now the trend should be clear. If youzzve got a dream and a team, in terms of value, you donzzt have much more than that.

Chapter 7 – Presenting Historical & Projected Financial Statements

Investors frequently say they donzzt pay much attention to financial projections, because such numbers are a stab in the dark. For instance Ted Schlein, a partner with powerhouse venture capital firm Kleiner, Perkins, Caufield & Byers, Menlo Park, CA, says “we will spend 10 minutes going over the financial issues versus three hours on the strategic issues.”

Itzzs hard to argue with any wisdom that comes out of Kleiner, Perkins. With deals such as Tandem Computers, Genentech, and Netscape to its credit, KPCB clearly knows its stuff. But Schleinzzs comment applies only to financial forecasts that appear reasonable to begin with. Projections that are way off the mark, wonzzt get 10 minutes indeed. In fact, they wonzzt even get the time of the day.

Another reason that financial projections must be done carefully is they are a window on an entrepreneurzzs thinking. And it is through this window that investors frequently peer. What are they looking at?

* Does the company seem to understand how long it will take to collect receivables?
* Does the cost of goods sold reflect industry norms?
* Are the assumptions on the frequency and timing of repeat business reasonable?
* Is the commitment to R&D realistic?
* Do the marketing costs reflect an understanding of the distribution channel?

And on and on it goes.

Finally, the role of financial projections in valuing a company cannot be underestimated. Investment banker Twaddell reiterates that “the future value of the business is the [italicize the] central number upon which the equity investor focuses. And it is the financial projections, to the exclusion of any other number, which show what this future value can be.”

The chart below demonstrates what happens to the actual [italicize actual] future values of a company when the growth in earnings fails to live up to the projections. The example assumes projected earnings of $1 million in three years, and a price earnings multiple of 15.

Actual Acutal Actual Actual
Earnings Growth=25% Earnings Growth=20% Earnings Growth=12.5% Earnings Growth=8%
(100% of Projected) (80% of Projected) (50% of Projected) (32% of Projected)

Future Value $15 million $13 million $11 million $9.7 million

Actual Future Value as
a % of Projected Future Value 100% 86% 73% 65%

Almost as important as projections, are carefully constructed historical financial statements. An entrepreneurzzs ability to discuss their financial history also provides a window on an his or her thinking. In addition, historical performance, is the most credible evidence a business owner has at his or her disposal to support the contentions of projected financial performance.

• The act of raising money from outside investors is fundamentally an act of financial communications. Ultimately, success is a function of financial presentation skills.

This chapter shows readers how to develop projected and historical financial statements that speak to the needs of equity investors. Rather than a line by line exercise of how to develop financial projections, the next sections deal with their conceptual framework. In addition, wezzll stick with the income statement only, since the balance sheet and cashflow statements flow from it.

A Guide to Developing Financial Projections

– Projecting Revenues
Given all of the importance laid upon earnings, itzzs amazing how much attention is paid to revenue. After all, a company with $100 million in revenues and $101 million in expenses, doesnzzt have an ounce of value. Still, revenues the starting point from which everything flows, so itzzs got to be right.

Established companies have it all over upstarts because they have some historically proven algorithm to predict future sales. Even if theyzzve never thought about it, itzzs there. For instance, historically:

* Each salesperson generated 15 sales per month, or
* The response rate on direct mail has been 1.1% for which the subsequent pay-up rate was 92%, or
* Each new manufacturerzzs representative generated $750,000 in sales, or
* Each 30 minute infomercial generated 7,000 inquiries and 400 sales, or
* Sales representative close on 12% of appointments, or
* The sales to media buy ratio has been 1.25
* The revenue per tabletop has been $12,000
* The cashflow from each well, net of drilling costs has been $350,000

Consider foodservice giant McDonaldzzs as an example. While the number of restaurants have increased, the revenues per restaurant have stayed in a narrow range. Thus, as McDonaldzzs opens new restaurants system wide, (2,642 between 1995 and 1996) in itzzs fairly easy to project the impact on revenues.

Graph: Units Per Year, and Average Sales Per Unit, System wide for McDonaldzzs Corp.

# of Sales/Unit
Units $ Thousands
1990 11,803 1,649
1991 12,418 1,658
1992 13,093 1,733
1993 14,163 1,768
1994 15,950 1,800
1995 18,380 1,844
1996 21,022 1,708

Source: McDonaldzzs Corporation

If itzzs historical, itzzs credible. But where entrepreneurs go wrong in projected revenues is suggesting a future performance that deviates significantly from the past record, a malaise which is often endemic to the presentation at large.

• If your projected revenues are going to depart substantially from past experience, there needs to be a good reason why. Without a good reason, the projections are not credible.

For example, Idaho Falls-based Dermaceutical Labs, Inc. was selling a line of skin care products through direct response short form television, i.e. commercials. Historically, the companyzzs sales were 1.25 times itszz expenditures on media. The more commercials it ran, the more sales it made. But DLIzzs projections made the assumption that the ratio going forward would be 1.50 [italicize 1.50]. Why? According to DLI founder and president, Marvin Taylor. “Once the company was funded, we would develop a new series of infomercials with better production values and which would feature a celebrity spokesperson. We were confident with these improvements, our short form TV would pull much better.” Fair enough. At least 83% of Taylorzzs assumed future performance was based on past experience.

– A Case In Point. Entrepreneur Ed Meltzer founded Intelligent Wireless Systems, Prairie Village, Kansas, which had developed radio frequency (RF) transceiver modules for the automation and control industry. Meltzerzzs research had pegged the market at $100 billion and growing. Intelligent Wireless had licensed the underlying technology, and had gotten as far as he could on product development. Now Meltzer needed funds to complete development and roll-out his first products.

The following summary projections are the ones Meltzer used to pitch investors on his deal. During the latter half 1997 Meltzer closed on approximately $450,000. The projections, as well as Meltzerzzs experience presenting them to investors will be used throughout this chapter to underscore key points.

1997 1998 1999 2000
Gross Sales
49 MHz Products (4 products) $1,762,500 $4,224,500 10,192,500 19,220,000
Router Products (2 products) 273,500 1,132,500 3,755,100 9,060,000
Transptn Product Line (2 pdcts.) 170,000 1,220,152 1,035,000 4,140,000
3.4 GHz Product Line (2 pdcts.0 0 315,000 4,972,500 10,880,000

Total Sales 2,206,000 6,892,152 19,955,100 43,300,000

Cost of Sales 1,313,801 3,767,755 10,283,720 21,289,024

Gross Margin 892,199 3,124,377 9,671,380 22,010,976

Selling, General & Adm. Expenses 778,671 2,391,498 4,650,389 7,296,580

Income From Operations 113,528 732,879 5,020,991 14,084,396

– Projecting Sales For New Products or Services. For companies that do not have revenues, such as Intelligent Wireless Systems, the act of projecting future sales is far more speculative, than those with a track record.

Venture capitalist Fred Beste with NEPA Venture Funds indicates that “Itzzs naive to simply start with baseline sales and apply a formula that increases them by 20% per year,” he says. “Itzzs probably even more naive to suggest that the market is a certain size, and that the penetration will increase a certain number of percentage points each year. The fact is, therezzs nothing formulaic whatsoever about projecting future sales. It requires going through the spread sheet cell by cell and thinking about each quarter, or month, and itzzs damn hard work.”

The most effective sales projections for pre-revenue stage companies, he suggests, rely on some original market research or trial sales conducted by the founders. Neither of these activities needs to be exhaustive or expensive. But they need to get done. Because by doing so, the sales projections move out of the realm of fantasy, and start moving into the world of reality.

At Intelligent Wireless Systems (IWS), Meltzer had an unfair advantage. Since the product technology was licensed from another firm that was fairly well known, IWS received a lot of inquires and even purchase orders for its products while they were in development. Even IBM called one day. Meltzer supplemented these inquiries with calls to buyers of RF products.

“We structured our questions very carefully,” says Meltzer, “so that the answers, when taken together would give us market research and some basis for estimating the sales we anticipated.” Some of Meltzer asked were

* What is your time frame for purchasing RF products?
* What is the application?
* Is your project funded?
* Is there a scheduled launch?
* Is your application mission critical?
* How many units would you buy in a best case scenario? Worst?

When he added everything up, Meltzer had some 750,000 units he could sell in the first year. Incredibly, he based his first year revenues, 1997 on selling 2% of what his research suggested, or 18,000 units and through the planning period never assumed he would hit more than 25% of what is research showed.

“That hurt and helped,” recalls Meltzer. Ultra-conservative investors were pleased. “Others said zzIzzm not interested in a $40 million company Ed, therezzs lots of those.” At the end of the day, Meltzer was not conservative enough, at least for 1997. Raising the required funds took longer than expected, so there was much less time in 1997 to hit even the conservative target.

• Estimates sales on empirical data rather than guesswork.

– Cost of Goods Sold & Gross Margin. Compared to sales, the cost of goods sold is much easier to work with. After all, while projected sales may require the business owner to consider, where, when and how long it will take to open new stores, the resulting cost of goods is a fait accompli because much of it relies on the thinking behind projected sales. When sales are known, the cost of sales is mostly just plugging and chugging.

But you can only plug and chug if unit costs are known with some degree of certainty, which for many companies is a challenge that has to be met. The reason is simple. No one will invest in a company where not even the founder is sure what it will cost to produce the product or service. Would you?

To get over this hurdle, Meltzer simply took his product design to the product manufacturer he knew he would be using and got a bill of materials from them. “They knew me, they knew I was a start-up, and what they would be in for when we started ordering products.” Meltzer took their prices, and added in a fudge factor of 25%. “I took some heat for that one,” says Meltzer. “But I ran a closely held family business, and used family money for a long time. When you do that, youzzre very conservative, because you don;t want to be wrong.”

• Pre-revenue stage companies can inspire confidence in the cost of goods sold by providing detailed cost schedules.

In reality though, the cost of goods sold is simply a means to the gross margin. Gross margin is defined as sales less cost of goods sold and is usually expressed as a percentage. During the first and second glance, investors will probably pay more attention to the gross margin than the cost of goods sold figure which produced it. So what must the gross margin say or not say?

First, the gross margin should not be too far out of kilter with the gross margins that are earned in the industry at large. For instance, the National Restaurant Association reports that the gross margins for so called full-menu table service establishments are about 36%.

If youzzre opening a restaurant and your financial projections show a 25% gross margin, up goes the red flag. If your projections show a 45% gross margin, up it goes again. While the former deviation is a tough sell, the latter is possible to overcome — with a plausible explanation.

In fact a really good explanation is a selling point. After all itzzs breakthroughs in technology, or manufacturing techniques, or management styles that can change the economics of doing business and create an exciting investment opportunity.

For instance, Abe Gustin, Jr. and Lloyd Hill, co chief executives of fast growing Applebeezzs International, Overland Park Kansas attribute restaurant dimensions to their superior margins. “The smaller size and seating capacity of our restaurants gives us a distinct advantage over competing concepts, allowing us to open more restaurants in a given market and effectively draw customers from a smaller radius. In addition, greater market penetration increases our visibility . . . and increases the cost effectiveness of our marketing and advertising efforts.”

Another important strategy regarding the projected gross margin is to pull it back a bit from what might be suggested by the numbers alone. For instance if the gross margin is 45%, itzzs wise to increase the cost of goods sold so that the gross margin in the projections is 42 or 43% instead.

Why? Because a gross margin on a projected income statement is utopia. In real life there are strikes, stockouts, equipment outages and absenteeism.

• To add credibility to projected gross profits, build in a fudge factor of two to three percent.

– Estimating Selling, General & Administrative Costs.
The easy part of SG&A is the general and administrative costs. If ever there were a place in the projections to simply let costs increase each year by a factor, general and administrative costs are it. Supplies are not expensive. Calculating the cost of running whatever centralized operations there might be such as executive and administrative staff is fairly straightforward.

Where companies go wrong is with the S, according to Peter Moore, a principal with corporate financial consulting firm Banking Dynamics, South Portland, ME, and the founder of the Maine Investment Exchange, an angel investor forum. “Estimating selling costs can be one of the most challenging aspects of developing financial projection,” he says, “because to do it right the entrepreneur must be absolutely certain that their sales model works.”

For products that have never been sold before, itzzs difficult to know this. But Moore says, the way in which the financial projections clue investors into the fact that the entrepreneur is uncertain how to sell their product or service is when they suggest too many kinds of selling costs.

Meltzerzzs selling costs for Intelligent Wireless Systems were straightforward. He had line items for salespeople and advertising. “I knew that our product would lend itself to relationship selling, and that manufacturers representatives couldnzzt do the job that we wanted.”

– Projected Operating Margins. As far as financial projections go, operating income or the operating margin, which is defined as gross income less selling, general and administrative expenses, is the [italicize the] bottom line. It simply doesnzzt add to the understanding of the business, or the future value, to project future gains and losses from extraordinary gains or losses, or for that matter, the tax liability on projected income. They defy any accurate prediction.

Many of the rules for better living on projected gross margins apply to the operating margins as well. For instance build in conservatism rather than extremism so that itzzs possible to exceed the projections rather than fall short of them.

Where operating margins exceed industry averages, have a tenable explanation of why. In the same way that technology, management style and manufacturing techniques can cause a breakthrough on the gross margins, so too can paradigm shifts have a salubrious effect on operating margins as well.

For example, Granite Financial, a Westminster, Colorado based equipment leasing company had, after 29 months in business a near vertical rise in revenues and saw the opportunity to generate above average operating margins. Why? According to vice president Rick Hilker, Granitezzs investments in connectivity technology with third party sales organizations delivered significant operating leverage. “After a certain point,” said Hilker “we were able to handle large increases in lease volume with no increases in personnel costs on our end.” Apparently, the strength of this reasoning delivered the goods, and allowed Granite to consummate and $11.25 million initial public offering during the fall of 1996.

For Meltzer, the percentage of the operating margin was of no particular concern because he was confident the company would be profitable, and he was not in an industry that had well known ratios he would be expected to meet or exceed. “For me,” he says, “They fell where they fell.”

Happily they fell well. In fact, the improvement in operating margins over time, from 5% to 32% on improving gross margins, and operating leverage, was, Meltzer reports, a good selling point for investors.

• To find out benchmarks for your industry on key financial ratios such as gross and operating margins, purchase a Statement Study [Italicize Statement Study] from banking trade organization Robert Morris Associates, Philadelphia, PA. 215-446-4000.

Another important aspect of the operating margin itzzs absolute value. In general, if the operating margin, as a percentage of sales is small, itzzs a turn-off for most investors. Therezzs little room for error, and itzzs harder to create the kind of value that offers an exit for investors.

• Donzzt compound the challenges of a narrow margins by suggesting that you are going to be the low cost producer or supplier.

For many businesses however, thin margins are just part of the territory. Where they can undermine the case of the entrepreneur, is when projected operating margins are thin because of a low cost pricing strategy. If the underlying assumption is that profits come with volume, the question becomes does the organization have the skill to generate the required volume? More important, what kind of cash is going to get eaten in inventory purchases (if there is any) and in carrying a large balance of accounts receivable that come part and parcel with a large sales volume?

“You have to questions the wisdom of an entrepreneur who is using a low cost approach,” says venture investor Beste, “In essence they are using the one strategy that almost every competitor has at their disposal, but has simply chosen not to use yet.”

The Importance of Having Historical Financial Statements
It may seem odd to say, but the first step toward making a good financial presentation is to actually have [italicize have] historical financial statements — one for each year the business has been in existence or for the most recent five years. This would not seem to be worth mentioning were it not for the fact that producing a consistent set of historical financial statements seems to be an unusually challenging task for many entrepreneurs.

• Therezzs lots of good reasons why a business doesnzzt have historical financial statements, but if itzzs raising money, none of them are good ones.

In addition, owners and managers of start-up companies are often prone to thinking they donzzt need financial statements because therezzs not much to put on them. This isnzzt necessarily the case.

First, if founders invested a lump of cash to get the business started, an extremely strong selling point, financial statements irrefutably document their commitment. Second, for founders who are working without pay, or at less pay than they may otherwise be entitled, financial statements give them a place to document the companyzzs growing liability to them.

Investors rarely pay off the companyzzs debt to founders with their investment. They will however convert it to equity. But, generally speaking, if the ownerszz sweat equity is going to be a material part of the eventual negotiations, it needs to be out front and on the table from the beginning — which is exactly what happens when itzzs in the financial statements.

• Even Start-Ups Need Financial Statements

Itzzs also worth pointing out that to raise money, it borders on necessity that historical financial statements be prepared by a certified public accountant (See Sidebar: The Levels of Review).

According to angel investor Rich Bendis, who also is the executive director of the Kansas Technology Enterprise Council, “The presence of a CPA goes a long way toward assuring the investor — particularly angel investors — that what they are looking at is for real.” Even if itzzs just a compilation, says Bendis, the investor knows the accountantzzs name is on them regardless, and nothing good can happen to his or her practice if the statements arenzzt accurate.

So even the lowest level of scrutiny offered by a certified public accountant provides a high degree of comfort to investors. Certainly it provides the minimum level of comfort needed to get anyone from the outside to put money in the company.

Sidebar: The Levels of Accounting Review

“Therezzs the audit which every taxpayer dreads,” says Steven Mayer, a partner with the New York City-based accounting firm of Goldstein Golub Kessler & Company, “and then there is the self-inflicted audit, generally just as dreaded, that many firms ask of their accountant.” But he says there are other levels of review which lead up to an audit, which adequate for entrepreneurs in many instances.

“First therezzs a compilation, which is where the accounting firm creates financial statements out of the figures that are supplied by management. In some cases, the accounting firm will simply retype numbers supplied to them by the company and might [italicize might] suggest the numbers appear [italicize appear] reasonable” says Mayer.

The next level is generally known as an analytical review. “In addition to compiling the numbers that are supplied by management, some testing is done” Mayer reports. Not testing to measure financial performance, but to triangulate, to see that everything is lining up properly. “For example, if sales are up, and commissions are down, thatzzs a strong signal that something may be very wrong with the way the numbers were put together.”

The most intensive review that an accounting firm can undertake is the audit. “Here” says Mayer “in addition to all of the testing, third party assurances are given that the figures presented are indeed accurate.” This is why an audit takes so long. If a firm says it has say, 25 microcomputers for sale in its inventory, then the auditor wants to see and count them. If they say they have 25,000, then the auditor wants to count them on a test basis. If the firm has 50 creditors that owe them money, the auditor wants a letter from each verifying the amount. If 5,000, well, you get the picture.

Perhaps one of the most frequent occasions for an audit comes when you look for bank financing. According to Mayer, “At some loan level, the bank is going to want audited financial statements, and if you donzzt have them, youzzll either need to get them, or go packing.” Though each bank is different, Mayer says that the minimum loan sizes where banks start talking about audited financial statements runs from $1 million to about $5 million.

Another reason for an audit, according to Mayer, is when absentee owners are involved in a business. Audited financials, because of the third party assurances, can protect the absentee owner against fraud and mismanagement.

Public offerings also require a minimum of two years audited financial statements. Firms on a fast growth track often have their financial statements audited in anticipation of a future offering.

In addition says Mayer, sometimes in private offerings, the investors collectively will insist on audited financial statements. “Not only do the private placement investors want assurances,” but says Mayer “they donzzt want anything to stand in the way of a public offering, which is often their “exit strategy” or way of cashing out of the deal.”

Mayer says that an audit might start at $7,500. But that would be for a service business, where there is no inventory to verify. If therezzs lots of inventory, and lots of receivables, then Mayer says therezzs almost no practical limit to how high the fees can run.

Therezzs a commitment of time as well. First, the accounting firm is going to camp out in your conference room for a couple of weeks. But because itzzs an audit, and because they issue an opinion, and because therezzs loads of liability behind that opinion, the accountant might tend to be more conservative on certain matters, such as recognizing revenue, than you, as the paying client, are likely to be. “So you often spend time negotiating, and reaching compromises on certain issues,” says Mayer, ” Frequently, itzzs a lot of time.”

• Internally generated financial statements are inadequate for raising capital

A Guided Tour of Historical Financial
Statements with A Venture Capitalist
Simply having financial statements canzzt carry the day completely however. Theyzzve got to say the right things. To see how yours might measure up, take the following tour through a set of financial statements accompanied by venture capital investor Peter Ligeti, a general partner with Keystone Venture Capital Management Co., which finances companies from the so-called first stage and on.

– Stops Along the Income Statement. The first stop is the income statement, according to Ligeti. He says that “most investors look at gross, operating and net margins to see if they are in line with industry averages.” Next, theyzzll tend to look at the trends in contributions to revenues, if the company has more than one product or line. “Ideally,” says Ligeti, “revenue figures will show a trend toward the higher margin products over time.”

In addition, most investors will be looking at whether or not the revenues are recurring in nature — that is, are they coming from new or existing customers? “Obviously,” says Ligeti, “itzzs much less expensive to generate revenues from existing customers than it is to go out and find new ones. If the revenue structure is a recurring one, itzzs easier to make the case for growing margins over time.”

• Trends in revenues will reveal how smart management is at capitalizing on their strengths.

Next are the general and administrative expenses. “If these are high by industry standards,” says Ligeti “itzzs not necessarily a negative, if you can make the case that youzzre simply managing income for tax purposes.” After all, thatzzs what small business owners are supposed [italicize supposed] to do. When general and administrative expenses pose a problem to investors, according to Ligeti, is where the organization is plain top heavy.

• Heavy SG&A expenses that are not going into the owners pocket signal potential management shortcomings

Next, if therezzs not R&D on the balance sheet in the form of capitalized expenditures, then most investors will be looking for some R&D expenses to show up on the income statement. Of course, this mainly applies to technology companies, where innovation offers an edge. “R&D can be a very important factor for leading edge technology companies,” says Ligeti “because innovations is the force that will drive future revenues.” At Intel for instance, perhaps the penultimate technology company, the commitment to R&D, at $1.8 billion, or 8.6% of 1996 sales, is high.

In addition to the overall volume of expenses, Ligeti says most equity investors will also look at the trend relative to revenues. “Theyzzre looking for operating leverage. Ideally, the company is engaged in a business where general and administrative expenses, as a percentage of sales, decrease as sales increase.”

Operating leverage is a significant benefit, since under those conditions, the company becomes more profitable, hence more valuable, the larger it gets. For example, Microsoft Corp. was able to deliver a $2.7 billion increase in revenues between fiscal 1995 and fiscal 1996, with an increase of just $811 million in selling, general and administrative expenses. Thatzzs leverage.

Stepping back and looking at the income statement, Ligeti says an investor might wonder if a more conservative approach to accounting would turn what appears to be a profit into a loss. Deferred expenses, questionable gains or losses, low returns and allowances charges relative to industry averages, might all conspire to make the entire presentation look questionable. Better to get it all on the table for a candid evaluation than to appear as if youzzre trying to fool the investor.

• Historical profits that turn into losses upon scrutiny will sour an investor on your deal.

– Looking At the Cashflow Statement. For an even closer look at how the company works, most investors will settle down with the cashflow statement. Overall, they want to see how capital intensive the business is, i.e. how many dollar have to be put into the business before one pops out.

“Itzzs not that a capital intensive business is bad,” says Ligeti, “itzzs simply, that if a business needs lots of money, the equity investor needs to know it, because he or she is the person everyone is going to turn as the business starts to expedience growing pains.”

For example, when analyzing the cashflow statements for capital intensity, many investors will look for seasonality. Why? Seasonality eats cash because a business carries inventory that it cannot sell.

Another harbinger of capital intensity is lengthy collection periods. If these are combined with overall increases in the volume of receivables, it means that the company is really getting squeezed. In fact, itzzs possible for a growth company to be highly profitable, but cashflow negative every month.

“While receivables financing from banks would appear to alleviate some of the capital intensity, thatzzs not always the case.” Ligeti says for new products, especially those which are technical in nature, there is uncertainty regarding their reliability, and as a result, market acceptance. In addition, services always make for funny receivables because there is no exchange of a physical product — nothing the seller can take back if the buyer fails to pay.

Because of these characteristics, service and growing technology companies often find receivables financing from banks difficult to come. “Often times, itzzs the equity investor that has to fork over an extra layer of capital, so that the operation can catch its breath,” says Ligeti.

• Understand the capital intensity of your business before talking with equity investors and have a plan for meeting working capital needs if sales take off as expected.

-The Balance Sheet. Next, the investor might move over to the balance sheet. Unlike a banker, Ligeti says an equity investor is much less concerned with the presence of assets to liquidate if there are problems. “Whatever hard assets there may be, are likely pledged to somebody else anyway.”

Most investors will zero in on the intangible assets. Whereas these donzzt mean boo to a lender, they speak volumes to an equity investor, especially for a technology-oriented company. For instance, if a company is capitalizing research and development (that is, treating expenditures for R&D as if they bought an asset), thatzzs good because it shows a significant commitment to product development and improvement, which hopefully will fuel future sales. By the same token if a company is too aggressive in their allocation of R&D expenditures to asset rather than expense accounts, it could be a negative. “A more conservative look at the income statement might cause a reclassification of expenditures as expenses, and in the process deliver a big hit to earnings,” says Ligeti.

• Have a clear policy on the capitalization, versus expensing of research and development expenditures.

Next, most investors will look at the inventory to see if itzzs in or out of kilter with revenues. If the inventory account is high relative to the revenues, or has been creeping up over time, it can give pause. “Maybe the company is gearing up for a big sale,” says Ligeti. “But then again, maybe the company has poor management controls and is not responding to changes in it sales cycle.”

Regarding accounts receivable, if there is any, many investors will take an interest in the revenue recognition policies — that is when during the sales cycle the firm actually books itzzs revenues. In general theyzzre trying to see just how firm the revenues are the company is reporting. “Growing businesses sometimes push sales out the door and book them right away, a policy that can be crippling with complex products or services that may take months to deliver to the satisfaction of the customer.”

Going over to the liabilities, Ligeti says the accounts payable can cause problems. Sometimes a $500,000 investment will get whittled down to $250,000 left after the creditors stake their claim. “So important are the accounts payable,” he says, “that investors may actually get on the phone to the creditors to see if they will hang in there a little longer.”

• Be prepared to explain the precise amount of accounts payable that will be paid from the proceeds of the investment.

Moving down the liabilities, if therezzs any term loans, the investorzzs comfort with them will vary directly with the length of the term. If its 2 years, that could be a problem. If itzzs seven, thatzzs much better.

Further down in the liabilities section, there are often accrued salaries or zzNotes Due Founders.zz These can spell trouble for the entrepreneur who is not flexible. “Bankers simply subordinate these to their own debts and forget about them.” says Ligeti. But equity investors get a little prickly on this topic. “Basically, they donzzt want to end up to paying off founderzzs loans.”

• What founders and owners call loans, equity investors typically call sweat equity.

Next, the investor will look at the equity section of the balance sheet. First they want to see if itzzs negative or positive. Remember, at the end of each year, the net income or net loss gets posted to the equity section of the balance sheet. So if the company has been stringing together a series of losses, the equity will be pretty thin. If the equity account is negative, the company is technically insolvent. At the very least, itzzs running on fumes.

Finally, the investor will take a good long look at the notes to the financial statements. “In fact,” say Ligeti, “So important are the notes, that some investors actually read them first. Notes to financial statements are just one more reason that CPA-prepared financial statements are essential. Internally generated financial statements rarely have them, which has the net effect handicapping the investor, who may simply walk until notes become available.

• You canzzt hide anything in the notes section of your financial statements, because equity investors always read them.
Chapter 8 – Preparing & Presenting Business Plans

Almost every equity financing begins with the same, seemingly innocuous question: zzSend me your business plan.zz

In a way, the words business plan, [italicize business plan] are a misnomer. After all, itzzs not like anybody refers to their business plan every morning before deciding what to do that day.

First and foremost, the business plan is a selling document. Itzzs a particularly difficult one to create, because it must balance the unbridled enthusiasm of future prospects with the reporting of facts and detail which are so important to investors.

Although every business and every business plan is different, the major sections of a successful plan are:

* Executive Summary
* Description of the company and its business
* Market analysis
* Marketing operations
* Key personnel
* Financial analysis
* Appendices

Despite the blood, sweat and tears that typically go into writing a business plan, investors frequently report they never read them. For instance, Hans Severiens, a private investor with 15 yearszz experience and the coordinator of the Band of Angels, a group of angel investors in San Francisco, says that he, like most members of the Band, “Skim through the plan.”

Severienzzs comment underscores an important point. Nobody ever raised money simply by writing a business plan. [Italicize previous sentence] They raised money by presenting [italicize presenting] a business plan before investors. But the latter cannot be done effectively without the former. Thus, writing the plan is really the blue print for selling the deal.

This chapter will provide an overview of the major sections of a business plan. Rather than focusing on “how to” aspects, it will help entrepreneurs overcome the common pitfalls of business plans that often cause investors to back off. In addition, this section provides entrepreneurs with the tools they will need to present their plan before investors, which ultimately, is where the rubber hits the road.

50 Questions a Business Plan Should Answer
By the time you are finished writing a business plan, you should be able to persuasively answer the following 50 questions.

1. What is the price of your product or service and why?
2. What are the companyzzs existing products?
3. How much is the company is worth?
4. How much capital is required to execute the expansion contemplated in the plan?
5. What are the use of the proceeds?
6. On a summary basis, what is the financial history of the company?
7. On a summary basis, what is the projected financial performance of the company
8. What new products are being developed and when will they be ready for market?
9. What is size of the market for your product in dollars?
10. What is the size of the market in terms of units?
11. How has the market for the product changed over the past 5 years and why?
12. How do you anticipate it will change going forward?
13. At what percentage rate is the market for your product growing?
14. Is the competition highly concentrated or highly fragmented?
15. What is your distribution channel and why is it the best one?
16. If you are planning to advertise, which publications, what are their circulations, frequencies and why did you choose them?
17. How many people are at the trade shows you plan to attend?
18. What funding is being devoted to new product development from the financing and from ongoing operations?
19. How many potential customers have you talked to?
20. What is the gross margin on your product? Why is it superior or inferior to a competitor?
21. What is your assumption on the collection period for outstanding receivables?
22. What are your working capital needs once sales take off and how will these needs be addressed?
23. What will happen to gross and operating margins as sales rise and why?
24. What percentage of your sales are recurring?
25. Who are your top five executives and what is their professional and educational background?
26. What regulatory or legal threats are present?
27. Are there international markets for this product and is the company positioned to take advantage of them?
28. Who is the largest competitor in your industry?
29. What criteria was used to choose locations for geographic expansion?
30. How will you get this product into mass market distribution channels?
31. Is the product patented?
32. Who are your suppliers?
33. Do you have more than one for each of your basic raw materials?
34. What are your payment terms with these manufacturers?
35. What will cause gross and operating margins to improve as volume increases? Deteriorate?
36. Where is the company located and how many square feet does it lease or own?
37. What is the length of the sales cycle?
38. How did you estimate returns and allowances?
39. How are sales personnel compensated? Incentivized?
40. What, as a percentage of sales, is the industry norm for annual R&D expenditures?
41. What is the earnings multiple of public companies like yours?
42. What are your immediate marketing objectives?
43. Does the company have a board of directors?
44. What is the ownership structure of the company? Who else is an owner?
45. How has the company been financed to date? What other financial transactions have occurred in the past three years?
46. Has the product generated any publicity? Where?
47. How many days is the oldest current liability on the balance sheet?
48. Who has prepared the historical financial statements and have they been compiled, reviewed or audited?
49. Is there any cyclically in sales?
50 What are the competitive advantages of your products?

The Company & Its Business Section of the Plan
Herezzs a true story:

A San Leandro, California-based manufacturer of photoluminescent lighting products called Triex Group International was, after three years, insolvent, $500,000 in debt, and on its last leg. Oddly, an investor who met with management felt the situation held great promise. The investorzzs exact words were: “This company has great products. Obviously, the time and money consumed so far has been very well spent.”

The point of this story is that the present status of a company is as important to securing capital as the future potential. Ric Klass, an investment banker in New York City, who concentrates on initial public offerings for emerging growth companies explains why this is so.

“Of course investors are buying into future potential,” he says. “But they know they are taking a lot of risk right now in the present. To soothe this uneasiness, they want to experience two emotions: comfort [italicize comfort] that the business and the opportunity is for real, and confidence [italicize confidence] that the management team can pull it off.”

Nothing delivers this emotional salve to investors better than tangible, concrete facilities, relationships, and actions by management. In fact, Klass says that “When a business plan sells the future only, and has nothing to report about the past or present, for me, it undermines the credibility of the company.”

• Use the description of The Company & Its Business section of your business plan to inspire comfort and confidence among investors.

Here is a list of 10 items could or should go into The Company & Its Business section of a plan. Some are quite obvious entries for established companies, others are creative suggestions for earlier-stage companies that donzzt have much history to bank on.

Note also the large numbers of names and telephone numbers which are suggested for inclusion. The tacit agreement is these contacts are fair game for the investorzzs due diligence. Though investors rarely call contacts out of the blue, the offer of so many contacts increases the investorzzs comfort because it shows how many other business people have confidence in the company.

* History or time line citing key accomplishments and critical milestones. This can be particularly helpful to “virtual” companies, not yet incorporated with the founders perhaps holding down other full time jobs.

* Equipment lists, patents, service marks, trademarks and copyrights.

* Description of facilities. Remember, details are important because they provide comfort. Therefore if facilities are leased, include price, lease expiration, square footage and special features such as elevated floors, security, proximity to vendors..

* List of suppliers. If therezzs too many, list the top 25 with name, city, state, telephone number, contact name, and approximate volume of business.

* Professional advisors. Lawyers and accountants are the obvious choices. But add in any other consultants which have been used in the past year, the existence of an advisory board (but not their names), the existence of a board of directors (but not their names).

* Strategic Partners. Formal or informal relationships with other firms, individuals, or organizations, all put meat on the bones. Some examples include the names of manufacturers representatives, independent agents selling product or service, joint venture partners,

* Overview of operations show how product is made or service offered.

* Customer lists. If there are too many, supply profiles of representative customers. Also, for relationship-based customers, get permission to include their name and telephone number and ask them to expect calls.

* Market studies. The actual results or analysis belong elsewhere in the plan. The fact that management conducted the study, and how they did it, is particularly effective for early stage companies.

* Description of products and services. The fact that products and services are just a part of the picture is should give entrepreneurs pause. It underscores the point that to investors, a company is much more than simply the products that it sells, or says it will sell.

Market Analysis
Venture capitalist Ted Schlein with Kleiner Perkins Caufield & Byers, says that when he gets a business plan he looks for just three things. “Do you have a market? Does your product address it? Do you have a team that can get the product into the market?”

The items which a market analysis should contain include
* Estimate of market size
* Estimate of growth rates
* Macroeconomic factors driving sales or creating opportunity
* Microeconomic factors driving sales or creating opportunity
* Description and analysis of competitors
* Description of competitive advantages

In the aggregate these analyses address the first, and most fundamental question that investors like Schlein have. Is there a market for your product or service? Itzzs an important job because if the analysis cannot answer this question, then many investors simply have no interest in the answers to the second and third question.

And itzzs not just venture capital investors who maintain this attitude. Bill Simms a private investor in Sacramento, California who invests for his own account, and for a Fortune 500 corporation, says that he continues to “turn down deals where the company founders are unable to articulate what the market opportunity is, and how they fit into it.”

• If your market analysis is very simple, itzzs probably inadequate.

Itzzs an act of courage to go against the grain of the universally useful Keep It Simple [italicize Keep It Simple] doctrine, but necessary however for an effective market analysis. Venture capitalist Schlein says that entrepreneurs are not credible when they suggest that a market is a certain size and they seek a certain percentage penetration. “As a typical example, an entrepreneur will tell me they want to do Java on-lines games, because itzzs a huge market with all those modems out there. But they are not credible because they haven;t found out how many of these modems are faster than the minimum 28K speed their product will require.”

– A Case In Point. Simplified approaches market analysis doesnzzt work because markets are rarely uniform. For any product or service, there is a wide range of buying behaviors and preferences, which a single source can rarely accommodate.

An excellent example of market definition and segmentation came from Energy Brands, Inc., a Whitestone, NY, beverage company whose major product line at the time it drafted a business plan was bottled water.

The overall market dimensions were quickly supplied by research firm Beverage Marketing Corporation, New York City. Overall growth in gallonage for bottled water had grown at a compound annual rate of 10%, and by 1995 stood at 2.8 billion gallons. Wholesale dollar sales had grown at 8.4% compounded annually since 1985, and by 1995 stood at $3.4 billion.

But to say that Energy Brands would capture one, two, five or even 10 percent of this market was too simple because of differences among buyers. More importantly, if Energy Brands stayed within the rigid confines of this definition, the company would lose an important selling point for its deal. By looking at the situation more carefully, Energy Brands could help investors see a much different, and much brighter picture.

In truth, the office segment of the market, sold in five gallon units, was stable. So too were sales of spring water sold in one gallon units through the supermarket channel. But what was red hot at the time, growing at a compound annual growth rate of 25% per year, was bottled water sold in containers of 1.5 liters or less through the convenience and gourmet distribution channel.

By segmenting their market this way, Energy Brands management had a story to tell. Bottled water in convenience [italicize convenience] sizes, they told investors, had been astutely packaged so that it could be sold as an alternative [italicize alternative] beverage to soda, New Age teas and juices. Health and purity conscious American consumers were taking the bait in unprecedented volumes, as the sales figures demonstrated.

So now, investors could understand the current dimensions of the market, but they could also see that it would continue to expand as water stole share from other beverage categories. In addition, the market segmentation helped management make the case for the packaging and brand-related expenditures which the plan called for. Suddenly, Energy Brandzzs business plan made sense. The market analysis showed the investor that pre-conceived notions about selling water had changed, and that the management of Energy Brands Inc. was clearly onto something.

• Find the research to document your analysis.

Unfortunately, a good market analysis is not something that a business owner can simply talk their way through either; it must be supported by original research and/or third party sources. As venture investor Schlein says, “The absence of detail is a possible kiss of death.”

Itzzs easy to see why. Without it, the entrepreneur is simply be talking off the top of his or her head. The entrepreneur might really [italicize really] know what they are talking about. But if the investor doesnzzt know the entrepreneur well, he or she might start to think zzWhy should I believe him?zz

Remember, the investor is looking for just two things: comfort and confidence. In this context, nothing builds comfort more than an authoritative, third party source supporting the conclusions of the business plan. Going out and finding this stuff is one of the necessary evils of the process.

Marketing Operations
Build a better mousetrap and the world will beat a path to your door may be a true statement.

But the rest of the story is that not nearly enough people will actually buy [italicize buy] your mousetrap so you can generate earnings growth of 25% per year. Not without some first rate marketing at least.

• The Marketing Operations section of the plan must make a logical break between the analysis, which illuminates the opportunity, to specific strategies and tactics which tell the investor how the company is going to capitalize on it.

For the majority of emerging companies, future marketing operations is the nib of the plan because it describes the activities upon which future success will rest.

“Unfortunately,” says Ron Conway, a private investor Atherton, CA, and also a member of San Franciscozzs Band of Angels, “The marketing [operations] section of the plan is also the downfall of companies raising money because it often reveals a lack of sophistication about how sales are actually made and product is moved.”

– Traps To Avoid in Describing Marketing Operations
* The Vice President of Sales. Company founders run amok in the Marketing Operations sections of their business plan by suggesting that future operations will consist of hiring a vice president of sales.

There may some day be a vice president of sales. “But to get enthusiastic about a company,” says Conway “I need to see a vision and a strategy for how they are going to get their product into the market,” The problem with the vice president of sales, is that it leaves open the question of whether or not there is a vision and a strategy to begin with.

• The equity investor is investing in you, not someone that you might hire.

* Using All Marketing Devices. Another way that entrepreneurs turn off investors with their future marketing operations by suggesting that the company will utilize several marketing devices. What this frequently tell investors is that the company really doesnzzt;t know how to sell the product.

A not uncommon gaffe reads: zzUpon financing the company will engage in an integrated program of sales and marketing encompassing direct selling through manufacturers representatives, the creation of a company sales force, trade advertising, direct mail, trade show promotion, telemarketing and networking.zz

This problem also becomes apparent in the financial statements as well when forecasted selling expenses reflect too many lines items (See Chapter 7, Presenting Historical & Projected Financial Statements in the section titled Estimating Selling, General & Administrative Costs).

According to financing consultant Peter Moore, founder of Banking Dynamics and the Maine Investment Exchange, “It doesnzzt matter if the problem shows up on the financial statements or the marketing operations section of the plan, when the investor sees you do not have a cohesive sales model, it will undermine your chances of raising capital.”

Naturally, established companies have a sales model developed from experience. But for companies that are raising capital to commence marketing, the best bet for inspiring confidence among investors is to suggest a simplified approach with moving parts which can be tested.

For example, giant Software Publishing Corp. was, in 1980, looking for $250,000 in equity financing to ramp up sales for its personal computer software. At the time, the market for its products was just $350 million. The companyzzs business plan boiled down itzzs marketing strategy down to a one-two punch. Specifically, the company used advertising to pull consumers into retail stores and point of purchase displays to push the product once consumers got there.

Chart: Sample Sales Models for Companies Using Proceeds to Commence Marketing Operations

Product or Service Tactic
Print Advertising Outbound telemarketing to uncover leads and set appointments, followed by direct selling to close the sale.

Consumer Product Utilize manufacturers in mass in Mass Market Channels to gain shelf space, stimulate in-store demand with cooperative advertising.

Restaurant Dining Saturation mailings in a three mile radius promoting discounts, followed by in- house promotions to stimulate repeat business.

Professional Services Short form television to
For Consumers coordinated with inbound telemarketing.

High Tech Product Direct selling by company-paid salespeople combined with direct mail to create a continuous flow of warm leads.

The beauty of applying this kind of logic to a business plan, is that it breaks the marketing operations down to a limited number of tasks that can be described with the kind of authority and detail that offer investors comfort. More importantly, as the chart indicates, this approach gives the entrepreneur the opportunity conduct marketing operations on a test basis and make claims based on experience rather than supposition.

Product or Service Test
Print Advertising Call 200 prospects, record
number of appointments

Consumer Product Interview 12 buyers for
in Mass Market Channels working for target retailers and get estimates for demand, cooperative advertising opportunities.

Restaurant Dining Hand deliver 1,000 flyers
within 3 mile radius, record

Professional Services Get response rates
For Consumers for similar programs from
that are published in trade literature.

High Tech Product Interview 25 potential customers and report buying protocols. Send out 1,000 direct mailers, and record response.

• To be effective the Marketing Operations sections of a business plan must contain equal parts strategy and tactics.

Key Personnel
While the majority of investors say they never read business plans cover to cover, they all refer to certain sections each and every time a plan is received. Though the precise sections vary from investor to investor, Key Personnel, is always in the repertoire.

Admiral Bob Inman, also an angel investor, says that when he gets a business plan, he first tries to determine if itzzs a field hezzs interested in, “But then I immediately turn to the key personnel section of the plan.”

Venture capitalist Ted Schlein with Kleiner, Perkins concurs with Inmanzzs approach to reading business plans. “As a general rule,” says “I donzzt read the business plan cover to cover. But I do look at the team almost right away because I want to see what right they have to make claims which they are making in the plan.”

Why do Inman and Schlein, like every other investor turn to the personnel section of a business plan first? Human nature. Most investors want to know who is running the company and how many degrees of separation are between these people and him or herself.

For some investors, a connection to management, no matter how thin, is vital to getting the process to the next step.

But, investors also turn to this section of the business plan first because, sooner or later, the attention focuses on the men and women at the helm of the company, and their qualifications. After all, like the old real estate mantra: location, location, location [italicize location, location, location] the entrepreneurial finance mantra is management, management, management [italicize management, management, management]. For better or for worse however, the first time an investor meets management is often from the biographical sketches in the business plan.

Herezzs a sample of how not just familiarity, but skills and experience play a huge role in getting investors to engage in a dialog with the entrepreneur.

“When I read the biographies of the people running the company, there are a number of things I am looking for,” says Inman. “Is this their idea or are they executing someone elsezzs? If itzzs someone elsezzs idea, I generally decline. Are the founders at great personal risk with this venture? Have they put in all the capital they can put in? Have they ever been through a downsizing and worked with scarce resources to create success? Naturally, each situation is different, but these are some of the benchmark experiences I look for.”

Herezzs a model biographical sketch of a business owner that founded a successful long distance reseller. This entrepreneur was looking for several million dollars to roll out Internet access services to her existing client base. The fictional name for this real person and real company is Betty B. Good and BBG Telecommunications.

Ms. Betty B. Good, president and chief executive officer. Ms. Good founded and capitalized the company with her own savings in 1990. Initially, Ms. Good served as the operations manager and primary salesperson for the company. However, upon reaching monthly sales of 1 million minutes in 1991, Ms. Good recruited, hired and trained a vice president of sales and a vice president of operations. From 1991 to 1994, Ms. Good was primarily responsible for business development. In this capacity she negotiated long term contracts with major facilities-based long distance carriers, and reduced BBGzzs average cost per minute by more than 70%. Though this was accomplished during a period of declining prices, the cost advantage that BBG currently maintains over several competitors is testimony to her negotiating skills. During this period, Ms. Good also led the companyzzs successful entry into switch-based telecommunications which lowered overall operating costs for the company and introduced a new revenue center. Since 1995, Ms. Good has been principally involved in planning the companyzzs expansion into new telecommunication services. In this capacity she forged strategic alliances with several key vendors, and recruited additional managerial and executive personnel to assist in the companyzzs planned roll out of Internet access services. Prior to forming the company, Ms. Good was vice president of marketing for Rival Communications. There, she managed the companyzzs direct marketing efforts, and was responsible for 300 telemarketers with 12 regional managers reporting directly to her. During her tenure there, Rival sales grew by more than 22% annually. Prior to joining Rival, Ms. Good was an account representative for AT&T Business Services Group where she sold advanced telecommunications services to middle market businesses. Ms. Good earned her bachelorzzs degree in English from Boston College.

• Effective management biographies speak in terms of skills and accomplishments rather than companies and titles.

Clearly, many companies raising money for expansion don;t have a complete management team. The best way to overcome this shortfall is to acknowledge it in the business plan. In fact, the very act of saying, in effect, zzI am going to surround myself with smarter people than me as we grow,zz tends to increase the currency of the entrepreneur.

• Confess management deficits up front, and create biographical profiles of the talent your will need.

A well conceived business plan will offer the reader a descriptions of the ideal candidate, including experience, critical skills and educational background. Most importantly, the biographical sketch will detail the tasks and responsibilities of this individual. By sketching out the successful candidate, the business owner is telling the investor he or she wonzzt simply pass function responsibility onto someone else, but has considered beforehand the skills and experience required in key positions in order for the business to succeed.

• Consider making organizational charts for each of the years covered by the financial projections in the business plan.

On a somewhat grander scale, another successful technique for inspiring confidence is to provide organizational charts. Again by offering critical thinking, rather than open ended declarative statements, the entrepreneur is inspiring confidence in the investor.

• Include biographical sketches for the board of directors, and an advisory board (if there is one) to increase the connection your company has with the potential investor.

Financial Analysis
The bulk of the Financial Analysis section of the business plan consists of historical and projected financial statements. This was covered in detail in chapter seven. As a result, the balance of this section lists the other items which should be included in the Financial Analysis section of the plan along with advice about how to make the most of them.

* Summary Valuation Analysis. The development of a valuation analysis was covered in chapter six. A summary valuation spreadsheet should be included in the in the Financial Analysis section of business plan, though its presence is somewhat controversial.

One school of thought says that putting a value on the company is a mistake because it will turn off many investors before they have been romanced by the business, the products or the management. The other school says to seize the initiative and tell the investors what you feel the business is worth. If a buyer really wants something, they wonzzt just walk away simply because they disagree with the price.

• Tell the investor the valuation you are placing on the business, because early in the game he or she is looking for guidance on the answer to this question.

* Summary Projected & Historical Financial Statements. Itzzs always a good idea to put summary projected and historical financial data in the Financial Analysis section of the plan before the full-blown financials as a simple convenience. Many times investors want to zoom out and look at the picture in toto rather than getting caught up in the minutia of monthly cashflow statements. When an investor puts the business plan down to summarize things later because therezzs no time at the present, it might never get picked up again.

The projected and historical financials can be summarized with five lines. These are 1) Revenues; 2) Cost of Sales 3) Gross Profit; 4) Selling, General & Administrative Expenses and 4) Operating Profit. Create one summary for historical performance and one for projected.

• Create summaries of historical and projected financial performance to satisfy the investorzzs need to look at the large picture first.

* Use of Proceeds. Most investors are used to seeing five to seven line zzUse of Proceedszz charts that are standard in prospectuses. A business plan however should go one level of organization deeper. Thus, while one line item might read zzMarketing: $300,000zz, a well written business plan will provide a little more support and under Marketing: $300,000zz offer zzSales Personnel: $150,000zz and zzDirect Mail: $150,000.zz

• At some point the investor will ask or look to see where the proposed investment is going. If therezzs no answer, it can be, or appear to be, a serious lapse in planning.

* Assumptions to Financial Projections. The credibility of the business plan at large hinges on how well the front of the book — which describes business — meshes with the back of the book — which estimates future financial performance.

For instance, if the Marketing Operations section of the plan calls for territorial expansion in year three, complete with satellite manufacturing facilities, then year three of the financial projections must reflect these expenditures. Similarly, unit costs described in the company and product description section of the business plan, must mesh with the costs of goods sold.

The most effective way to accomplish this seamless bonding is to have a well documented set of assumptions to the financial projections. In the flora and fauna of a business plan, the projections are somewhat of a hybrid mutation. They are not quite numerical, but then they are not quite descriptive prose either. But the act of out spelling the many variables and formulas of the financial projections makes it easier to integrate their implications into the rest of the plan.

For instance the assumption, that zzadvertising equals 9% of saleszz provides a budget around which several aspects of the Marketing Operations section of the plan can be built. Likewise, the assumption that zzeach five new stores opened will require a dedicated manager, and each 20 stores opened will require a regional managerzz makes it much easier to create projected organizational charts.

Going back to the notion that the investor is looking for confidence and comfort when they read a business plan, the appendices are a good place to build up the latter. After all, itzzs the place where the company can actually show something that is real. Herezzs a list of items companies should or could put in the appendices of their business plans, with a brief description of mileage they earn for doing so.

* Product Literature. Shows the product is for real. Provides insight into the caliber of managementzzs thinking and execution on marketing.

* Patents. Indisputable proof of patent protection. Demonstrates foresight.

* Company Sponsored Research. Obviously, few emerging companies have the resources to hire professional survey firms, but every firm can take the temperature of the market in one way or another. Even transcripts from interviews with potential customers demonstrates management is basing their planning or reality rather than supposition.

* Sample Sales Contracts and Agreements. Shows that the firm is ready to make sales and has considered some of the legal implications of selling the product or service.

* Publicity. Provides third party verification of the companyzzs activities. Shows the company and or itszz products are favorably received by a critical and unbiased audience.

* Trade Articles. Provides additional support for the companyzzs claims regarding market trends and sizes.

* Advertising Concepts. For electronic media, sample scripts with rudimentary storyboards; for print media, copy and rough visuals. Demonstrates the company has considered the positioning of its products. Provides greater validity to the claim the company will utilize advertising to stimulate sales. Offers additional evidence that the company is in a state of readiness to commence marketing activities.

* Supporting Financial Schedules. Items such as additional detail on cost of goods calculations, bills of material, the anatomy of profit earned on a single sale, increase the investorzzs feeling that the financial projections are based in reality.

* Licenses and Permits. Shows the company is law abiding and will not experience an interruption of operations at the hands of regulatory authorities.

* References. The contact names, addresses and telephone numbers of selected customers, key suppliers and professional advisors will increase the sense of cooperation the investor feels. Will also increase the amount the perceived level managerial talent at the firmzzs disposal.

* Customer Testimonials. The oldest trick in the book, for good reason.

* Graphics. Pictures of facilities, manufacturing, sites, maps, engineering drawings all add to the credibility of the company and its management

There are no hard and fast rules about what to put into the appendices of a business plan because each company has its own unique story to tell. The general theory though is to include items which increase the credibility of the company with the investor.

As a final note, itzzs important make clear separations between different appendices. The many elements which can go into appendices are graphically and visually disparate. When presented without the “editing” of coversheets or separations, the effect is more confusing than enlightening.

Executive Summary
If the executive summary is done last itzzs the easiest part of the plan to write because all of the really hard thinking is already done.

Itzzs also the most important part of the business plan.

Again, most investors donzzt read business plans cover to cover. But most will force themselves to read the executive summary. Hans Severien, coordinator for The Band of Angels says “When I get a business plan I look at the people, the executive summary and the market analysis. I use the executive summary to decide whether or not to go any further with the company.”

Kleiner Perkinszz Ted Schlein concurs. “I look at the executive summary first. If the company cannot explain what they are doing in two to three pages, itzzs very difficult for me to get interested.

Schleinzzs comment underscores one of the most important features about an Executive Summary: length.

Highly detailed and lengthy Executive Summaries are not generally effective. If the Executive Summary is presented on two pages however, the investor can take in everything at one glance. Boiling a venture down to this length should not be too hard since the Executive Summary need only recap the major sections of the plan. In fact, if the plan is really wired tight, itzzs simply a matter of lifting sentences from the body of the plan and stringing them together.

• Make sure the Executive Summary has a summary.

The only section in the executive summary that is not lifted verbatim from the body of the plan is something called a Summary Statement. This summary statement is the first paragraph an investor reads about the company. It is similar to the preface of a book that provides a reader context and perspective; it tells them why they need to read the rest of the plan. But unlike a preface, which can run many pages, a summary statement must do its work in a single paragraph and must do it well enough to capture the imagination of the reader, and keep them from putting the plan down.

Here is a sample summary statement from a business plan which ultimately raised more than $1 million.

Dermaceutical Labs, Inc. has developed and markets a line of revolutionary anti-aging and skin care products marketed under the brand name NuCelle®. The moment for a line of products like NuCelle is now. Several demographic and attitudinal shifts — an aging population, rising importance of physical appearance, growing concern over skin-related disease and consumer acceptance of alpha hydroxy based products — are delivering double digit increases in the market for cosmetic products sold through direct response channels. The management of DLI believes that with an equity capital infusion, NuCelle can capture the full potential of opportunities which are now emerging in the $200 billion market for cosmetics. Dermaceutical Labs estimates that the programs and strategies outlined in this plan will generate sales and net income of $27 million and $2.5 million respectively during the first 12 months following funding.

As a parting comment, remember that the executive summary is the [italicize the] section of the plan the investor will read first. If an investor likes what they read in the summary, decides to meet with management and gets turned on, the rest of the deal might get negotiated without the plan ever getting read cover to cover. If however, the investor cannot make it through the summary the plan has failed to help you achieve your ultimate objective, then the rest of the plan is for naught.

Do not be discouraged though. Many Nozzs are required to get to Yes. And you didnzzt waste any time preparing the plan. The analysis, planning and downright hard analytical thinking that went into the document will pay dividends for a long time to come.

Presenting Your Business Plan
One of the main purposes of writing a business plan is to prepare entrepreneurs to meet with, present, and defend their plan before investors.

The discipline of presenting a business plan to investors is beyond the scope of this work. However, this section will provide the framework for presenting to investors and list of dozzs and donzzts.

– The Framework: Presenting a business plan to investors is roughly the same whether or not the group is large or small, and regardless of whether the investors are angels, investment bankers, individuals or venture capitalists. At the broad brush level the presentation must, in 20 minutes, answer the following five questions:

* What is the company and what are its strengths?

* How has it performed?

* Where is it going and why?

* How is it going to get there?

* What does it mean for the investor?

To do this, the entrepreneur must cover the same functional areas around which their business plan is organized. Specifically:

* Summary
* Description of the company and its business
* Market analysis
* Marketing operations/Expansion Plan
* Key personnel
* Financial analysis

– Dozzs & Donzzts. Telling someone how to make an effective presentation is analogous to a giving directions: Itzzs easy to say what to do, but much more difficult on the driver who has to get behind the wheel navigate his or her way through unfamiliar territory.

Perhaps the nationzzs leading authority on investor presentations, by sheer numbers alone, is Jeffrey Adduci, president of the Regional Investment Bankers Association, Charleston, South Carolina. The Regional Investment Bankers Association (RIBA) is a trade association, which among other activities, hosts five investment banking presentations per year for companies seeking an investment banker, selling an IPO, or developing market support. During his tenure as with the group, Adduci has run 50 conferences, and as a result has seen 1,600 [italicize 1,600] presentations by companies raising money.

“I have not only seen these presentations, but have the context of perspective,” he says. “By far, the most successful companies at raising money are in which management is effective at presenting themselves.” Here are Adducizzs observations on areas where companies frequently go wrong.

* Poor timing. “Entrepreneurs frequently say too much, or donzzt say enough. Either extreme is deadly,” according to Adduci. When the presentation is too long, it puts investors to sleep, indicates the entrepreneur is unsophisticated about the rules of engagement, and is uncertain what information is important to the investors. When the presentation is too short, the entrepreneur appears to be unwilling to share important information.

• The right length for your presentation is 20 minutes, 25 if your company is the next Microsoft.

* Live demonstrations. These are almost always a failure, particularly for technology-based products.

Adduci recalls one conference where a company attempted a live on-line demonstration. The screen on the speakerzzs laptop was projected onto a large screen at the front of the auditorium so that the 175 investment bankers in the room could see what was happening. “The entrepreneur took the podium, and hit the magic “start” button on his laptop computer,” recalls Adduci. “Unfortunately, the response was an error messaged indicated the Internet connection was broken.”

The speaker tried to log back on while introducing himself and the company. When the second attempt failed, the great elixir of personal computing, rebooting, was applied. Unfortunately, this threw the large screen projector, and threw it terribly, causing the large screen image to disintegrate into a sickly rainbow. The AV staff began to scramble but it was too late, the damage had been done.

• Use videotape for perfect demonstrations every [italicize every] time.

* Suspect numbers. Many times an entrepreneur will present historical profits which upon further, and perhaps more conservative, examination might actually show a loss. Others will present growth curves that look like a hockey stick. Aggressive revenue recognition policies, unrealistic reserves for returns or bad debts, overzealous capitalization of expenditures, the presence of deferred expenses turn profits into losses all work against the company. “When outrageous numbers show up on the overheads,” says Adduci, “Izzve noticed thatzzs when investors leave the room.”

• Present credible numbers.

* Droning on About Technology. “Entrepreneurs who are scientists or engineers are prone to make this error,” according to Adduci. “It hurts,” he says because “Once you lose an investorzzs attention, it can be hard to get them back.” Granted the technical aspects of companyzzs product or service are important — inasmuch as they deliver competitive advantages, open new markets, or change the balance of power in an existing one — but to investors technology is not important in and of itself.

• Spend no more than three to five minutes discussing technology. Any more time spent on science is less time devoted to selling the deal.

* Poor Attitudes. A banker might tolerate a fractious borrower. After all, if the company can repay a loan, a company can repay a loan. Equity investors are different however. In many ways, they are partners, and nobody wants a partner that will not listen to them. Adduci says that “Entrepreneurs who come across as condescending, unhelpful, rude, or above it all, tend to be less successful than those who are engaging.”

• Present your company with a positive mental attitude.

* Poor Response to Questions. “Many entrepreneurs goof on the inevitable question and answer part of the program,” according to Adduci. Therezzs many ways to do this. The most damaging however, is when the entrepreneur gives the impression that theyzzre smarter than the person asking the question, and compounds their error by throwing lots of technical jargon into the answer.

• Repeat the investorzzs question before answering it, and give them an opportunity to verify that you have repeated it correctly.

* Inappropriate Audio Visual Support. “Itzzs a mistake to let a corporate video run on for more than five minutes,” says Adduci. “After that amount of time, it start to give investors the impression that management is trying to hide something.”

At the same time, he says, making a presentation with no visual support whatsoever is difficult for all but the most gifted of speakers. Reason? “With so little time to say so much, if an investor gets distracted for even a moment, they may lose the context of the speakerzzs remarks without a visual outline.” The most effective presentations are accompanied by 10 to 15 slides, overheads or handouts that punctuate the speakers remarks, and give the listener a constant source of context. The slides below were used in presentations by Cooperative Images, Inc., a company which helps physicians market elective surgical procedures. The company was successful in raising $300,000.

* Inappropriate follow-up. When raising capital, particularly through private investors, the old rule is that yes comes fast, and no takes forever. Still, many investors will test the mettle of the business owner by seeing how long it takes them to follow-up. If itzzs not forthcoming, even for reasons of courtesy, many investors will get turned off. On the other side of the coin, calling everyday doesnzzt work either.

• Follow-up rapidly, but no more than three times. Then wait. If you havenzzt gotten an answer in two weeks, write the investor off, and move on.

* Burning Bridges. Raising money often takes a long, long time. Adduci has seen companies come to his conferences over the course of two years. Sometimes the things that turned investors off who saw the deal early on — product not fully developed, no sales, incomplete management team — correct themselves during the fundraising process. “Contacts made early on, may at some point become fertile ground for raising capital, unless of course the entrepreneur hasnzzt kept in touch, or worse yet, was less than gracious when the investor said no thanks the first time around.”


Now what?

In the face of so much information, itzzs often difficult to know what your first step should be.

Thatzzs easy. Start talking. Donzzt commit yourself to any particular course of action such as youzzve decided to go public or raise venture capital.

Simply start talking with business people who know you well, and who you respect, and tell them you are considering raising capital. See what they say, and see what directions they point you in. Challenge their ideas with the knowledge you have gotten from this book. After a while you will get a feeling for the direction you should be heading and who can help you get there.

Next, get out from behind your desk. You cannot raise outside capital by staying inside. The resources section of this book offers several venture capital clubs and forums that are worth attending. Go. Talk. Listen. Will you comeback with a check? Probably not. But you will know where to turn when you formally commence your search.

Next, start writing your business plan. We are frequently asked to write these plans, and entrepreneurs want to know zzHow long does it take?zz The answer is always the same. No matter how fast we write, it will not happen in less than 45 days, and might take as along as 180. The reason is that writing the plan provokes all kinds of thorny issues which must be settled, and sometimes requires the benefit of lengthy analysis and consideration. These issues range from engineering, to sales and sometimes at the most fundamental level, the form of incorporation.

So start this process now, for the reasons mentioned above, and because luck is where opportunity and preparation meet.

Finally start planning. I believe that planning is hard to do, especially for entrepreneurs. So, Izzm not talking about a Gantt chart. But work toward getting all of the fundamental pieces you will need in place. Get historical financial statements. Line up references that can speak on your behalf. Have a finished [italicized] business plan. Rehearse your pitch to investors. Start generating the leads you will need.

Raising the capital you need will take you through a gamut of emotions ranging from discouraging to exhilarating. One of itszz enduring charms however is the people you meet along the way. Equity investors are different, especially at this stage of the game. They are really partners. They meet with you in expectation of perhaps sharing a common goal. They know that your success could be their success and therefore ultimately, they want to see you win.



Appendix A – Overview of Securities Laws Influencing Private and Exempt Transactions

Probably the only barrier standing between investors, and the unbridled salesmanship — in some cases outright debauchery — of entrepreneurs are state and federal securities laws. The many layers of regulation are so complex, that it is an act of courage to attempt discourse on securities laws without the benefit of a legal background. Chiefly, this is because without formal legal training, the remaining tool is common sense, which quickly becomes woefully inadequate in this arena.

Securities laws prove bewildering for several reasons.

First, they exist at the state and the federal level. In addition to the Securities and Exchange Commission, which was created in the 1930s, every state in the nation fields their own securities commission, which generally speaking, carry out their duties with vigor.

Second, they are antiquated. For instance, at the federal level, The Securities Act of 1933, dates back to the same year — a time when regulators were still reeling from the crash of 1929, and the word Nasdaq was a bluff in a Scrabble game.

Third, changes in capital formation are raising thorny policy questions which not even the regulators are certain how to address. If an entrepreneur in New York generates interest, and eventually an investment through a private capital network from an investor England, are federal or New York state securities laws invoked? Are any U.S. securities laws invoked?

Fourth, securities regulators are perhaps the most tenacious of all regulators. Of course each new investment scam is more horrible than the one which preceded it, and salvation lies in regulation — but the democracy of these rules extracts a terrible burden upon upstanding corporate citizens.

This environment notwithstanding, entrepreneurs seeking to raise capital from private investors in more than one state, may be exempt from registration [italicize registration] under the Securities Act of 1933, a federal law which governs the pubic sale of securities, (and which incidentally is a bear) by adhering to the rules set fourth in Regulation D and Regulation A of the 1933 Act.

Regulation D
So called Reg D [italicize Reg D] is made of up six rules. The first three of these rules deal with definitions, general conditions and disclosure requirements, i.e., what the company must tell the investor, while the latter three deal with the kinds of offerings that are permitted under Regulation D. Herezzs a quick and essential overview of the definitions, as well as the kinds of offerings permitted by Reg D.

– Definitions. Eight terms are defined in Regulation D. Of these, the most important is the definition of an accredited investor [italicize accredited investor] and of the 16 definitions for accredited investors, the most relevant is the one which applies to individuals, as opposed to institutions such as banks and insurance companies. An individual [italicize individual ] who is an accredited investor has a net worth or joint net worth with spouse in excess of $1 million at the time they are purchasing any securities which you might be selling them; or have net income in excess of $200,000 or joint income with spouse in excess of $300,000 in each of the last two years and who reasonably expects similar income in the current year.

– Rule 504, Offerings Up to $1 Million. Rule 504 is the least restrictive of the exemptions and allows companies to raise $1 million in any 12 month period. There are no restrictions on the number or the qualification of investors. Unlike other Regulation D rules, 504 allows for advertising and solicitation of investors. Perhaps most importantly, shares purchased by investors in Rule 504 are freely transferable, without restriction placed on their resale.

– Rule 505, Offerings Up to $5 million. Offerings under Rule 505 may be sold to no more than 35 non accredited [italicize non accredited] investors and or an unlimited number of accredited investors. When non accredited investors are in the deal, certain information disclosure requirements about the offering and company come into play.

– Rule 506, Unlimited Private Offerings. Under Rule 506, the same limitation on non accredited investors applies, but with one additional caveat. The issuer, i.e., the company selling the securities, must “reasonably” believe, that the non accredited investors has ample sophistication to evaluate the deal on its merits and understand the inherent risks and opportunities. And again, when non accredited investors are in the deal, certain information disclosure requirements materialize.

Regulation A
So called “Reg A” offers the same exemption from registration under the Securities Exchange Act of 1933 offered by Regulation D, but with important distinctions, of which some are good, and some are restrictive. The good parts are that companies can issue up to $5 million in any 12 month period, there are no restrictions on the number or qualifications of the investors, and there are no restrictions on the resale of securities.

On the flip side, Regulation A may require the company have positive net income, and that an offering circular similar to a prospectus in scope (and degree of difficulty) be provided to investors. While the feds donzzt require audited financial statements in this circular, some states do, and the circular, as part of a more comprehensive offering statement must be filed with, reviewed and cleared by the Securities and Exchange Commission. Uh-oh.

One frequently touted advantage Regulation A has over Regulation D, is the so called “testing the waters” provision. This allows entrepreneurs to promote their offering through the media or live presentations prior to filing the SEC-required offering statement, and gauge whether or not their is sufficient interest in the deal to warrant the expense of moving forward. Although at first blush this seems like a handy tool, itzzs rarely used. Principally this is because the mind set of most entrepreneurs is that of course [italicize of course] therezzs going to be sufficient interest, while the orientation of high strung intermediaries such as small brokerage firms which often place the offering is they are either doing a deal or they arenzzt. Finally, the testing the waters provision is rarely dusted off because itzzs difficult enough to solicit investors once, so therezzs little to be gained except more work, by trying to do it twice.

Intra-State Offerings & State Securities Laws
Finally, as any disciple of the United States constitution would suspect, any intra-state [italicize intra] offering, that is an offering sold to investors within the borders of a single state is exempt from registration under the Securities Act of 1933 via the SECzzs Rule 147. The reasoning goes that an offering within a state, is that statezzs province, and that the imposition of any federal requirement constitutes a violation of its sovereignty. Accordingly offerings which are exempt under Rule 147, need only meet the requirements of the relevant state securities laws. However, along with selling only to residents of one state, those residents canzzt resell shares to out of state persons for nine months, at least 80% of the money raised has to be spent in that state (which has to be the “home” state of the business) and other
strict rules.

But in many cases, the states are where the trouble can begin.

All of the above-mentioned exemptions offered by the Securities and Exchange Commission were crafted to ease access to capital by small companies. It quickly became apparent to all parties concerned (though not so quickly changed) that the federal laws governing the public offering of securities, chiefly the Securities Act of 1933, and the federal laws governing the periodic reporting requirements for the benefit of investors, chiefly the Securities Exchange Act of 1934, caused serious impediments to raising capital.

Regulation D, in particular, works like a charm providing relief from these federal securities laws. The challenge enters with state securities administrators which often have very different views regarding the protection of investors in their domain.

For instance while federal securities laws set standards regarding the disclosure of information to investors, many states, so called merit states, actually set suitability standards that the company or the investors must meet to participate in an offering. And while the feds say itzzs ok to advertise a Reg D, 504 offering and solicit investors, many state securities regulators say such activity is strictly verboten.

With 51 regulators to contend with — 50 states and one federal government — entrepreneurs face myriad inconsistencies, agendas and intents. Sometimes, these inconsistencies conspire to perpetrate unusual and at times undesirable results — for companies seeking capital as well as investors. For instance, when Apple Computer went public, investors in Massachusetts could not purchase stock in the initial public offering, because the then tiny computer maker could not pass muster on the merit review. Apparently, there was some puritanical residue in the statezzs securities laws.

Worse, the problem can be compounded in an Internet-based matching environment such as the one Ace-Net is operating in, where the idea of a boundary is very difficult to control. To see this in action, consider the following hypothetical, but possible scenario.

An investor in one state could see an offering on Ace-Net for a company in Colorado. Even though the offering is not registered with the investorzzs state securities commission, he or she might nonetheless contact the entrepreneur. Further suppose the investor visits the entrepreneur, and a handshake deal is stuck for the company to sell, and the investor to buy, common shares in the company. To ensure the legality of the transaction, the entrepreneur then registers the offering in the investorzzs state. The regulators there declare the offering illegal and prevent its consummation. Why? Because the investorzzs state, like many others, has a prohibition against soliciting investors in the state without prior registration of the offering, and posting an advertisement of the deal on a national network visible to the statezzs investors constitutes such a solicitation. This doesnzzt mean that cooler heads wonzzt prevail in the final analysis, but therezzs no guarantee they will either. After all regulators exist to regulate.

At the state level, the best news is the growing popularity of the Small Company Offering Registration, also known as Form U-7. Basically, the SCOR form, which gave rise to the term SCOR offerings [italicize SCOR offerings] is a common registration statement accepted by 43 states for offerings of less than $1 million.

Such offerings, by virtue of their size, are also exempt from federal securities laws under Regulation D. Using a SCOR form, companies can easily file a registration statement for their offering in several states in which they want to sell the offering.

While filing of the registration statement is made easier by virtue of the SCOR form, gaining the separate approval of the states to sell [italicize] the securities is another matter altogether. The approval processes range from a rubber stamp, to zzput me in a rubber room.zz In a favorable trend, the states have established zzregional review,zz so that only one state in each region will actually go over the filing and make comments on behalf of all the others. This coordinated review is now available for Regulation A and other small business filings.

Appendix B – Sources You Might Not Have Considered

The financing sources and techniques discussed in chapters two through five are the most popular and conventional techniques for raising capital. Still, there are other ways to raise money. The techniques described below represent some creative strategies used by entrepreneurs to fund their businesses. Of these techniques,

to following techniques below

Contact a Community Loan Development Fund
These are not for profit groups staffed by community and business leaders and funded by churches, private citizens, and in some cases other banks to make smaller, community-based loans. The agenda of these funds is pretty clear. Theyzzre trying to improve the quality of life in an area by brining in jobs, and to do this they will go where a bank wouldnzzt dare.

Consider the case of Mike Bryan and Dave Miller, veteran managers of saw mills who longed for a business of their own. When the opportunity came up to buy a closed down mill for cheap, the pair jumped at the chance. The only problem was capital. They needed about $100,000.

There were risks to be sure. Not only was the business they had in mind a pure start-up, but mills were closing by the score throughout the northwest. In short, there wasnzzt a bank that would touch the deal. But the Cascadia Revolving Loan Fund, a community loan development group in Seattle would.

According to loan officer Josh Drake, Cascadia stepped up to the plate in December of 1995 with $75,000 in equity and a $25,000, five year term loan. The fund, as well as the surrounding community has been well rewarded for their confidence in the pair of rough hewn entrepreneurs. Bryan and Millerzzs North Star Lumber Co., in Shelton, WA about 150 miles southwest of Seattle, was profitable in 1996 on $5 million in revenues, and the payroll has grown to 50 employees.

Cascadiazzs Drake says equity investment, though unusual for a community loan development fund by historical standards, is a growing trend.

• To locate a community loan development fund near you call the National Association of Community Loan Development Funds at 215-923-4754.

Tap Your 401(K)
For would-be entrepreneurs cut loose from corporate America with a 401(K) plan, capital is right at their fingertips. They need only set up an employee stock ownership plan (ESOP) in their new company, and have their 401(k) purchase shares from the ESOP.

In truth, itzzs a tricky transaction, but the benefits are compelling: capital can be raised without the time or expense of seeking outside investors, and most importantly, founders do not give up any equity. In addition, if the company grows, and employees participate in the plan, founding shareholders get a built in exit strategy since the ESOP will purchase their shares at fair market value.

“Every accountant, attorney and securities professional I spoke with told me the transaction could not be done because 401(k) plans are prohibited from investing in private companies,” says Jim OzzBrien one of the founders of Print Management Partners based in DesPlaines, IL. Attorney Greg Brown, however, an ESOP specialist, with Seyfarth, Shaw, Fairweather & Geraldson, Chicago, IL, said with little fanfare, but a great deal of confidence, that such a transaction could be done and went on to engineer one for Print Management Partners.

Brown, who is the head of the Legislative and Regulatory Advisory Committee for the ESOP Association, Washington, D.C., says that many professionals donzzt think 401(K) financing is viable for small private companies because they believe the issuance of stock to employees requires a full blown registration statement, similar to regitrations filed when a company goes public. “If that were the case,” says Brown, “this technique probably wouldnzzt work for small companies.” But he says, companies can issue stock under Rule 701 of the Securities Act of 1933 for compensatory benefit programs. “Benefit plan registrations,” says Brown are much easier to complete, and much less expensive to file, which makes it viable for emerging companies.”

Print Management Partners was formed when six associates from a large label and forms printer left en masse, each taking with them a 401(k). Working with Brown, a valuation specialist, an accountant, and a brokerage firm to act as custodian, the principals of the new firm were able to tap their 401(k)s to the tune of $427,000 for equipment, receivables and inventory. There were no adverse tax consequences, and the company did not relinquish any equity to outsiders. While their 401(k)s still hold other securities, Jim OzzBrien, one of Print Managementzzs founders, feels confident about the investment in his own company. “This was the safest investment we could make because we understand the business inside and out, and have control over its destiny.”

• Contact ESOP specialist Greg Brown with Seyfarth, Shaw, Fairweather & Geraldson, Chicago, IL. 312-346-8000.

Put Your Business In An Incubator
So-called incubators offer their small business clients financial and professional assistance that typically includes flexible space and leases, orchestrated exposure to a network of business and technical consultants, access to university resources and entree to new business opportunities through cooperative ventures with other incubator clients. Most importantly, according to Dinah Adkins, at the National Business Incubation Association, Athens, Ohio, most of the 550 incubators in North America offer some formal or informal access to financing, in the form of affiliated angel networks, in-house seed funds, or dedicated revolving loan funds.

To see just how effective business incubation can be, consider the case of Katherine Hammer founder and chief executive officer of Evolutionary Technologies International, Inc., Austin, TX,

Though an assistant professor of linguistics, in 1991 Hammer traded in the challenges of ancient Norse dialects for the contemporary brain teasers associated with COBOL. She founded Evolutionary Technologies to help large companies with data integration management and keep related data on different systems consistent.

After doing basic research at the Micro Electronics and Computer Technology Corporation in Austin, Hammer moved across town to the Austin Technology Incubator. According to Hammer the founder of the incubator was George Kozmatsky, who was also the founder of technology giant Teledyne. “George provided us with unbelievably helpful counsel and guidance,” recalls Hammer.

But he also provided her with introductions to an informal network of angel investors that were affiliated with the incubator. One of these investors was Admiral Robert Inman, made a $250,000 commitment that anchored another $1.25 million from other area investors, for a total first round financing of $1.5 million. “Our acceptance in the incubator carried weight,” she says, “by being accepted there, it offered due diligence value to investors.” Hammer worked miracles with the capital, and today her Evolutionary Technologies, some say the poster child of Austin, is profitable with some $22 million in sales.

Though many incubators focus on technology, in reality, the majority do not. According to Adkins, of the current incubators in operations 40% concentrate on service, 23% on light manufacturing, 22% on technology, 7% on basic research and the remaining 8% support diverse businesses and industries.

To find an incubator near you, send a self addressed stamped envelope to:

National Business Incubation Association
20 East Circle Drive
Suite 190
Athens, OH 45701

Utilize Royalty Financing
Conventional wisdom suggests that to raise money, companies sell equity. A creative approach suggests selling a piece of companyzzs revenue stream instead. So-called royalty financing works well in several situations and delivers a host of benefits to early stage companies.

The technique was used by Terralink Software Systems, South Portland, Maine, to turbocharge its sales and marketing efforts. Terralink developed and sells a PC-based software product to help companies manage hazardous waste information, and comply with environmental laws.

Though company founder David Fernald was pleased with the companyzzs growth in sales, he said, “My feeling was, we needed to get to $750,000 in sales before repeat and referral business would really kick in, and to get to that [italicize that] level we would need funds to expand our marketing efforts.”

But Fernald faced the typical dilemma of early stage companies. With the Terralink still in its formative stages, investors — whether venture capitalists or angels — would want a big piece of the company.

To avoid this dilemma, Fernald turned to royalty financing. He structured a deal so that instead of equity or debt financings investor put up an “advance” of $200,000 against its future sales. In Terralinkzzs case, the investors were two state economic development organizations.

In exchange for the advance, investors each received 3% of Terralinkzzs sales for 10 years, or until they received payments totaling $600,000. This $600,000 would represent the original $200,000 investment, plus $400,000 more. If Terralink repays the advance over 10 years, investors will earn a compound annual return of 11.6% on their investment. If however, Terralinkzzs sales mushroom, and $600,000 is paid to the investors in five years, their compound annual return will mushroom also to 24.5%.

Fernald says the technique has several advantages.

First, royalty financings can be easily structured with individual investors. He speculates that a monthly or quarterly return — which happens as long as sales occur — would be more preferable to individual investors than the total absence of a yield and zero liquidity that is typical of early stage venture deals.

Second, because the royalty advance is, at the end of the day a loan it does not provoke any state or federal securities laws which may require complex filings that generate significant legal fees.

Third, investors taste the fruits of success early and for a prolonged period of time rather than waiting for the discrete and sometimes elusive payday of an IPO or buyout.

Fourth, a company funded by royalty payments increases its financeability down the road. If the funds do in fact ramp up sales, the company becomes a more attractive candidate for additional financing. In addition, sometimes the presence of one kind of equity investor precludes the participation of other kinds. For instance, a company financed with institutional venture capital funds cannot, in most cases, ever go back to raising money from individuals. But by “saving” itself for outside investors to a later round of financing, a company keeps its options wide open.

Fifth, and most importantly, the royalty structure preserves the equity positions of the founders.

Fernald says that while royalty financing is a great technique, itzzs not for everyone.

For instance, he says, “Itzzs not a good idea for companies that have very thin margins.” After all, if your gross margin (sales less cost of goods sold) is just 10%, and six percent goes to royalty payments, then the remaining four percent doesnzzt leave much room for making any money. Terralink, for instance, has a gross margin of 90%.

Fernald posits that royalty financings work best for companies whose pricing is fairly elastic. “If you can raise your prices to cover the lost margin, and not lose any loose any customers, you are a better candidate than a company where customers are price sensitive.”

In addition, Fernald suggests that royalty financing wonzzt work for companies that do not see an immediate cause and effect between marketing efforts and sales. “Youzzve got to be able to turn on sales like a spigot,” he says. Otherwise, one of the primary benefits for which investors are in the deal — namely a monthly royalty check — becomes seriously compromised.

In theory, royalty financing will work for a company that is about to launch a product, but doesnzzt yet have revenues. Obviously you have to be able to inspire confidence among investors that you have the skills an experience that will move products or services off the shelf frequently and quickly.

Finally, royalty financing probably wonzzt solve all of a companyzzs financing needs for all time. But it can definitely deliver a company from the dilemma of giving up too much equity too early on.

• For a primer on royalty financing send a self addressed stamped envelope to Banking Dynamics, 97 A Exchange Street.
Portland, ME 04101.

• If you are located in the northeastern United States, maintain high gross margins and want to raise $500,000 or less in royalty financing contact Royalty Capital Management, Five Downing Road, Lexington, MA 02173. 781-861-8490. Contact: Arthur Fox

Look Overseas
Believe it or not, itzzs different here. While in America, it seems that everyone and his brother has a business plan and a deal, there simply isnzzt the same volume of investment opportunity in Europe, South America and Asia. To find exciting young companies however, with new technologies or new products that can open up vast new markets virtually overnight, foreign investors have to hunt further afield. Fortunately, their hunting frequently brings them to U.S. shores.

But therezzs another, strategic factor that can bring the foreign investors to your door: licensing and joint venture opportunities. Many foreign investors want the opportunity to capitalize on new technology, new products and new business concepts in their immediate geography. One way for them to do this is to make an investment the U.S. company with licensing rights in their territory as part of the deal.

As a case in point, consider Larry Fondren, founder, president, and chief executive officer of InterVest, Berwyn, PA, a technology company seeking to revolutionize the trading of debt instruments.

Little known to many investors the trading market for most corporate and municipal bonds has not kept pace with the technological developments which have driven equity trading. “Rather than the leading edge technology, bonds rely on the simple technology of phones and faxes.” says Fondren. In fact, he says, for most bonds, there is very little centralized trading information that lets investors understand trading history, recent prices and bids from other buyers — all of which is standard for even the humblest of equities that trade on the lowest rung of the Nasdaq Stock market, the shadowy Bulletin Board.

As a result, the bond market can be terribly inefficient with hidden costs which have a serious negative impact on the profits of bond investors. Enter Fondrenzzs InterVest which has developed an electronic exchange for fixed income securities (i.e., bonds) through which institutional investors can trade directly with each other without third party intermediation. The official launch of the system occurred during the first quarter of 1997.

Of course an idea like this takes capital and plenty of it. After plowing in all he had, plus another $1.5 million borrowed funds from friends, family and credit cards, Fondren went looking for more capital. Working with Shamrock Partners, an investment banking firm with offices in New York, Chicago and Philadelphia, Fondren quickly closed a deal with his first outside investor, British merchant banking and trading firm, Dawnay, Day. Though merchant bankers are always looking for investments, the InterVest deal demonstrates the synergies that can occur between U.S firms and their counterparts overseas.

According to Fondren, Dawnay, Day, based in London, and which trades government bonds throughout Europe invested “not only get a return, but also have the ability to license and import technology that would give them a competitive edge in their marketplace.” Indeed, the InterVest technology was just the kind of system that Dawnay Day would soon find itself competing against, and to have it in their arsenal was a powerful strategic advantage.

Naturally, Fondren wanted capital, but he also wanted something more. “Our business has global potential. But trading bonds in the U.S. is tricky enough. To take our system, say into Europe, we needed a local partner that knew the subtleties, conventions and regulations in the many different markets there.”

According to Shamrockzzs Joseph Huard, the United Kingdom, Germany, and the advanced economies of the Pacific Rim such as Japan and Malaysia are presently where interest in American companies is highest. “These countries have many large businesses that are well established and forward looking,” says Huard. “But they do not necessarily have the infrastructure to support growing companies that are so commonplace here.” Moreover, Huard adds that in many of these countries, consensus and status quo rules, not the engineer in the laboratory with unconventional ideas that lead to new products and services. Accordingly he says, therezzs not likely to be a surge in entrepreneurialism anytime soon that will detract from the interest in American companies.

Key requirements for success in raising capital overseas says Huard are products or services which are universal in appeal, but for which, at least initially, there is a specific target or clientele. Unfortunately, unless you have relatives overseas finding investors there is probably too risky to attempt without professional guidance. “Itzzs still a wild world out there,” says Fondren, “without a professional that knows the territory, you could find yourself quickly lost and in trouble.”

Get a Margin Loan From a Wealthy Investor
According to Steve Cohen, once a financing consultant who helped raise capital for emerging companies, and now vice president of finance for Tradepoint of America, New York City, wealthy individuals which typically do not invest in emerging companies, might be convinced to do so utilizing margin loans. Herezzs how it works.

A wealthy individual with large investments in the stock market takes a loan out against their holdings in a particular security. For instance, if an investor owns $200,000 of Consolidated Edison, the brokerage firm holding the stock will loan the investor $100,000, or more. This is called a margin loan, and margin interest rates, because the loan is fully collateralized, are typically one to one and a half points below [italicize below] prime.

The investor then lends the proceeds of the margin loan to the entrepreneur utilizing a straight promissory note. The terms of the promissory note are simple, says Cohen. “The borrower agrees to pay the margin interest plus a premium of perhaps 3%, plus any margin calls.” A margin call occurs when the value of the stock collateralizing the loan falls below the value of the loan. This happens when the price of the stock declines and the result is the brokerage firm calls [italicize calls] their customer and asks them to make up the difference.

Cohen says that stock market investors will often make this kind of deal because it doesnzzt cost them anything, leaves all of their personal capital at their disposal, and if all goes well, lets them enjoy a certain amount of leverage from their stock market holdings The very real risk to the entrepreneur, says Cohen, is that they may have to make what amounts to principal payments on funds they did not borrow when their lender gets a margin call. Naturally, this source of capital is more appropriate for companies which can support an interest and principal payment, but which for one reason or another, canzzt get the commitment of a bank.

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