Companies require capital to thrive. While a few companies manage to succeed with just the funds they raised at the kitchen table, most successful companies, particularly those involved in technology, raise money from professional investors, or from the public, at some time in their histories. Strategies for raising funds include angel financing, venture capital financing, public market IPOs and direct IPOs.
Angel Financing refers to backing from one or more individuals who take an interest in helping small businesses grow. These investors make most or all of the same demands that professional venture capital (VC) firms make, but are sometimes willing to get involved at an earlier stage in a company’s development, and are interested in (and sometimes limited to) smaller financing than would typically interest a VC firm.
Venture Capital (VC) refers to financing that comes from firms in the business of investing in young, privately-held companies. VC firms usually don’t want to participate in the initial financing of a company unless the company has management with a proven track record. Generally, they prefer to invest in companies that have already received significant equity investments from the founders, and, if necessary, their friends and family, and have something to show for their efforts, either in the form of a patent, a proven demand for the product, or a very special (and protectable) idea. VC investors often take a hands-on approach to their investments, requiring representation on the board of directors and sometimes the hiring of new corporate officers. VC investors can provide valuable guidance and business advice, and are looking for substantial returns on their equity investments. VC firms are often structured as limited partnerships whose investing partners include 501(c)(3) organizations or offshore entities. To reduce certain tax risks for these types of investors, VC firms will usually only invest in C Corporations (and may therefore require businesses using other structures to convert to C Corporations before receiving an investment). In addition, because VC firms are not individuals, an S Corporation will be automatically converted to a C Corporation if a VC firm becomes a shareholder.
Public Market IPOs
Public Market IPOs are usually available to companies with profitable operations, management stability, and strong demand for their products or services. This generally doesn’t happen until the company has been in business for several years. To get to that point, the company will usually have had to raise money privately on more than one occasion.
While a start-up may not be able to access public markets right away, it can improve its future appeal by being careful in structuring its early financing. For example, a company can include in its standard shareholders agreement a provision that requires each shareholder to refrain from selling into the public markets for some period (such as 6 months) after an initial public offering (IPO). Underwriters routinely require such a share lock-up, which can be difficult to arrange if, for example, shares have been left by a deceased founder to a widow who has little interest in locking up her shares and less appreciation of the importance of agreeing to do so. Other planning issues will affect a company’s ability to show a profit after the IPO, which is always a key concern to underwriters.
Direct IPOs, or initial public offerings, made directly by the company, are possible through the Small Corporate Offering Registration (SCOR) form U-7. In such an offering, a company sells stock to the public without the benefit of an underwriter. When these transactions work, they are wonderful, but successful SCOR offerings are few and far between. They require a special relationship between the Company and a target investor group that is numerous, loyal, and well-heeled enough to be able to invest at least $5,000 to $10,000 of high-risk capital in a young company.
At Sunstein, we have represented companies at each of these stages of financing, and have advised clients on how best to position themselves to attract such financing. Please contact our Business Practice Group for more information about these options.