A Lawyer’s Guide to Raising Capital

By: Todd KulkinLaw Offices of Todd Kulkin, P.C. 60 East 42nd Street, Suite 4600

New York, New York 10017(212) 485-9884

todd@kulkinlaw.com

Agenda⚫ Introduction to business fundraising⚫ Types of capital and sources⚫ Introduction to Private Placements⚫ Discussion of new crowdfunding regulations⚫ Valuation considerations⚫ Creating a great pitch deck

When Does Your Client Need Fundraising

⚫ All new businesses require start-up capital and many businesses need capital infusions to weather difficult times or expand.

⚫ Not every business needs $1M to begin⚫ Cost considerations in seed phase:

◦ Prototype (if needed)◦ Operating capital◦ Inventory◦ Marketing◦ Salary for founders◦ Legal (especially IP)

Fundraising Sources ⚫ Solutions for smaller capital needs:

◦ Friends/Family◦ Factoring◦ Invoice Discounting◦ Crowdfunding (New)◦ Traditional Banking

⚫ Solutions for larger capital needs:◦ Venture Capital◦ Angel Investors◦ Project Finance◦ Investment Banks/private equity◦ Initial Public Offering◦ Traditional Banking

Debt Financing vs. Equity Sale ⚫ Fundraising comes in two broad categories: debt and equity financing⚫ Debt financing = obtaining capital via a promissory note⚫ Bond issuance = Tradeable secured notes⚫ Equity financing = selling the company’s securities for cash⚫ Equity financing may also be used to obtain IP⚫ Cost of debt financing is interest whereas cost of equity financing is

control and capital distributions⚫ Hybrid models available (e.g., equity buyback)

Convertible Notes⚫ Sometimes called “debt/equity swap”⚫ Agreement for secured or unsecured debt with option for equity buyout⚫ Usually includes a discount on the equity⚫ Partial conversion may be available⚫ Beware unintended consequences for future valuation⚫ Conversion is a sale of securities for regulatory purposes⚫ Remember: accrued interest factors into the conversion rate

Angel Investors⚫ High net worth individuals who invest their own funds on high risk

start-ups⚫ Usually are the first to invest after friends/family⚫ Provide “seed capital” so a company can obtain proof of concept⚫ Favor convertible notes and large equity buys⚫ Despite being an individual, investment is usually done through an

intermediary entity⚫ Subject to dilution in later rounds of investment⚫ Most “expensive” capital available

Venture Capital⚫ A type of private equity firm – pooled funds from high net worth

individuals ⚫ High risk -> high reward model⚫ Generally come in for “Series A” capital raise⚫ Series A refers to initial manufacture⚫ Exit strategy for VCs is Initial Public Offering or acquisition⚫ Appropriate for start-ups with high capital needs that are not obtainable

by other means. ⚫ Provide access to “venture debt” (i.e., loans)⚫ Larger investment amounts than angels

Project Finance⚫ A type of debt financing relying on a project’s revenue generation for

payment. ⚫ Almost always secured by the project’s tangible assets (UCC article 9

interest)⚫ Sometimes secured by surety bond⚫ To insulate liability, project financing is usually done via a Special Purpose

Entity (SPE)⚫ Lenders take equity in the SPE as well as secured interest⚫ Popular in construction and energy projects

Factoring vs Invoice Discounting⚫ Factoring refers to the purchase of accounts receivable for a discount⚫ Invoice discounting is a loan based on projected receivables⚫ Factoring is useful for quick cash, but the discount is usually deep⚫ Invoice discounting comes with risk: repayment is required regardless of

the company’s ability to collect on the receivables⚫ Most popular in the retail market and companies who require lots of

supplies (e.g., construction, manufacturing, and transportation)⚫ Risk assessment in factoring depends on the credit worthiness of the

customers whereas in invoice discounting its based on the credit worthiness of the company

Negative Cash Conversion⚫ Also called “vendor financing”⚫ This technique is rarely available for brand new businesses, as it requires

a certain size, but its worth noting as a “tool in the belt.”⚫ Generally used during an expansion in a retail company such as a new

location⚫ In vendor financing, suppliers retain ownership over their products until

an end customer purchases it from a company⚫ This allows a company to focus its capital raise on other aspects which

make higher sales more likely (e.g., marketing)⚫ Famous example: AutoZone

SEC Registration Requirement⚫ Registration statements include:

◦ A description of the company's properties and business;◦ A description of the security to be offered for sale;◦ Information about the management of the company; and◦ Financial statements certified by independent accountants.

⚫ Under the Securities Act of 1933 (the “33 Act”) a company may not offer or sell its securities in the United States unless: ◦ (1) such securities have been registered with the Securities and

Exchange Commission and registered/qualified with applicable state commissions; or

◦ (2) there is an applicable exemption from registration.

Crowdfunding⚫ On October 30, 2015 the SEC adopted crowdfunding regulations under

Section 4(a)(6) of the Securities Act of 1933⚫ For the first time, companies may offer their securities via crowdfunding

“portals.” ⚫ US companies may crowdfund without registration with the SEC so long

as the aggregate raise is less than $1 Mil in a calendar year (similar to Rule 504)

⚫ Offerings may take the form of common stock, preferred stock, another form of equity interest in the issuer, or debt

⚫ Securities bought this way may not be transferred for one (1) year ⚫ Crowdfunding Investor Limitations

◦ If net worth <$100,000: greater of $2K or 5% annual income or net worth

◦ If net worth > $100,000: Lesser of $100K, 10% annual income or net worth

Private Placement⚫ Rules 504, 505, & 506 ⚫ This includes all securities (yes, even options). ⚫ Accredited vs Non-accredited investors (Reg D)

◦$1,000,000 net worth or $200,000 annual income (not including primary residence)

⚫ Rule 147 (i.e. the Intrastate securities rule)◦ The company must be incorporated in the state in which it is offering

the securities◦ The company must carry out at least 80% of its operations in its home

state (i.e., state of incorporation)◦ Sale of securities is limited to the company’s home state

Introduction to Private Placement Procedure

⚫ Letter of Intent⚫ Private placement memoranda⚫ Due Diligence re: accredited investor⚫ Equity Purchase Agreement⚫ Bad Actor Affidavit ⚫ SEC Form D:

https://www.sec.gov/about/forms/formd.pdf

What is an Accredited Investor?⚫ Defined by Rule 501 of Regulation D⚫ Institutional Accredited Investors ⚫ Any bank or any savings and loan association or other institution as defined in section

3(a)(5)(A) of the Act whether acting in its individual or fiduciary capacity;⚫ any broker or dealer registered pursuant to section 15 of the Securities Exchange Act of 1934;⚫ any insurance company as defined in section 2(a)(13) of the Act; ⚫ any investment company registered under the Investment Company Act of 1940 or a business

development company as defined in section 2(a)(48) of that Act;⚫ any Small Business Investment Company licensed by the U.S. Small Business Administration

under section 301(c) or (d) of the Small Business Investment Act of 1958; ⚫ any plan established and maintained by a state, its political subdivisions, or any agency or

instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5,000,000;

⚫ any employee benefit plan within the meaning of the Employee Retirement Income Security Act of 1974 if the investment decision is made by a plan fiduciary, as defined in section 3(21) of such act, which is either a bank, savings and loan association, insurance company, or registered investment adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited investors;

⚫ (2) Any private business development company as defined in section 202(a)(22) of the Investment Advisers Act of 1940;

⚫ (3) Any organization described in section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;

Individual Accredited Investors⚫ Any director, executive officer, or general partner of the issuer of the securities being offered or

sold, or any director, executive officer, or general partner of a general partner of that issuer;⚫ Any natural person whose individual net worth, or joint net worth with that person's spouse,

exceeds $1,000,000.◦ For natural persons, keep this in mind: The person's primary residence shall not be included

as an asset;⚫ (B) Indebtedness that is secured by the person's primary residence, up to the estimated fair

market value of the primary residence at the time of the sale of securities, shall not be included as a liability (except that if the amount of such indebtedness outstanding at the time of sale of securities exceeds the amount outstanding 60 days before such time, other than as a result of the acquisition of the primary residence, the amount of such excess shall be included as a liability); and

⚫ (C) Indebtedness that is secured by the person's primary residence in excess of the estimated fair market value of the primary residence at the time of the sale of securities shall be included as a liability;

⚫ Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;

⚫ (7) Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in §230.506(b)(2)(ii); and

⚫ (8) Any entity in which all of the equity owners are accredited investors.

Utilizing Sweat Equity⚫ This is a tactic to raise much needed human capital⚫ Places a value on the services of an employee/independent contractor to

the company⚫ Employee/independent contractor takes a cut on the value for cash and

the remainder is placed on a ledger for the future purchase of securities⚫ Tag the sale of securities to a period of time or triggering event (e.g.,

equity sale)⚫ Caution – do not tag the sweat equity to a specific percentage⚫ Do, however, place a ceiling on the percentage⚫ Example:

◦ An engineer usually charges $300/hour for his services which are required by ABC start-up. ABC start-up pays the engineer $100/hour and places $200 on a ledger for each billable hour spent.

Valuation Considerations⚫ Always subjective, regardless of time⚫ Previous rounds of investment may affect future

valuation⚫ Third-party valuation based on projections or

liquidated value of hard assets (including IP)⚫ Projections are rarely reliable unless backed by

contracts & insurance.

Beware the Option Shuffle ⚫ Common practice which dilutes pre-money share price ⚫ Valuation is decreased due to a 20% option pool determined by investors⚫ Large option pool = less capital provided by investors⚫ Investors generally don’t put the option pool in post-money valuation⚫ Cancelled by acquisition before Series B, which ups valuation without

added value⚫ Can be circumvented by phantom equity plan or mitigated by a hiring

plan⚫ For more detail, see: http://venturehacks.com/articles/option-pool-shuffle

6 Questions a Pitch Deck Must Answer

⚫ What is the inherent problem that the start-up wants to solve?

⚫ In what way for the start-up solve the problem that’s different from the competition?

⚫ What is the nature of the target market?⚫ How much money does the start-up need for the next step

and where will it be used?⚫ What is the start-up’s growth strategy over a significant

period of time?⚫ How does the investor get out with their capital and a

strong ROI? (i.e. what is the exit strategy)

Questions?

Law Offices of Todd Kulkin, P.C. 60 East 42nd Street, Suite 4600

New York, New York 10017(212) 485-9884

todd@kulkinlaw.com