A great business idea is not enough—a business needs capital to thrive. Attorneys can help their clients consider all the financing options, figure out which one(s) are the best fit, and comply with applicable laws.
Financing sources vary in their appropriateness for a particular business venture and in the type and amount of financing they’ll provide. That’s why it’s so important to know about the pros and cons of each potential source. And don’t just focus on a single source of capital; it’s often safer to pursue multiple paths concurrently, just in case one falls through.
Consider these 10 major capital sources when a client needs a financing infusion:
- Friends, Relatives, and Business Associates. These people are probably the largest potential source of capital, at least in numbers if not in dollars. They may be well acquainted with the business’ principals and may be familiar with its operating history and need for capital. It may be relatively easy to interest them in providing capital, but keep in mind that state and federal securities laws apply to these transactions. This means that the business will need to identify and comply with one of the available exemptions for so-called “private placements” under those laws.
- Angels. Angels are high-net-worth individuals who seek high-risk/high-return investment opportunities. They can be a good source for bridge financings, used to raise seed capital for start-ups or small amounts of capital between financing rounds. They’re often harder to find than other capital sources, but beware of trying to find them through general solicitation or advertising because this could run afoul of federal or state securities laws.
- Government Programs. Government agencies may be the largest source of funding available to small businesses. The programs available are often not totally government-funded and controlled. In some cases, the federal government provides financial leverage and in others it guarantees funding by banks or other private sources. State and local governments also provide an array of financial assistance, with availability based on the company’s industry and location.
- Venture Capital. Venture capital investors (so-called “VCs”) include those with capital from private sources only and those that funnel both government and private funds to invest in startups. Depending on their source of funds, VCs may make their investments via loans or convertible debentures or else via preferred or common stock. Venture capital providers include private equity funds, small business investment companies (SBICs), capital access companies, and business development companies.
- Corporate Partners. Corporate partnering can take various structures, but often involves a debt or equity financing by a corporate investor that may be coupled with a business relationship. Unlike a traditional partnership, corporate partnering often involves a contractual relationship but not a separate new legal entity. The goal for a new business is to receive financial and other assistance from the partner while remaining an independent company.
- Institutional Sources. Commercial banks, finance companies, insurance companies, pension funds, and other institutional lenders are a major source of private financing. Transactions with these lenders are usually structured as direct loans, but a new business may be able to negotiate important terms such as the interest rate, maturity, and prepayment terms if the loan is coupled with warrants or other equity features. This type of financing is often accompanied by restrictive covenants on future financing, operation of the business, and other matters.
- Incubators and Accelerators. Incubators and accelerators provide new entrepreneurs with mentors, advisors, and practical training on technical, business, and fundraising topics to help them get from idea to product launch and beyond. They also may invest small amounts of capital for small equity stakes (at very favorable valuations) in exchange for entry into their programs. Accelerators provide mentorship to new ventures formed around externally developed ideas and generally operate 3- to 4-month “boot camp” style programs, while incubators bring in external management teams to manage ideas that were developed internally.
- Crowdfunding. Crowdfunding generally refers to raising large amounts of capital to finance a project or business venture through small dollar contributions from a large number of people, typically over the Internet, exploiting social media tools. There are many crowdfunding sites on the Internet (e.g., Kickstarter and IndieGoGo), but in the U.S. those sites have only been allowed to operate on a donation or reward basis, by offering a product, discount, or other inducement in exchange for monetary contributions. However, the Jumpstart Our Business Startups Act (JOBS Act) (Pub L 112–106, 126 Stat 306) established a new crowdfunding exemption from registration under Securites Act §4(a)(6) (15 USC §77d(a)(6)). When implemented, this exemption will allow companies to issue equity securities in exchange for contributions from people who don’t qualify as “accredited investors.”
- Peer-to-Peer Lending. Peer-to-peer (P2P) lending is another type of crowdfunding structure under which Internet sites such as Lending Club, Funding Circle, and Prosper act as intermediaries between businesses or individuals seeking loans and members of the public willing to lend them money, thus eliminating conventional banks from the lending process.
- Other Enterprise Sources. Enterprises such as investment banking firms and merchant banks also may be sources of capital for small companies when presented with an attractive combination of factors. Other possibilities might include the implementation of an employee stock ownership plan (ESOP) to purchase stock of the company through bank financing.
Your role as attorney is to make sure that your client understands the benefits and drawbacks of each type of financing, as well as the possible application of federal and state securities laws. Once you’ve helped your client evaluate the chances of getting the most favorable financing, you can help your client comply with applicable laws and focus energy and resources where a payoff is most likely.
Get much more on these 10 major sources of financing and the ways to evaluate and locate them in CEB’s Financing and Protecting California Businesses, chap 1.
Other CEBblog™ posts you may find useful:
- Before Starting Up a Start-Up
- So Happy Together: 15 Things to Discuss with Joint Venturers
- What’s in a (Business) Name?
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