An Alternative to Venture Capital Funding – Give Control to the Company

Using Reverse Mergers Instead of Venture Capital for Venture Funding

The more you look at reverse mergers the more you start to understand that reverse mergers compare favorably with the classic venture capital model for venture funding.

Venture funding is obviously key to the success of any new or growing venture. The classic venture capital model seems to work like this: The entrepreneur and his team formulate a business plan and try to get it in front of a venture capital firm. If they are well connected, they may succeed, but most venture capital firms are overloaded with funding requests.

If the entrepreneur is not in a business that is the latest fad among venture capitalists, he may not be able to find funding.

If the entrepreneur is very lucky, he will be invited to pitch the VC. If the venture survives this trial, it will receive a venture capital terms sheets. After prolonged and adversarial negotiations, a deal is struck and the venture company signs hundreds of pages of documents. In these documents, the entrepreneur and his team give up most of the control of the company and usually most of the equity in the deal. Their stock is locked up and if they want to sell to get some cash, they probably have to offer the buyer to the VC first. Time from start to finish – 90 days or more.

If the company needs more money, it must negotiate with the VC and the entrepreneurial team may lose ground in the deal. The company may have to reach certain set milestones to get funds. If the company falls behind of schedule, it may lose equity share.

As the venture develops, the venture capitalists may or may not add value, and most likely will second-guess the entrepreneur and his team. If the venture succeeds, the venture capital firm will reap most of the rewards. If the venture does not succeed, most of the capital will be lost forever. Some ventures wind up in the land of the living dead – not bad enough to end, not good enough to succeed.

Worst case scenario, the venture capitalists take control at the outset, become dissatisfied with management, and oust the original management which loses most of not all of their position and their jobs.

The Reverse Merger Model

The entrepreneur finds a public shell. He has to come up with some cash to do this and pay the legal and accounting bills.

He buys control and merges into the shell on terms he determines. He keeps control but he has the burdens of a public company.

He determines how to run his company, including salaries. He can offer stock options to attract talent. He can acquire others companies for stock. He determines when he cashes out.

Instead of having to report to the venture fund, he has to report to the shareholders.

Subject to the limitations of the securities laws, he can sell part of his stock for cash.

He can seek money whenever he wants; he is in control.

Problems: He may be attacked by short sellers. He may buy a shell with a hidden defect. He has to pay for the shell.

From the Investors’ Point of View

Venture capital funds are typically funding by institutional investors seeking professional management. They do not have the time to manage a number of small companies and delegate this task to the venture capital partners. Small investors are rarely permitted. Venture capital funds allow the institutional investors to diversify.

Venture capital fund investors are locked in over a period of years. If they make 30% per year returns, they have done very well.

The venture capital model encourages the venture capital firm to negotiate hard for a low price and harsh terms. A venture team seeking funding that knows it has a big future may not submit to such terms. However, for a weak company that is just looking to collect salaries for a few years before folding, in other words a company that is a bad investment, can accept any terms, no matter how harsh. Thus, the venture capital model is skewed toward selecting out the worst investments and repelling the best.

Small investors can buy stock in reverse merger companies. They must take the time to investigate these companies but may lack the resources to do so intensively. Most small investors lose money. If they win, they can win big. They can, if they choose do so, diversify their investments. They have no influence on management, except to sell when they are displeased.

Summary

The reverse merger model compares very favorably with venture capital. Whereas venture capital is perpetually in scarce supply, reverse mergers are always out there for any company that can interest investors. The company can usually raise money on better terms from the public than from venture capitalists.

Overall, the big advantage of the reverse merger is that the company has total control over its destiny. The team can be assured of being rewarded well for success. The company sets the terms, can sell stock whenever it sees fit on whatever terms it merits, the insiders can sell too, and the venture team is not second-guessed by amateurs in their field, and the venture team does not have to fear losing equity or jobs.

Another advantage is less risk to the investor. The investor is in a publicly trading stock. If the investor does not like what is happening, he can sell. He may sell at a loss, but he can get out. The investor can also pick and choose companies himself, instead of making only one investment decision – the decision to back the VC company which then takes control of the rest of the decisions.

Alternative Financing Vs. Venture Capital: Which Option Is Best for Boosting Working Capital?

There are several potential financing options available to cash-strapped businesses that need a healthy dose of working capital. A bank loan or line of credit is often the first option that owners think of – and for businesses that qualify, this may be the best option.

In today’s uncertain business, economic and regulatory environment, qualifying for a bank loan can be difficult – especially for start-up companies and those that have experienced any type of financial difficulty. Sometimes, owners of businesses that don’t qualify for a bank loan decide that seeking venture capital or bringing on equity investors are other viable options.

But are they really? While there are some potential benefits to bringing venture capital and so-called “angel” investors into your business, there are drawbacks as well. Unfortunately, owners sometimes don’t think about these drawbacks until the ink has dried on a contract with a venture capitalist or angel investor – and it’s too late to back out of the deal.

Different Types of Financing

One problem with bringing in equity investors to help provide a working capital boost is that working capital and equity are really two different types of financing.

Working capital – or the money that is used to pay business expenses incurred during the time lag until cash from sales (or accounts receivable) is collected – is short-term in nature, so it should be financed via a short-term financing tool. Equity, however, should generally be used to finance rapid growth, business expansion, acquisitions or the purchase of long-term assets, which are defined as assets that are repaid over more than one 12-month business cycle.

But the biggest drawback to bringing equity investors into your business is a potential loss of control. When you sell equity (or shares) in your business to venture capitalists or angels, you are giving up a percentage of ownership in your business, and you may be doing so at an inopportune time. With this dilution of ownership most often comes a loss of control over some or all of the most important business decisions that must be made.

Sometimes, owners are enticed to sell equity by the fact that there is little (if any) out-of-pocket expense. Unlike debt financing, you don’t usually pay interest with equity financing. The equity investor gains its return via the ownership stake gained in your business. But the long-term “cost” of selling equity is always much higher than the short-term cost of debt, in terms of both actual cash cost as well as soft costs like the loss of control and stewardship of your company and the potential future value of the ownership shares that are sold.

Alternative Financing Solutions

But what if your business needs working capital and you don’t qualify for a bank loan or line of credit? Alternative financing solutions are often appropriate for injecting working capital into businesses in this situation. Three of the most common types of alternative financing used by such businesses are:

1. Full-Service Factoring – Businesses sell outstanding accounts receivable on an ongoing basis to a commercial finance (or factoring) company at a discount. The factoring company then manages the receivable until it is paid. Factoring is a well-established and accepted method of temporary alternative finance that is especially well-suited for rapidly growing companies and those with customer concentrations.

2. Accounts Receivable (A/R) Financing – A/R financing is an ideal solution for companies that are not yet bankable but have a stable financial condition and a more diverse customer base. Here, the business provides details on all accounts receivable and pledges those assets as collateral. The proceeds of those receivables are sent to a lockbox while the finance company calculates a borrowing base to determine the amount the company can borrow. When the borrower needs money, it makes an advance request and the finance company advances money using a percentage of the accounts receivable.

3. Asset-Based Lending (ABL) – This is a credit facility secured by all of a company’s assets, which may include A/R, equipment and inventory. Unlike with factoring, the business continues to manage and collect its own receivables and submits collateral reports on an ongoing basis to the finance company, which will review and periodically audit the reports.

In addition to providing working capital and enabling owners to maintain business control, alternative financing may provide other benefits as well:

  • It’s easy to determine the exact cost of financing and obtain an increase.
  • Professional collateral management can be included depending on the facility type and the lender.
  • Real-time, online interactive reporting is often available.
  • It may provide the business with access to more capital.
  • It’s flexible – financing ebbs and flows with the business’ needs.

It’s important to note that there are some circumstances in which equity is a viable and attractive financing solution. This is especially true in cases of business expansion and acquisition and new product launches – these are capital needs that are not generally well suited to debt financing. However, equity is not usually the appropriate financing solution to solve a working capital problem or help plug a cash-flow gap.

A Precious Commodity

Remember that business equity is a precious commodity that should only be considered under the right circumstances and at the right time. When equity financing is sought, ideally this should be done at a time when the company has good growth prospects and a significant cash need for this growth. Ideally, majority ownership (and thus, absolute control) should remain with the company founder(s).

Alternative financing solutions like factoring, A/R financing and ABL can provide the working capital boost many cash-strapped businesses that don’t qualify for bank financing need – without diluting ownership and possibly giving up business control at an inopportune time for the owner. If and when these companies become bankable later, it’s often an easy transition to a traditional bank line of credit. Your banker may be able to refer you to a commercial finance company that can offer the right type of alternative financing solution for your particular situation.

Taking the time to understand all the different financing options available to your business, and the pros and cons of each, is the best way to make sure you choose the best option for your business. The use of alternative financing can help your company grow without diluting your ownership. After all, it’s your business – shouldn’t you keep as much of it as possible?

Alternative Options to Venture Capital For Raising Growth Capital

Venture Capital is a specific term that refers to funding obtained from a venture capitalist. These are professional serial investors and may be individuals or part of a firm. Often venture capitalists have a niche based on business type and or size and or stage of growth. They are likely to see a lot of proposals in front of them (sometimes hundreds a month), be interested in a few, and invest in even fewer. Around 1-3% of all deals put to a venture capitalist get funded. So, with the numbers that low, you need to be clearly impressive.

Growth is usually associated with access to, and conservation of cash while maximising profitable business. People often see venture capital as the magic bullet to fix everything, but it isn’t. Owners need to have a huge desire to grow and a willingness to give up some ownership or control. For many, not wanting to lose control will make them a poor fit for venture capital. (If you work this out early on you might save a lot of headaches).

Remember, it’s not just about the money. From the perspective of a business owner, there is money and smart money. Smart money means it comes with expertise, advice and often contacts and new sales opportunities. This helps the owner, and the investors grow the business.

Venture Capital is just one way to fund a business and in fact it is one of the least common, yet most often discussed. It may or may not be the right option for you (a discussion with a corporate advisor might help you decide what is the right path for you).

Here’s a few other options to consider.

Your Own Money – many business are funded from the owner’s own savings, or from money drawn from equity in property. This is often the simplest money to access. Often an investor would like to see some of the owner’s fund in the company (“skin in the game”) before they’d consider investing.

Private Equity – Private Equity and Venture Capital are almost the same, but with a slightly different flavour. Venture Capital tends to be the term used for an early stage company and Private Equity for a later stage funding for further growth. There are specialists in each area and you’ll find different companies with their own criteria.

FF & F – Family, Friends and Fools. Those closer to the business and often not sophisticated investors. This type of money can come with more emotional baggage and interference (as opposed to help) from its providers, but may be the fastest way to access smaller amounts of capital. Often multiple investors will make up the overall amount needed.

Angel Investors – The main business angels vary from venture capitalists in their motives and level of involvement. Often angels are more involved in the business, providing ongoing mentorship and advice based on experience in a particular industry. For that reason, matching angels and owners is critical. There are substantial easily locatable networks of angels. Pitching to them is no less demanding than to a venture capitalist as they still review hundreds of proposals and accept only a handful. Often the demands around exit strategies are different for an angel and they are satisfied with a slightly longer term investment (say 5-7 years compared to 3-4 for a venture capitalist).

Bootstrapping – growing organically through reinvesting profits. No external capital injected.

Banks – banks will lend money, but are more concerned about your assets than your business. Expect to personally guarantee everything.

Leases – this may be a way to fund particular purchases that allow for expansion. They will normally be leases over assets, and secured by those assets. Often it is possible to lease specialist equipment that a bank would not lend on.

Merger / Acquisition Strategy – you may seek to acquire or be acquired. Generally even a merger has a stronger and a weaker partner. Combining the resources of two or more companies can be a path to growth – and when it is done with a company in the same business, can make a lot of sense – on paper at least. Many mergers suffer from differences in culture and unforeseen resentments that can kill the benefits.

Inventory Financing – specialist lenders will lend money against inventory you own. This may be more expensive than a bank, but might allow you to access funds you could not have otherwise.

Accounts Receivable Financing / Factoring – again a specialist area of lending that may allow you to tap into a source of funds you didn’t know you had.

IPO – this is normally a strategy after some initial capital raising and having proven a business is viable through the development of a track record. In Australia there are various ways to “list”. They are useful for raising larger amounts of money ($50m and up) as the costs can be quite high ($1m plus).

MBO (Management Buy Out) – This tends to be a later stage strategy, rather than a startup funding strategy. In essence debt is raised to buy out the owners and investors. It is often a strategy to gain back control from outside investors, or when investors seek to divest themselves from the business.

One of the most important things to remember across all these strategies is that they all require a significant amount of work in order to make them work – from the way the business is structured, to dealings with staff, suppliers and customers – need to be examined and groomed so that they make the company attractive as an investment proposition. This process of grooming and derisking can take anywhere from three months to a year. It is often costly both in actual expenses (consultants, legal advice, accounting advice) as well as changing the focus of the owners from “sticking to the knitting” and making money within the business to a focus on how the business presents itself.