These are the confessions of an experienced investment banker with the battle scars to stand as a witness that no capital transaction is ever easy. As such, the following is made as required reading for anyone that comes to us looking to raise debt or equity capital for business or real estate. What follows includes detailed reasons as to why raising capital can be a vast vacuum in time and resources that your business (and your investment banker) would not–in hindsight–be willing to undertake.
So, if you’re looking to raise capital, please take some time to review the following as it should provide insight(s) into ways you can improve your offering and be better prepared whether your engage with an investment banker or not.
Talk to any middle-market investment banker and they will all unanimously rank their deal preferences as follows:
Sell-Side M&A > Buy-Side M&A > Capital Raise
Investment bankers who perform capital raise transactions would also likely rank their capital transaction preference as follows:
Institutional Debt/Recapitalization > Institutional Equity/Growth Equity > Accredited Investor Debt/Equity
There are various deal structures in sell and buy-side M&A as well, but we’ll not delve into them here. On the lowest end of all the deal spectrum is Regulation D for accredited investors.
Institutions invest for a profession. It is quite literally what they do. Most individual accredited investors do not. In fact, most accredited investors are successful in their own professions and are not spending time sifting through countless deal opportunities where they may want to invest. No, most have their money tied up in money market accounts and RIAs who help provide them with a nice steady return. Furthermore, those that are the most savvy are also not going to be placing more than 10% of their overall portfolio in higher-risk, small businesses with less of a track record.
With individual accredited investors, it is quite literally a cat-corralling exercise that often ends in futility. Deal platforms may have thousands of individual accredited investors registered and actively viewing opportunities, but most publicly-listed private placement offerings die on the vine.
General solicitation promulgates the idea that advertising for an offering increases its likelihood of success. In principle this may be true, but it practice it is extremely difficult. Apart from the proverbial corralling of the individual accredited investor cats, these offers are often hampered by regulation (which we will discuss further later).
No, investment bankers are more likely to get behind institutional-grade deals they can pitch to active, professional investors. Cat corralling is an exercise in futility.
If I were to represent deal size vs. deal quantity graphically, it would look something like this:
This is probably somewhat obvious, but it underscores the underpinnings of oft-referenced Pareto Principle. That is, 80% of the capital flows to 20% of the deals. That top 20% are always larger companies who have already reached some type of scale. Smaller deals just do not get the attention. I will repeat it again, unless you are a company in the top 10% in your field, your likelihood of raising the capital you seek is greatly diminished. Institutional money pays attention to those deals like the hot girl at the party. If you’re mediocre, you won’t even get noticed.
Keep in mind, I am defining deal size as the size of the company in this case, not necessarily the size of the capital in the transaction. I have seen plenty of individuals looking for $20M, but with no written plan, no track record and no intellectual property. Such deals need not apply.
Like everyone else, investment bankers are busy people. In most cases, your average investment banker can handle 1 to 4 clients at any given time. There is an opportunity cost to each opportunity an investment banker engages in. If I take on three or four capital raise clients and a quality sell-side transaction comes across my desk, then I may have traded a less-than-mediocre deal for a great one.
This scenario has played itself out in times past wherein I eventually break my personal rule of not taking on more than three or four clients, but then a quality deal comes on board and all the clients inevitably suffer because my attention is not as razor focused as it could be.
While larger, quality deals are less frequent, they are often what investment bankers will both wait around for and will get behind wholeheartedly.
Failed deals are less frequent in sell-side M&A. The most frequently failed deals on the sell-side include business owners who have overly-optimistic expectations on what their business is ultimately worth. Not true with capital raises, particularly those that raise capital via Reg D 506(c). The graveyard for Reg D offerings–particularly those that allow for general solicitation–is large and growing. The success probability of a deal can always be enhanced. That’s at least part of the job of an investment banker. There are those items we can control and those we cannot. An investment banker wants to have control over the value-added items and increase the probability of success. Ideally that would look like the following:
Unfortunately, many factors are out of the investment banker’s control. Industry, size, team and experience are difficult to enhance in a short period of time. In reality, this chart would look more like something that plateaus pretty quickly. Unless I can envision the scenario above, it’s likely not a deal in which I would personally engage.
When 99% of an investment banker’s income is based on the contingency-driven success fee, why would s/he engage in any deal where the confidence toward a close was not extremely high? It’s bad for business. The best investment bankers are extremely picky and selective in the opportunities in which they will engage. When they see a lower probability of success–like what is acutely witnessed with capital raise transactions, there is a higher likelihood they will run for the hills. Many of the succeeding items here will delve further into the idea that smaller deals that are capital raise transactions have a much lower probability of success.
Any dealmaker will tell you that it takes the same (if not more) work to accomplish a small deal is it does to accomplish a large deal. The resulting rhetoric that follows is, “why do small deals?” Perhaps you’re desperate for dealflow. There could be a litany of reasons.
In my experience, the smaller the deal is, the greater effort required to get the deal over the finish line. Here are the reasons why:
If an investment banker is good, s/he likely has a full deal pipeline and will avoid lower middle-market deals where the work is in the trenches and the pay is similar.
I like to consider myself as someone who maintains a high level of integrity. I strive to over-deliver on client expectations. Consequently, I am less inclined to take on a client that has a capital need if I am not 90%+ positive on the success of the outcome. The problem is that I am rarely so positive unless we are discussing some of the recapitalization structures previously mentioned.
In fact, the integrity component is perhaps one of the greatest reasons I get heartburn over capital raise transactions. Let me paint a picture as to why:
There are several reasons this is a problem. First, I have taken money from the client and ultimately not delivered what the client initially came asking for in the first place. Did I add value? Yes, certainly. I’m sure the client is more prepared with flashy offering documents and now knows a larger number of people that are NOT interested in his/her offering, but the offering ultimately failed. If I were an accountant or videographer or some other service-centric business, I would expect to have a completed deliverable by a specific date. Issuers expect the same. I hate not delivering.
One might say, “why don’t you base your capital raises entirely on contingency?” My response, see header entitled “Lower Probability of Success” listed above. I would likely have to take on 10x the work, just to ensure getting paid. Not worth the risk, stress and effort. This also breaks my focus rule of just a couple of quality clients at any given time. If you juggle too many balls, you end up dropping all of them, not just one or two. In addition, investment bankers have their own operating costs. Contingency-only engagements put the risk of the offering in the hands of the investment banker.
The conundrum is real. Investment bankers want to make sure they are covering their time and operating cost when doing all the preparation, marketing and due diligence work on a deal, but there is ultimately not a guarantee of success. No doubt the banker will add value, but if the deal does not stand on its own, the value may not live up to the high expectations set by the issuer at the outset.
Inevitably, the money-seeking riff-raff follow the blood trail. Quality clients, seeking some type of merger or acquisition, on the other hand, are often educated in all things finance. They talk the talk and walk the walk. They typical have advanced degrees, which may include finance. There is no need to educate the client on the nuances of their deal. They likely already know. They are also looking to find someone to assist with their deal who will be a quick-study and can get up to speak on their technology and operations relatively quickly.
It’s those looking for easy money who need educated on the various nuances. The following quote is fitting:
It is by following the path of least resistance, that makes rivers and men crooked.
There is no easy path to success. Most successful entrepreneurs built something that was worthy of capital before they raised a dime. In some cases this is impossible, but many a would-be capital raise client is often looking for the path of least resistance. Issuers frequently come thinking that there is a magic wand that can be waived and all their company’s capital needs can be easily met. Such deal opportunities often come via someone looking to do a reverse merger, direct public offering (DPO) or Regulation A+, thinking that going public will solve their capital shortage issues. There is so much educating that goes on with this particular group, I could tell stories all day.
Not everyone can be an expert on everything and I am content educating and discussing the nuances of various structures with issuers and sellers. But, when I have to explain to a startup founder with no revenue that his business should not go public, I get exasperated and impatient.
There is a reason the SEC came up with a securities exemption in HR-2274 for middle-market M&A deals. They are less risky. There is also a reason that while the federal government allows for general solicitation under Regulation D 506(c) that the states still want to see state registrations and notice filings of such offerings. It certainly represents an additional revenue opportunity for the states themselves, but it also adds to the complexity and risk for both issuers and their broker-dealer/investment banker.
The registrations and notice filings are more than just a simple money-grab by the states, however. States securities laws, like those at the federal level are there to protect investors from themselves and from the unscrupulous promoters who may attempt to get into their pockets.
Investment bankers measure their successes in months and years, not weeks and days. Unfortunately, capital raise deals are almost always time constrained. “We need $XXM by XX/XX/20XX or else we lose our exclusivity. We have been elsewhere and we need help to get this capital in.” There is frequently a major gap between what is required/wanted from the issuer and what is a reasonable time frame for the investment banker to deliver in.
I am frequently asked:
“How long will it take to raise this capital?” or “What is the average time it takes to raise capital in an offering like this?”
Unfortunately, investment bankers do not have the crystal ball. Even M&A transactions, which are almost always easier transactions when it comes to process, can take 12 months or more, if done right.
Sell-side mergers and acquisitions are the “Belle of the Ball” for investment bankers. Many an investment banker will sprinkle in engagement work on the buy-side. Buy side can also be great as quality buy-side work, begets more sell-side deals where targets and suitors may not exactly match.
Here are some likely capital raise deal parameters that qualify a deal as something I would personally look at:
When it comes to companies looking to raise capital, I am a pessimist, especially for lower middle-market businesses. I have been approached by several domainers interesting in selling me RaiseCapital.com or RaisingCapital.com. If I had a dollar for every business that comes to me looking to raise capital, I could literally make a living from that alone. There is no shortage of capital raise opportunities, but as in any courtship, the issuer needs to fully vet the investment banker and the investment banker needs to fully vet the issuer.
Disclaimer. Some of this may come across as arrogant and offensive. This was not the intent. The intent is to provide some insight into the difficulties in raising capital. If you were offended in reading this, then you are not likely prepared to raise capital and you are not likely a good candidate to work with our team.