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Bringing new inventions, improved processes, superior products, and services to market benefits our world in so many ways. However, most folks would be shocked at the number of innovations that are never brought to market, primarily due to the lack of permanent capital available for start-up and early-stage companies. Historically, less than one and a half percent of start-up and early-stage companies receive equity capital from professional investors, such as; venture capital and private equity firms.
Many entrepreneurs have the skill sets necessary to deliver on their promises because they know their business. The problem is, that other than applying for bank loans, most entrepreneurs do not understand the world of corporate finance, law, or accounting, which is required to attract permanent equity capital. Sadly, most entrepreneurs will not receive the capital needed to grow their businesses beyond modest profitability, due to a lack of this knowledge. We hope to shed some light on the nuances necessary for all entrepreneurs to build companies that are “investable” by professional, as well as passive investors.
Proper corporate engineering mandates revenue & profit maximization as a primary goal with risk minimization, as a close, secondary goal. Since most Start-Up and Early-Stage Companies have yet to produce revenue or a profit, i, therefore,e becomes inherent that risk mitigation is the primary focus. One is often wise to design a start-up or early-stage company’s overall policy structure to mitigate operational, financial ®ulation/litigation risks. This effort starts formulating the basis of the company’s capitalization structure, if one’s goal is to raise sufficient capital to create a company that can be sold to family members, employees, competitors, private equity, or to the public, through an initial public offering.
With that in mind, let’s start from the beginning.
a. The Vision: What is your overall vision of your company? Why are you going into business? The vision is normally based on a macro perspective of the overall market and the profit potential.
i. The vision is the original broad-brush-stroke definition of why you’re going into business. ii. The vision is then broken down into categories to further define that vision. iii. The categories are then further broken into operating plans, formalizing the vision. iv. The operating plans are then further broken into written departmental policies, formulating the vision. v. The departmental policies are then further broken down into written procedures and protocols, guiding the vision. vi. The written procedures and protocols are then further broken into training materials, further cementing the probability of success.
II. FORMAL ORGANIZATIONAL STRUCTURE:
a. Type of Entity. What type of business entity will you use and why?
i. A Sole Proprietorship?
ii. A General or Limited Partnership?
1. If so, a Limited Liability Partnership? Or
2. A Limited Partnership? Or
3. A General Partnership?
iii. A Corporation?
1. If so, an S-Corp.? or
2. A C-Corp.?
iv. A Limited Liability Company?
1. If so, a “Member” Managed LLC? Or
2. A “Manager” Managed LLC?
b. Legal Jurisdiction. The legal jurisdiction is normally the state in which the entity is formally recognized. Various states have differing laws regarding how you operate your entity. Some states enable the founders to be anonymous. Some states have favorable state tax treatment. Which jurisdiction will you organize the business entity and why?
c. Filing the Organization. After deciding on the Type of Entity, one must file the appropriate documents with the state of legal jurisdiction, i.e. Articles of Incorporation for Corps. or Articles of Organization for Limited Liability Companies, for instance.
i. EIN. Obtain an Employer Identification Number (EIN) or Tax ID for the newly created Entity.
ii. Other Licenses. Obtain any occupational licenses that may also be required by the state of jurisdiction to operate within compliance of any other regulations.
c. Formalizing the Organization. Establish the written By-laws (Corps.) or the written Operating Agreement (LLCs). These formal documents lay out how the administration of the business is to function and can and should be maintained as “working documents” by you or your attorney.
d. Calendaring Formal Events. Establish calendared reoccurring events, such as; quarterly director and annual (or semi-annual) shareholder meetings.
III. REVENUE EXPECTATIONS: What is the company’s strategy for generating revenue? In other words, what is the business going to sell: one or more products, services, or both? And what is the timing for production, sales, marketing, and distribution for these products or services over a certain period, like 5 years for instance.
a. Sales & Marketing:
i. Market Research: What market research have you done for the products or services that your company will be selling? Is this research empirical based only on your experience or can you back it up with one or more 3rd party’s research data? What is the company’s target market for the new product or service? Is it saturated with similar services/products? Who are the main competitors of your company’s products or services? Are the competitive markets for your company’s products or services vertical in nature, meaning you're competing within a pre-established market based on price and/or quality; better quality socks at a higher or lower price for instance? Or are the competitive markets horizontal, meaning it’s a brand-new product or service on the horizontal market spectrum to solve an old problem, pushing out current competitors with obsolete products or services, irrespective of the quality and price?
ii. Market Differentials: How are the products or services different from the marketplace? What about Brand differentiation and management, have you formalized this process in writing? iii. Target Markets: To whom will your company be selling these products or services? What markets will these products or services compete in? iv. Sales: How will you sell your company’s products or services? Through one or more outsourced sales forces on a commission-only basis [External Sales Model] or in-house with the senior management team members or others fulfilling various sales roles to create sales internally [Internal Sales Model] or both? v. Customer Service. How will customer service be handled now and in the future? Will it be outsourced or handled “in-house”? What is the plan to keep existing customers and develop new customers? vi. SWOT Analysis. What are the Strengths, Weaknesses, Opportunities, and Threats of, and to, the company? vii. Distribution. What is the company’s marketing and distribution plan? viii. Time Frames and Budgeting. Is the vision further reduced to a monthly, weekly, or daily calendar list of items to be accomplished? What are the milestones that must be achieved for the business entity to have a minimum viable concept or move to the next milestone? What is the timeline to achieve each milestone? ix. Barriers to Entry: Are there barriers to entry such as licenses, patents, or high capital costs, and how do you plan to overcome the current barriers to entry for your company? What is your company’s plan to construct further barriers to entry for your company’s would-be competitors? x. Sales & Marketing Policies, Procedures, and Protocols. Is the Sales & Marketing plan reduced to a written Marketing Policy Manual?
IV. COST EXPECTATIONS: What is the company’s strategy for containing costs and expenses? In other words, how is the business going to establish budgeting procedures, internal checks, and balances on the cost of goods sold (COGS), and cost of services delivered (COSD)? How is the company going to arrive at gross operating margins, EBITDA, and net operating profit or loss? And what is the plan for managing capital budgeting for asset purchases and the related depreciation or amortization of said costs?
a. Cost of Goods Sold or Services Delivered
i. These variable costs are normally calculated as a percentage of gross revenue. However, that percentage of gross revenue may change and if it does change, it normally is reflected as a percentage change. For instance, categories such as; packaging, freight, and materials cost may decline as a percentage of gross revenue due to the growth of the company and volume purchase discounts from vendors. One may want to illustrate this decline in costs as a decreased percentage of the percentage of gross revenue. If one’s cost of material is 40% of the gross revenue derived from the sale of a product, it is reduced by 5% per year projected over 5 years. Then the 1st year would show 40%, the 2nd year 38%, the 3rd year 36.1%, the 4th year 34.3% and finally 32.6% in the 5th year. Have you assigned these variable cost components as a percentage of gross revenue? Have you assigned an annualized increasing or decreasing percentage of each category of the revenue mix to arrive at the projected Gross Profit?
b. General & Administrative Expenses
i. These are fixed costs or budgets that do not have a direct correlation to revenue generated. One must pay these costs regardless of how much revenue the company makes. These costs can certainly be adjusted to save money and increase profit, but for the most part (like Office Rent) they are fixed. Also budgets, such as; legal, accounting, telephone, etc. are not necessarily fixed, but one must include them in any financial projections to be thorough in one’s projections. Have you estimated these relatively fixed costs, normally referred to as “overhead”? Are they increasing or decreasing over time, due to economies of scale?
c. Capitalized Assets & Budgets. These are additional fixed costs (capital outlay) or budgets do not get immediately expensed, as those expenses are spread (amortized or depreciated over a set schedule of time. For instance, one may not be able to lease but must purchase an overhead crane system for a manufacturer or a fixture build-out of spa equipment for a nail salon. One must incur these capital outlays regardless of how much revenue the company makes. Have you estimated these relatively fixed costs, normally referred to as “capitalized assets”? Are these budgets increasing due to general expansion, or decreasing over time due to economies of scale?
V. OPERATIONAL RISK MANAGEMENT & MITIGATION:
a. SENIOR MANAGEMENT.
i. Quantity. How many senior management team members (Officers & Directors), and direct hire employees and/or outside contractors will be needed to carry-out the vision over the next 5-years, for instance, to achieve the overall financial goals of the company? ii. Quality. How will your company attract top talent? What is the proposed compensation plan for said senior team members, employees and/or contractors? Will there be performance bonuses, health insurance benefits, and/or an ESOP or 401(k) plan?
b. Founders. Who are the founders and what skills, and or experiences do they offer to the business entity?
i. Have you vetted their backgrounds by obtaining a professional background check report? ii. In what capacities will they serve, if any?
c. Officers & Directors. What does the management structure of the business look like?
i. Who are the members of the management team? ii. Who is the CEO, CFO, and COO of the company? iii. Do the management personnel have reputable backgrounds, education, and experience? iv. Does the company have a formal Board of Directors? v. Does the company have an informal “Advisory Board”? vi. Have you written position definitions of Job functions and duties? Are the written statements of Responsibility in line with the appropriately related Authority?
d. Employees. What are the necessary skill sets of the initial employees? Do you have an organizational chart, so everyone knows who reports to whom, and why?
e. Compensation Agreements. Do you have written compensation agreements for everyone engaged in work for the company? f. Risk Mitigation. What is the plan to minimize employee turnover?
g. Human Resources Policies, Procedures, and Protocols. Is the Human Resources plan reduced to a written Human Resources Policy Manual?
h. Outside Counsel
i. Lawyers. Hire and retain legal counsel (Law Firm) to review all correspondence and/or actionable items with employees, shareholders, note or bond-holders, and/or financial institutions regarding capital formation (and related financial), employment matters, as well as all other items that require legal counsel review, such as; contracts, leases, etc.
ii. Certified Public Accountants. Hire and retain tax counsel (CPA Firm) for assuring compliance with your bookkeeping, accounting, and tax reporting matters. If you have planned an exit strategy that involves the outright sale of the company to heirs, employees, or other entities through merger or acquisition or to exit through an Initial Public Offering “IPO,” it is often wise to prepare your firm financial records and statements to become “auditable” as soon as possible.
VI. FINANCIAL RISK MANAGEMENT & MITIGATION:
a. Return Expectations: What is the expected annualized Rate of Return (ROR), Internal Rate of Return (IRR), or Return on Investment (ROI) over time on either the common voting equity for founders, investors, or some other security to be issued to investors? Pro forma means “as a matter of form.” In the world of corporate finance “pro forma” means illustrating future estimates to arrive at financial projections. Have you run pro forma financial projections? Do they include pro forma Income Statements, Balance Sheets, Consolidated Statement of Operations, Consolidated Statement of Cash Flows, Sources & Uses Statements? Are they GAAP (General Accepted Accounting Practice) Compliant? Have you built a “Chart of Accounts” for setting up your company’s books & budgets? Will you be comparing budgets of the actual revenues and expenditures booked to projected budgets for management reports? What internal controls do you have, or will you have for mitigation of financial loss or theft? Are the internal controls written into an accounting policy manual form? What reporting are you required to make to investors, the IRS, or other regulatory agencies that regulate your industry?
b. Assets – Balance Sheet Items.
i. Current Assets. What are the current, liquid assets of the company that can be easily converted into cash? Current Assets would include, but not necessarily be limited to: Accounts receivable; Inventory; Cash on hand; Time Deposits (CDs); Marketable Securities, Capital Calls from subscriptions to purchase securities, etc. ii. Fixed Assets: What are the fixed, relatively non-liquid assets of the company? Fixed Assets would include, but not necessarily be limited to: Intangible assets, such as; intellectual property, patents, and trademarks, licenses, contractual agreements, cash investments, non-compete agreements, etc. or tangible assets such as physical plant, vehicles, office furniture, computers, etc. iii. Titled Assets. Are the assets titled in the name of the business entity?
1. Are intangible assets that are not publicly registered, such as intellectual property (software code for instance), memorialized in Board of Director resolutions?
2. Are intangible assets registered for copyright, patent, or trademark protection?
3. Are the assets represented or identified in a contractual agreement, such as; a license agreement with another entity granting authorization, use, or control to the business entity?
i. Other Assets. These might include non-monetary factors, such as; contracts for labor stability, supply chain stability, customer database network relationships, social media presence, and follower base, financial and credit resources, etc.
1. How do you know if and when it makes sense to refinance short or long-term liabilities?
2. Do you have an adequate understanding and a working knowledge of the private, as well as public U.S. Capital Markets?
3. Is the Financial plan reduced to a written Financial Department Manual?
c. Liabilities – Balance Sheet Items:
i. Current Liabilities What are the current liabilities of the company that must be paid in a timely fashion to avoid insolvency? Current Liabilities would include, but not necessarily be limited to: Accounts payable; payroll; interest due on mortgages or loans, lease payments, and/or revolving lines of credit, for instance.
ii. Long-Term Liabilities: What are the fixed, relatively non-negotiable liabilities of the company? Long-Term Liabilities would include, but not necessarily be limited to: Building Mortgages, Term Loans, Capital Leases, vehicle loans or leases, etc.
d. Budgeting, Internal Controls, & Reporting.
i. What are the funding options at each stage of growth?
1. What stage of growth is the company?
2. What are the company’s current and projected sources of working capital?
3. What is the current monthly “burn rate” of capital?
4. What is the projected monthly “burn rate” of capital?
5. How has the company been paying its bills thus far?
6. What are the next stages of growth and funding options for each stage?
e. Financial Statements.
i. Will the company need either Audited, Reviewed, or Compiled financial statements by a CPA Firm?
ii. If Audited, Reviewed, or Compiled financial statements are needed, when will they be needed and how much will it cost, and which audit firm will be engaged?
iii. What are the financial statement disclosure schedules of the company?
VII. LITIGATION / REGULATORY RISK MANAGEMENT & MITIGATION:
a. Asset Protection & Liability Management.
i. How do you plan to secure and protect corporate assets?
ii. Do you currently have, or will you have, various forms of Business Insurance, such as?
1. Business Casualty and Continuation Insurance;
2. Errors & Omissions coverage;
3. Director & Officer Insurance;
4. Keyman Insurance; and
5. Cybersecurity Insurance.
iii. Do you have segregation of duties and internal-theft protection? How do you, or will you, manage these issues?
iv. Do you have litigation threats or pending claims and or litigation insurance? How do you, or will you, manage these issues?
v. Who in the company has access to critical or strategic assets of the company? Are they or can they be bonded?
vi. Do you have adequate internal controls for each department and the company as a whole? Are these in the form of a written Administrative Policy Manual?
VIII. CAPITAL STRUCTURES
a. Pertinent issues to address when preparing to approach Financial Institutions:
i. Is your company bankable? Does it have assets and cash flow? ii. Are there leases available for equipment you might need? iii. What are the company’s lease cost funding options? iv. What will the capitalization mix (debt to equity ratio) look like?
1. How will the debt, if any, be repaid? How soon?
v. Has the company approached traditional sources of capital, such as; commercial, community, or merchant banks, SBA loans, joint venture arrangements, bootstrapping with credit cards, and/or Kickstarter campaigns?
vi. What are the future operational needs of the company?
vii. What are the future technological needs of the company?
viii. What are the short-term and long-term financial needs of the company?
b. Pertinent issues to address when preparing to approach Individual Investors:
i. Where and how will the business entity find suitable investors?
ii. What types of investment terms will appeal to each group of investors?
iii. How will the proceeds from the capital raise be used?
iv. How much is budgeted to market a capital raise and for investor communications?
v. How often will the business entity communicate with investors and what types of information will be provided to them?
vi. How soon is the Company going to need a second or third capital infusion? In what amounts and for what purposes?
vii. What is the exit strategy for each class or tier of investors that will make them a profit?
viii. What is the length of time projected for an exit event?
c. Start-Up - (Pre-Revenue):
1. Founders’ Loans: Whether one creates the company as a sole proprietorship, partnership, LLC or corporation, some start-ups start out with loans from the founders to the company for its initial capitalization. Founder loans to the company are considered part of the company’s “temporary” capital, as these loans are to be paid back.
a. Formal loan documents may be required, by the IRS and other state taxing authorities, from the founders to the company in such instances. More importantly, however, disclosure of these formal loan documents may be required by banks or other lending authorities if one will be seeking traditional bank financing in the future.
2. Founders’ Equity: Whether one creates the company as a sole proprietorship, partnership, LLC or corporation, some start-ups start out with direct equity investments from the Founders. Founders’ equity to the company are considered part of the company’s “permanent” capital, as these investments are normally only “monetized” or to be paid back to the Founders through future dividends or proceeds from the sale of the company. How much of the business entity will be allocated for founders’ equity participation and incentives for employees, retirement plans, and outside investors directly through common equity ownership or through convertible securities, upon conversion?
3. Outside Professional Investor Equity: Traditional venture capital and/or private equity firms rarely invest equity or debt in start-ups, due to the inherent risks involved with most start-ups. For those start-ups that do receive traditional venture capital or private equity, more often than not, founders, without substantial amounts of personal cash investments into the company, often give up significant amounts of equity and/or voting control to these professional investors. Professional investor equity into the company is normally considered part of the company’s “permanent” capital, as these investments are normally only “monetized” to be paid back to the Professional Investor, only through future dividends or from the proceeds of the sale of the company. At the start-up stage, the cost of equity capital can quickly become cost prohibitive unless one employs hybrid securities, such as Convertible Notes or Bonds, as a method to obtain the capital.
4. Outside Individual Investor Equity or Debt. This is where securities offerings, compliant with federal and state(s) securities laws, rules, and regulations come into play. Start-ups have an advantage here in that they are not beholden to the financing terms of any financial institution or professional investor. They, as an issuer of securities, have the power to determine the terms of the offering or the “deal structure” when producing their securities for sale. This is a very sophisticated process requiring the assistance of competent legal counsel, as well as the knowledge of investment bankers on the proper way to valuate a company and price its securities to create an attractive investment for investors.
d. Early-Stage – (Post Revenue, Pre-Profit):
1. Traditional Bank Loans: Bank loans to the company are considered part of the company’s “temporary” capital, as these loans are to be paid back.
a. Collateral: A first lien security against the company’s net assets will likely be required by the community, commercial or merchant bank to secure such financing, whether it be for commercial lines of credit, inventory financing, building mortgages, etc.
b. Personal Guarantees: Founders’ personal guarantees will likely be required by the community, commercial or merchant bank to secure such financing, whether it be for commercial lines of credit, inventory financing, building mortgages, etc. These personal guarantees are normally “joint and several”, meaning each founder is on the hook for the full amount of debt acquired through these financial institutions. c. Performance: In order to renew or re-finance these forms of capital over time, one normally needs to show that the company is ongoing and solvent.
2. Outside Professional Investor Debt Financing: Traditional venture capital and/or private equity firms rarely invest equity in early-stage companies, due to the unproven nature of early-stage companies, but they may loan the company money with some sort of incentive or additional securities, such as; equity kickers, warrants, or the option of convertibility of the debt into equity over an extended period. However, for those early-stage companies that do receive debt from venture capital or private equity, more often than not, founders, without substantial amounts of personal cash investments into the company, often give up significant amounts of equity and/or voting control to these professional investors. Professional investor debt into the company is normally considered part of the company’s “temporary” capital, as these loans are to be paid back. For most early-stage companies, the cost of this type of debt capital can quickly become cost prohibitive unless one employs hybrid securities, such as Convertible Notes or Bonds, as a method to obtain the capital.
3. Outside Professional Investor Equity: Traditional venture capital and/or private equity firms rarely invest equity in early-stage companies, due to the inherent risks involved with most start-ups. For those early-stage companies that do receive traditional venture capital or private equity, more often than not, founders, without substantial amounts of personal cash investments into the company, often give up significant amounts of equity and or voting control to these professional investors. Professional investor equity into the company is normally considered part of the company’s “permanent” capital, as these investments are normally only “monetized” to be paid back to the Professional Investors, but only through future dividends or from the proceeds of the sale of the company. For most early-stage companies, the cost of equity capital can quickly become cost prohibitive unless one employs hybrid securities, such as Convertible Preferred Equity, as a method to obtain the capital.
4. Outside Individual Investor Equity or Debt. This is where securities offerings, compliant with federal and state(s) securities laws, rules, and regulations come into play. Early-stage companies have an advantage here in that they are not beholden to the financing terms of any financial institution or professional investor. They, as an issuer of securities, have the power to determine the terms of the offering or the “deal structure” when producing their securities for sale. This is a very sophisticated process requiring the assistance of competent legal counsel, as well as the knowledge of investment bankers on the proper way to valuate and company and price its securities so that they are attractive. There are many valuable resources from various publications on the internet. However, one would be wise to consolidate this effort with a common source.
See https://www.commonwealthcapital.com/conservatory for further information and to make a qualified decision if a securities offering is right for your company’s capitalization needs.
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