raising capital get the money you need to grow your business

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RAISING CAPITAL
SECOND EDITION
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RAISING CAPITAL
SECOND EDITION
Get the Money You Need to
Grow Your Business
ANDREW J. SHERMAN
American Management Association
New York • Atlanta • Brussels • Chicago • Mexico City • San Francisco
Shanghai • Tokyo • Toronto • Washington, D.C.
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Special discounts on bulk quantities of AMACOM books are
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Web site: www.amacombooks.org
© 2005 Andrew J. Sherman.
All rights reserved.
Printed in the United States of America.
This publication may not be reproduced, stored in a retrieval
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a division of American Management Association,
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Printing number
10 9 8 7 6 5 4 3 2 1
This publication is designed to provide accurate and authoritative
information in regard to the subject matter covered. It is sold with
the understanding that the publisher is not engaged in rendering
legal, accounting, or other professional service. If legal advice or other
expert assistance is required, the services of a competent professional
person should be sought.
Library of Congress Cataloging-in-Publication Data
Sherman, Andrew J.
Raising capital : get the money you need to grow your business / Andrew J.
Sherman.— 2nd ed.
p. cm.
Includes index.

ISBN 0-8144-0856-7
1. New business enterprises—United States—Finance. 2. Venture capital—
United States. I. Title.
HG4027.6.S534 2005
658.15’224—dc22
2004022298
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FOR MY WIFE JUDY AND MY CHILDREN, MATTHEW AND JENNIFER;
THEY ARE MY NEVER-ENDING SOURCE OF SUPPORT AND INSPIRATION.
I
N LOVING MEMORY OF HELEN HUNTER AND GARY GOLDMAN.
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vii
Contents
ACKNOWLEDGMENTS ix
PREFACE xi
PART I GETTING READY TO RAISE CAPITAL 1
CHAPTER 1 Capital-Formation Strategies and Trends 3
CHAPTER 2 Understanding Legal and Governance
Structures 25
CHAPTER 3 The Role Your Business Plan Plays 47
PART II EARLY-STAGE FINANCING 63
CHAPTER 4 Start-Up Financing 65
CHAPTER 5 The Art and Science of Bootstrapping 87
CHAPTER 6 Private Placements 101
CHAPTER 7 Commercial Lending 119
CHAPTER 8 Leasing, Factoring, and Government
Programs 137

PART III GROWTH FINANCING 161
CHAPTER 9 Venture Capital 163
CHAPTER 10 Anatomy of a Venture-Capital Transaction 187
CHAPTER 11 Preparing for an Initial Public Offering 197
C
HAPTER 12 The Mechanics of an Initial Public
Offering 227
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PART IV ALTERNATIVES TO TRADITIONAL FINANCING 255
CHAPTER 13 Franchising, Joint Venture, Co-Branding,
and Licensing 257
CHAPTER 14 Mergers and Acquisitions 291
CHAPTER 15 Capital Formation Business Growth
Resources Directory 321
A
PPENDIX 337
INDEX 437
viii
CONTENTS
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ix
Acknowledgments
There are always many more people to acknowledge than space per-
mits, and for
Raising Capital, Second Edition, this is no exception. I
am grateful to my clients for trusting in my advice, to my partners
for their support, and to my family and friends for their love and
patience. A special thanks to my mentors and sounding boards,
Venne Harnish at Gazelles, Mark Stevens at MSCO, Bill Posten at
Eagle Rock Partners, John May at New Vantage Partners, Ralph

Crozier at Case Design, Michael Keller, Jason Levinson, Mary
MacPherson, Virgil Klunder, Milledge Hart, Nancy Cass, and Jim
Blasingame—The Small Business Advocate.
I want especially to thank Al Schaeffer and Debra Hamson for
being there and for twenty years being the best partners that any-
one could ever expect. The same goes for Jo Lynch, my assistant and
right arm for more than four years.
Once again, the team at AMACOM was excellent and a pleas-
ure to work with, lead by Jacquie Flynn and the masterful editing
of Doug Puchowski and Jim Bessent.
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xi
Preface to the Second Edition
S
INCE THE PUBLICATION OF THE FIRST EDITION of Raising
Capital
in early 2000, so much has changed, yet the fundaments
of creating an effective capital formation strategy have remained
the same and are timeless. The text of
Raising Capital’s first edition
was written in 1998 and 1999—the heyday of the dot-com boom, a
peaking of Nasdaq at nearly 5200, and an environment where vir-
tually anybody with a draft of a business plan could raise venture
funding. Since early 2000, we have seen the plunge of the Nasdaq,
the attacks of September 11th, 2001, and the corporate scandals
involving WorldCom, Enron, and many more public companies, the
subsequent passage of Sarbanes-Oxley, and the wars in Afghanistan
and Iraq. As a pleasant surprise, we have also begun to experience

what appears to be a recovery, or at least a stabilization of the cap-
ital markets. What does this mean for emerging-growth companies
who are developing capital formation strategies?
It means that business plans and proposals for financing must
emphasize the strengths and compensate (and explain) for the
weaknesses. It means that the strongest companies will attract
financing commitments on reasonable terms and weaker compa-
nies will not. It means that capital formation will take longer and
generally be a more expensive and time-consuming process for the
growing company’s management team. It means that you must
have highly skilled
and highly connected professional advisors who
can make strategic introductions to capital sources and then prop-
erly advise you on the “market terms” and structure of the trans-
action. It means you need to understand the key value drivers that
will influence the availability and structure of the transaction. (See
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the chart in Figure P-1.) In sum, a growing company must be
PATIENT, PREPARED, and PERSISTENT in its quest for capital.
xii
PREFACE
An Overview—How Things Have Changed
The climate for entrepreneurship and business growth has changed
considerably since the publication of the first edition of
Raising
Capital.
Stock market corrections, dot-com failures, the events of
9/11 and war on terrorism, the wave of corporate scandals and the
passage of Sarbanes-Oxley, the crisis in the Middle East, ongoing
tension in Iraq, and many other factors have made the challenge of

raising capital and building a growing company as difficult as it has
been in nearly a decade.
FIGURE P-1. WHAT FACTORS WILL DRIVE VALUE IN VENTURE-
INVESTING TERMS AND CONDITIONS?
Commitment to
Strong/Proper
Governance
Clearly Defined Sales
and Marketing
Strategy
Intellectual Asset
Harvesting and
Management
Systems
Recognizable Brands
and Industry/Peer
Respect
Transparency in
Accounting and
Financial Systems
Culture of Innovation
and Adaptability
Growing
Company
Value Drivers
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Preface
xiii
That Was Then
1. Resource Management

●
Doing less with more.
●
Overfunded balance sheets.
●
Overvalued companies.
●
Overpaid workers.
●
Waste runs amok.
2. Exit Strategies
●
In through the out door.
●
Built to flip.
●
Viability of business model
seemed irrelevant.
3. Capital Expenditures
●
If it can be spent, it will be spent.
●
Sales like shooting fish in a
barrel.
●
Constant technology and
facility upgrades.
4. Infrastructure/Systems & Staffing
●
If we build it, they will come

and even if they don’t that’s OK
as long as we look marvelous on
paper . . .
5. Intellectual Property
●
Defensive strategy.
●
Filling up baskets of fruit.
●
Business model patents flood the
USPTO.
6. Dealing With Bad News
●
Euphoria—don’t rain on my
parade.
●
3 monkeys (Hear no evil, see no
evil, speak no evil).
●
Find a rug and scoop it under.
This Is Now
Resource Management
●
Doing more with less.
●
Bar has been raised.
●
Need to run faster, jump
higher.
●

Bootstrappers rule the roost.
Exit Strategies
●
No exit.
●
Built to last.
●
Must build real companies.
Capital Expenditures
●
If it can be deferred, it will be
deferred.
●
Capital expenditures must
produce an immediate cost
savings or revenue opportunity.
So:
●
Does your product or service
meet this criteria?
●
How does this change your
business model, growth, or
exit plans?
●
How does this longer selling
cycle affect your cash flow and
capital-formation needs?
Infrastructure/System & Staffing
●

Get the customer, stretch
resources to the max, then
build it slowly and be sure
demand exceeds capacity.
Intellectual Property
●
Offensive strategy.
●
Capital-efficient growth.
●
Squeezing more juice out of
the fruit we have already
harvested.
●
From cost center to profit center.
●
Show me the money—IP
leveraging.
Dealing with Bad News
●
You better look good in a
swimsuit.
●
Nowhere to run, nowhere to
hide.
●
Accountability/trust/credibility
is key with stakeholders and
employees.
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xiv
PREFACE
7. Motivating/Compensating Your
Team
●
Stock options are cool and pool
tables rule.
●
Chill-out rooms more populated
than conference rooms.
●
Overnight millionaires.
●
Excessive salaries, expense
accounts, and overhead.
●
Sizzle rules over steak.
8. Capital Formation
●
Borrow, why borrow?
●
Business plans on the back of
cocktail napkins.
●
Term sheets actually get
negotiated.
9. Customer Acquisition/Retention
●
Customers, who needs customers?
●

Customers too closely tied to a
trend or a window that was
closing too quickly.
●
Lots of shallow alliances.
●
Overreliance on a single customer
was acceptable.
Motivating/Compensating Your
Team
●
Your integrity is under a
microscope.
●
Harder to keep folks happy.
●
Must be a true leader and
passion must be genuine.
●
Employees want to be better
informed—have some influence
over their destiny.
●
More realistic and patient but
want upside.
●
Consider outsourcing strategies.
●
Need to get more creative on
benefits/work conditions.

●
Experience really matters most.
Capital Formation
●
Credit markets look very
attractive.
●
Low rates.
●
Banks more open to IP assets.
●
Avoid dilution at low valuations.
●
Banks under pressure to lend
to smaller companies.
●
Equity capital sources demand
durable, recurring, and
profitable revenue streams as
precursor to investing.
●
Much tougher term sheets.
Customer Acquisition/Retention
●
Customers more demanding,
less loyal—need TLC and best
prices/service.
●
Customer relations must be
durable, interdependent, and

diversified.
●
Alliances/JVs must be bona fide
with shared risk/shared reward.
●
Don’t overrely on one personal
relationship in an age of
downsizing and reshaping.
●
Government (federal/state/
local) as a customer.
That Was Then (continued) This Is Now (continued)
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Preface
xv
10. M&A
●
Great time to be a seller.
●
Roll-ups and consolidations.
●
Post-closing synergies.
●
Private equity funds fuel M&A.
M&A
●
Great time to be a buyer.
●
M&A as precise surgery—very
specific objection—must have a

game plan.
●
Post-closing nightmares and
surprises.
●
Commercial lenders will
support the right M&A deals.
Understanding the Private Equity Markets
In many ways, the private equity markets mimic the conditions of
the public stock market, much like the behavior of a little brother
copying the mannerisms of an admired big brother. When the bar
to access has been raised by the public markets, as it has been since
spring of 2000, so too moves the bar to access the private equity
markets. When the bar is raised, Darwinian principles begin to
strongly apply. It is survival of the fittest. The “fittest” companies
are those with the strongest management teams, the largest poten-
tial markets, the most loyal and established customers, the most
defendable market positions, and the clearest path to profitability. I
have often explained it as the “state of the capital markets” snow-
man, diagrammed in Figure P-2 below.
In some ways, the private equity markets are like a snowman;
the head represents the top-notch companies, the body represents
the bulk of the companies, and the legs represent the weakest ven-
tures. The condition of the markets reflects where the line of
demarcation will be drawn between those companies that
will get
access to the capital markets and those that
will not as depicted
below.
As the second edition of this book is being published in early

2005, we have a relatively typical set of private equity conditions, as
demonstrated below. The venture investor has returned to the
basics, a focus on fundamental blockage and tackling skills, with a
“little something extra” that influences the venture investors’ final
That Was Then (continued) This Is Now (continued)
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xvi
PREFACE
FIGURE P-2. STATE OF THE CAPITAL MARKETS SNOWMAN
Normal Private Equity Conditions (ex. 1994 to 1997, 2004)
All truly excellent
companies and some
typical growth
companies have
access to the capital
markets.
Truly Excellent
Companies
Typical Growth
Companies
Weaker (Limited
Growth Companies)
Truly Excellent
Companies
Typical Growth
Companies
Weaker (Limited
Growth Companies)
Truly Excellent
Companies

Typical Growth
Companies
Weaker (Limited
Operating Companies)
Weak Capital Market Conditions (ex. 2000 to 2002)
Only the “best of the best”
in favored industry
sectors get access to
the private equity markets
(and even those face
much tougher terms and
conditions).
Abnormally Exuberant Market Conditions (ex. 1998 to 2000)
The exuberance of the markets
provides capital to all
excellent, typical, and even
some weaker companies
and business models
in a “gold rush” mentality.
Open
Access
Closed
Access
Open
Access
Closed
Access
Open
Access
Closed

Access
01RC-FM-04 12/15/04 4:17 PM Page xvi
Preface
xvii
decisions. As my old friend John May (author of Every Business Needs
an Angel
) has often said, “It is not enough these days to build a bet-
ter mousetrap, you now need to demonstrate that you can lead a
team with a passion for murdering mice.” Wise words.
Andrew J. Sherman
Bethesda, Maryland
June 2004
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RAISING CAPITAL
SECOND EDITION
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PART
1
GETTING READY TO RAISE
CAPITAL
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A
FTER MORE THAN TWO DECADES of being an entrepreneur,
serving as a legal and strategic adviser to entrepreneurs and

growing companies, and speaking and writing on entrepreneurial
finance, I have found one recurrent theme running through all
these businesses:
Capital is the lifeblood of a growing business. In
an environment where cash is king, no entrepreneur I have ever
met or worked with seems to have enough of it. One irony is that
the creativity entrepreneurs typically show in starting and building
their businesses seems to fall apart when it comes to the business
planning and capital formation process. Most entrepreneurs start
their search without really understanding the process and, to para-
phrase the old country song, waste a lot of time and resources
“lookin’ for love [money] in all the wrong places.”
I wrote
Raising Capital to help entrepreneurs and their advisers
navigate the often murky waters of entrepreneurial finance and
explore all of the traditional and nontraditional sources of capital
that may be available to a growing business. I’m assuming that you,
the reader, are the entrepreneur—the owner of a business that’s
looking for new money. So, wherever possible, I’ll address you
directly, as if you were a client sitting across from me. My goal is to
provide you with pragmatic guidance based on years of experience
and a view from the trenches so that you’ll end up with a thorough
understanding as to
how and where companies at various growth
3
CHAPTER 1
Capital-Formation Strategies
and Trends
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