How one CEO found $5m in small checks THIS WEEK

Here’s what I’ve learned about this newsletter community after a few weeks of writing in this new format …

1. The Stories: I include stories about Asher, my 9-year old hockey player because it’s eerie how the exact same coaching I give him to win on the ice … ALSO works for you guys in finance! I’ve had more people email, text, and call me out of the blue after reading one of these issues and they always mention how much they enjoy the personal stories.

   
   

   

2. The Strategy: “Raising $100K from Small Check writers” topic apparently struck a vein. I’ve had several people writing in telling me the previous email about $100k check writers was the “best email you’ve written mate” and the “first time I feel like you're actually addressing the actual pain points of startups CEOs that are far from the glam deal making stories narrated in your books.”

Let’s start with the TLDR on what’s going on this week at the Klaff household so far: My wife Amalia is gone for the week… and running a business while managing an active athlete of a child is way harder than I thought.

And to keep the conversation going on raising capital from small balance check writers, today’s email is about the actual mechanics of running a true “retail round” of fundraising.

-Oren

How to Manage a ~$5m Retail Raise with ~30 Check writers.

About an hour after I hit send on Monday’s email, I got a call from a friend of mine who is an experienced Capital Raising CEO.

“Oren, I’m out raising $5m, but with SVB and all the VC destruction, I stopped even trying to raise that money, and am just funding the deal myself - which is painful …

But then I read your email and I realized that I definitely know 30+ people who could write $100k checks to me … and would gladly fund anything I’m doing.

… I just don’t know what to do to get them into my deal. What do I offer them, how does this even work?”

Keep in mind that this person has raised more than $30m from institutions in the past few years, so it’s not like he doesn’t know how the many parts of the money game work…

He just doesn’t know THIS part of the game: The F.A.S.T. Funding Syndication Strategy

Here’s what’s different about raising one $5M check from an institution vs $5M from 30-50 individuals (called a Syndication).

1. Different pitch: Most of these investors don’t have access to 30 other deals that look just like yours. This is probably the best thing they DO have access to, so you can keep it simple and short
   

2. Different timeframe: Individuals by definition invest their own capital and can make faster decisions. They don’t need weeks and months. They need a gut feeling that says “yes, I’m in!” – that takes one 15-30min meeting
   

3. YOUR legal documents: Say goodbye to tons of legal fees negotiating terms. This is a retail product. They take it on your terms on your paper, or they don’t.
   

4. More risk disclosures: The one area you don’t want to cut corners on legal fees is making sure you’ve included the proper disclosures and have set proper expectations with these investors. No point in a lawsuit later on because you couldn’t be bothered to cover your a## on the front end.
   

5. More control: Say goodbye to preferred shares with toxic controls! You can even offer common stock, with limited information rights, and no board seats.

Another concern he had…

My client has a pretty good understanding of what a 100k investor is looking for … and he’s correct in his thinking that these retail investors don’t want to be locked up for 5-10 years the way a fund can.

Retail wants to be out in 3 years or less.

So how do you structure this financing to address the liquidity needs of a small balance investor? Especially if you don’t plan on going public or selling the business within the next 3 years?

Answer: A 3-Year Recapitalization Plan

To understand how – and why – this Playbook works, we have to talk about an important concept every executive must understand…

How The Cost of Capital Impacts Fundraising

More specifically, the cost of equity vs the cost of debt.

Let’s take a look at the classic leveraged buyout (LBO) strategy used by private equity firms. These transactions typically occur when a PE firm borrows as much as it can from a variety of lenders – up to 70-80% of the purchase price – and funds the balance with equity.

Why do they use so much debt? Simply put, their financial models say that the cost of debt servicing is cheaper than the cost of equity capital… and they expect to generate better total returns by loading up on debt.

In a falling interest rate environment that goes towards zero, this sets the stage for growth through pure financial engineering and arbitrage.

It used to be that you could put in $1 of equity and borrow a $2-$3 of debt for basically nothing, and expect to make an easy 20%+ IRR.

We can see from the chart below, what has driven the enormous PE gains over the past decade has been mostly multiple expansion – an artifact of the “everything bubble” where more money was always coming in to drive prices higher.

But with interest rates edging towards 5%, debt has become way more expensive, investors are valuing profit over growth, and there’s no more “Free Lunch” in multiple expansion.

Today, you have to work hard for your money and make what you buy better (margin expansion and revenue growth).

And if you’re smart, you’ll use your core asset the way PE firms do – as a “platform” that can be set up to acquire and integrate other assets into it.

So what does this have to do with small balance checkwriters and a recap strategy?

Simple. If you go into the institutional channel, the Cost of Capital – for both equity and debt – is higher than it was 6 months ago.

Chances are, your business isn’t in a position to qualify for a senior secured loan from a bank at ~7-9%.

Maybe you can get yourself some ultra predatory unsecured line of credit at some loan shark level rates of 20-30%...

But unless you are VERY confident about your ability to service that debt, all you’re doing is adding tons of long term risk for a very short-term reward.

• Equity financing means more control. This might sound counterintuitive, but taking on a ton of debt simply to avoid dilution is a stupid idea. You don’t know this, but there are entire financial firms whose strategy is to load a company up with debt, knowing it’s going to default, and then take it over for pennies on the dollar.
  

• You can always “buy back” equity later when you qualify for cheaper debt. If you think interest rates are going to be lower three years from today – or you can grow large enough to qualify for better financing – this is an obvious trade to make.

This is exactly what we’re starting to see in the PE markets. Instead of 80/20 debt-to-equity financings, we’re seeing more 50/50 rounds with a plan to recap out the early shareholders in 3-4 years.

Basically, what you wind up doing is this…

Step 1) Raise equity capital: The whole point of equity is Capital Formation. This means the money raised is used to build a Capital Asset – an asset with a productive life of longer than a year that you don’t sell to customers (that’s called inventory).

In other words, you want equity to be used to build the assets that make the products that you sell for revenue.

Once you’ve got that asset built…

Step 2) Optimize Cash Flow: The cheapest capital is and always will be retained earnings. The stronger and more predictable your cashflow is, the easier it is to obtain financing based on the expected future cashflows of the Capital Asset.

Once you’ve had a chance to clean your business up and get your financials in order, now you’re ready for…

Step 3) Focus on building credit facilities: The best time to raise capital is when you don’t need it.

This is especially true when it comes to developing relationships with lenders… and why it’s critically important you present yourself as a CEO and not “founder” of some high risk startup.

Remember. Lenders care about getting paid back. All you need to do is give them confidence that your financial model is sound…

You have the financial infrastructure to comply with their reporting requirements…

And you can be trusted to manage the capital they give you responsibly.

This will probably take 1-2 years of building your track record, hiring the right advisors, and building relationships with the right lenders.

So now the question is, where are you going to get that first traunch of equity capital to get this process started?

You guessed it. Small balance check writers.

And now that you understand how you can build a financial product that meets the liquidity needs and check size of this retail audience…

It means you can unlock a major competitive advantage when everyone else in your industry is trying to raise from institutions (or are foregoing raising capital at all).

Help me help you? Answer the poll below

The best thing about this newsletter format is the data I’ve been able to collect from our group. It’s been enormously helpful at identifying where you’re getting stuck, and how I can help you get unstuck.

Let’s talk about you as a CEO. In my experience working with founder led companies, here is what you have to decide.

1. I have what it takes to function at the CEO level: CEOs job is to communicate the vision, build strategy, raise capital, mergers & acquisitions, and exits. Everything else is done by other people.

2. I am an excellent operator / salesperson: Someone still needs to run the actual business and service the customers. Many founders would be happier – and their business more successful – if they stayed close to the customers and hired a CEO to do the other stuff.

Tell me what describes you best in the poll below…