Updated: Apr 10, 2021
What is the cost of private equity today? The answer depends on the target amount, preparation, and creative money raising strategies.
The fund raising market tends to divide itself into three categories: businesses seeking less than $1mm, $1mm – 10mm and over $10mm. Investment bankers usually won’t touch deals for companies raising less than $1mm, according to Stephen Brewer, President of Brewer Capital in Houston. “To raise amounts over $1mm, a FINRA licensed investment banker typically charges a 10% success fee and a 2-3% unaccountable allowance (expenses to raise the money). Fees decline for raising larger amounts – 8% for raising $2-5 mm and 4-6% to raise more than $5 million, with the same 2-3% unaccountable allowance.”
Kyle Holland, principal of First Avantus Securities in Austin and shareholder of Wired Angel.com, Inc. of Houston sees tougher deal terms now. “It is brutal out there trying to raise funds. Investors were burned and are very conservative now. On the other hand, some fund-raising companies really need money, so it is a seller’s market. I’m working with some guys who are factoring, doing credit lines, paying 25% on their money. Some deals are really creative with differing percentages of cash and warrants, with floating percentages of free trading stock depending on the amount raised. For example, to raise up to $2mm, I am seeing deals for 13% cash with 7% warrants. If $3mm is raised, the terms shift to 11% cash with 5% in free trading stock.”
Because it is so hard to attract investment, Karl Maier, principal of Houston Biz Starter, sees small businesses “raising money the old fashioned way – bank loans based on inventory and receivables,” or increased commitment to making sales and retaining customers. “Entrepreneurs have to spend money on professionals to raise money, just as they need to spend money on marketing to gain customers.” Neither expenditure guarantees success – it needs to be a smart “spend” either way. The biggest mistake Mr. Maier sees in companies trying to raise money is lack of objectivity in their valuation and business opportunity. He recommends that they pay to get an independent assessment of their proposal before they go before savvy investors.
The costs of raising money include many expenses other than those of the fund-raising sources themselves. To position themselves for private equity, companies need supporting materials. They can create them in-house or hire professionals to do so. The higher the stakes, the more impressive these items need to be. Documents include executive summaries, longer business plans, private placement memoranda (PPMs), and contracts. Other items include PowerPoint presentations, websites, marketing collateral and press releases. Businesses also incur costs for networking and traveling to give presentations to potential investors.
Prices for these services vary broadly, depending on several factors. The most controllable cost is how prepared a company is to engage investors’ attention. Has it done what attorney Chuck Powell, partner at Haynes and Boone LLP in Houston, refers to as “blocking and tackling” early in the life of the company? For example, does it have clear documentation of IP ownership and shareholder stakes (two areas of frequent conflict)? Has it already written a professional quality business plan with a short executive summary? Can marketing materials and PowerPoint presentations geared to customers be tweaked for potential investors? If so, the company can save tens of thousands of dollars in service fees.
Companies less well prepared must budget accordingly for time or money. An investor-oriented business plan generated from scratch or from piles of papers can cost a five-figure sum. If the executives of a company want to write it themselves, they should calculate the value of their time. Arturo Romero, President of Mejores Compras in Houston (and a client company of Houston Technology Center), put it this way: “The real cost in the search for capital has been the cost of my executive team’s time and effort. The late nights and long days producing the business plan and preparing for presentations will pay off, but it took away from the business and from our families. It is hard to put a value on that.” Other companies calculated the time for creating in-house an acceptable executive summary at ten hours and for an effective investor-oriented PowerPoint presentation at twenty-four hours.
For legal fees, a “rule of thumb” is that companies should budget 1% of the amount to be raised, so a company seeking $5mm should budget $50,000. These fees cover documentation of transaction terms, IP ownership, due diligence, disclosure, employer/founder arrangements, employee options, and closing. Of course, this amount can rise or fall depending on numerous factors, many of which are within the company’s control.
Three things can save a company thousands of dollars in legal fees,” advises Powell. “First, sophisticated, first-rate financial people on the management team” can clear a lot of the landmines that other businesses miss, such as market conditions, the success of similar deals, unrealistic financial projections, and the effect of future investment rounds on early investors and management. Second, companies would do well to address the tough stuff and reach agreement before they bring in the lawyers. The more often people change their minds or change the terms once an attorney is engaged, the more the hours rack up. “One deal that should have cost $50,000 ran $100,000 because the terms kept changing. The investor had requested long form non-compete and non-disclosure terms for all employees, each of whom engaged his/her own attorney. In addition, the VC wanted other rights that had not previously been discussed.” Third, companies should come to lawyers with a fully negotiated, non-binding term sheet in hand. “Negotiating a deal through the documents really raises fees, compared to a thirty minute conference call between the parties and their attorneys.”
The common mistakes of companies seeking private equity are overestimation of their appeal to investors and underestimation of the time it takes to do what needs to be done. By being prudent and practical, they can save both time and money.