Capital Financing and Syndications
I. Capital Structures and Needs
The lifeblood of business, capital fuels start-ups, company growth and, for the benefit of owners, the sale of the company. To address these different needs, financial markets have developed innumerable products with unique characteristics targeted to the following types of needs.
A. Start-Ups
Start-up companies typically finance development and commercialization through a “seed capital friends and family” round, followed by an angel round, one or more venture capital rounds. Once established, the company may obtain growth capital as described in Corporate Finance below. The final stage of these companies involves the exit of the owners financed by an initial public offering or a sale of the company.
B. Real Estate Syndication
Through real estate syndications, real estate developers finance property acquisitions and development. Real estate syndications (which may also be viewed as serial start-ups) usually allocate returns between the investors and the developer with a “waterfall” approach. Called “waterfalls” based on the analogy of “economic returns” cascading into subsequent pools of cash after filling the previous pool, the developer earns increased carried interests or shares of return as higher investor return levels are achieved. These financial structures are complex and require financial modeling of projected returns. Although numerous financial software models are available, an example of one commercial model is available at https://breakingintowallstreet.com/biws/real-estate-modeling/. Before using any financial model, the software calculations should be examined to confirm proper structure.
C. Corporate Finance
More established businesses obtain debt capital from institutional lenders (such as banks, insurance companies and large private lenders) and equity capital from investment banks, private equity groups, family offices and large private investors. Debt capital may be structured as senior debt, mezzanine debt, convertible debt and exchangeable debt. Stock warrants (right to purchase equity on favorable terms) may be issued to lenders as an “equity sweetener” to increase their return. Equity capital may be raised by the sale of common stock, convertible preferred stock, warrants and various other equity instruments.
II. Common Restrictions and Requirements
While financing structure variations are too numerous to catalogue, securities laws and financial covenants apply to all financings.
A. Securities Laws
In response to fraudulent securities offerings considered to cause the Great Depression, Congress passed federal laws in the 1930s requiring registration of sales of securities (the “registration requirement”) and disclosure of all material facts (the “antifraud requirements”). The states followed suit with their own state securities or “blue sky” laws. These laws apply to “securities” – a term which has been expansively defined beyond traditional concepts (such as stock) to include equity interests other entities such as limited liability companies and limited partnerships), certain debt instruments issued by a borrower for a loan, and even interests in orange groves managed by the promoter.
Without a statutory exemption from the registration requirements, sales of securities must be registered with the U.S. Securities and Exchange Commission (SEC) for review prior to sale. Selling a “security” in violation of the registration requirements is illegal. The issuer (seller) of the securities and its “control persons” (directors, managers and officers) in an illegal offering can be personally liable for the full amount received from investors, even if the business fails for unrelated and unforeseeable reasons. No exemption exists from the antifraud requirements of full disclosure. A violation of the antifraud requirement also results in an illegal offering with liability to the issuer and its control persons.
With registration costs typically being significant six-figures, capital raises are structured to meet registration requirement exemptions when possible. One of the most popular registration exemptions is the “Rule 506” offering because it also overrides state registration requirements.
While not limiting the amount of capital that can be raised or the number of “accredited investors,” no more than 35 nonaccredited investors are permitted. An accredited investor includes certain types of entities as well as an individuals who: (i) is a director/manager or executive officer of the issuing company; (ii) individually or jointly with his or her spouse, has a net worth (excluding primary residence, total assets in excess of total liabilities) in excess of $1,000,000 at the time of purchase; or (iii) had annual income exceeding $200,000 (or $300,000 jointly with his or her spouse) for the two most recent calendar years and reasonably expects the same level of income for the current calendar year. If the offering is limited to “accredited investors,” there is no required disclosure format but an offering circular/private placement memorandum should be prepared to address the antifraud requirement. If any nonaccredited investors are permitted, an offering document satisfying SEC registration requirements becomes necessary which dramatically increases costs. Other requirements to satisfy the Rule 506 exemption exist. As required by the Jumpstart Our Business Startups Act (the JOBS Act), the SEC recently relaxed the prohibition against “general solicitation” activities which severely limited selling activities.
B. Financing Covenants
All financing sources, including institutional, venture capital, private investor and other capital providers, require representations, warranties and covenants to protect their funds. The principal owners may also be required to guarantee certain obligations. While these restrictions and obligations are common to all financings, their scope and extent vary based on the company’s capital structure. The capital structure governs the payment priority among the financing sources. This payment priority, in turn, influences the protective representations, warranties and covenants sought. Even in equity investments, preferred stock (the favored investment form of venture capital and private capital sources) contain protective provisions and preferential payment rights over common stock (typically owned by founders and management) which constitutes the residual economic interest in the company after payment of all debt and senior equity.
This brief overview is only an introduction to the complex issues inherent in financing transactions and this summary belies the complexity of legal issues in this area. No financing transaction should be undertaken without experienced and knowledgeable legal counsel.
This blog does not establish an attorney-client relationship and does not constitute legal advice. Legal outcomes are based on the particular facts of a situation and the application of the law to those facts. Anyone with issues described in this blog should hire an attorney for legal advice based on the relevant facts. The firm has no obligation to maintain the confidentiality of any information received by email or comments.
