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13 July 2015

Raising Capital For Your Business

For many startup to medium sized businesses, owners will quickly discover raising capital as a major headache and limiter when considering expansion, improved infrastructure, marketing and brand awareness, corporate structuring, obtaining key personnel and product development.

Too often a good business or business idea never gets of the ground due to a lack of capital or financial backing.

How does a business grow and what options are available. There are three main methods that this BLOG covers and they have been around since the dawn of time.

Other programs, not covered by this blog, include Government incentive grants and more recently, Crowd Funding.   With Government grants, only use the official government web sites and avoid organisations that claim to help you secure a grant on payment of a fee.  All government grant applications are free and paying a fee will not escalate your application.

We will look at each of these options to provide you with a basic understanding of the differences.

Bank Loans

It's important to also understand the ratio of Debt to Equity. The main source of debt financing is through a loan, usually with a bank. With a loan, the principal amount needs to be repaid and interest over a period of time. Banks are not risk takers so they will also take security over personal assets of the business owners. 

Therefore the capacity of a business to finance growth is somewhat limited to the capacity of the owners to provide security, often in the form of first mortgage finance over the family home. The advantage of debt finance is that, once the loan is repaid, the owners retain one hundred per cent of the business. 

Pros

  • 100% ownership once the debt is repaid.
  • Access to funds in most cases if the owner have full owner of bricks and mortar type assets to used as security.
Cons
  • Interest must be paid on the amount borrowed.
  • Banks require security against the debt, often in the form of personal assets of the business owner.
  • The amount is limited by the value of the assets available for use as security.  

Equity Raising

An alternative to debt funding is capital or equity raising. A common way to raise private capital is to bring in a business partner, perhaps someone already known to the owner or an outside investor, often called an angel investor. 

The investor puts money into the business in exchange for a share of the business. All shareholders of the company gain revenue through paid dividends based on the share holding. (A share of company profits normally calculated at the end of the financial year)

Dividends are not to be confused with wages or consultancy fees paid separately to the shareholders as work performed. Dividends can be considered as paying interest on the capital raised.   Most companies pay a share of profits back to shareholders while retaining a majority of the profits to fund further growth. 

The advantage over a loan is that there is no interest, no debt to repay and no security required. However, there is now another part owner who will expect a say in running the business and may also have a different exit strategy. Angel investor are often difficult to locate and normally insist on special terms or conditions around terminating the arrangement if the relationship fails.

Pros
  • No Interest.
  • No personal assets to be used as security.
  • Personal assets don't limit the amount that can be raised.

Cons

  • A degree of control over the business is relinquished.
  • A risk of different ideas about running the business and direction.
  • Investors that are not well matched can be very difficult to exit from the business.

Passive Shareholders (Retail & Wholesale Investors)

Passive shareholders provide a different approach when it comes to raising capital from a number of passive shareholders. These investors invest money with an expectation of profit by way of dividends and/or growth in the share price of their shareholding. They have no involvement in the strategy or day-to-day running of the business. If they become dissatisfied with the company’s performance they can sell their shares.

In Australia, the actions of companies and its executive team are governed by the Corporations Act.

In general terms, the Corporations Act prohibits smaller type businesses approaching the public for capital without a prospectus (See note below). The law does, however, provide a limited opportunity for small businesses to raise capital.

Under Class Order 02/273 (2001 Act), small businesses may raise capital under what is called the 20/12 Rule under Section 708. Under these provisions, small business owners can raise up to $2 million from up to twenty ‘Retail or Wholesale’ investors in a twelve-month period.

Retail Investors are normally smaller investors, "Mum & Dad Investors" not acting on behalf of a larger corporation while Wholesale investors are normally investment groups or larger organisations. As Retail Investors are smaller, the level of effort to provide understanding becomes a greater consideration when raising capital.

Advertising is restricted and only personal offers can be made. The class order extends the $2 million cap to $5 million if the capital is raised through an operator of a business introduction or matching service such as ASSOB, Paragon, Axant to name a few.

People resident overseas and ‘Sophisticated Investors’ (Informed investors), are not counted, so it is possible to finish up with a lot more than twenty investors.

Capital may also be raised through an Offer Information Statement (OIS). While not a prospectus, it requires a higher level of disclosure than under the 20/12 Rule and must be registered with Australian Securities and Investments Commission (ASIC). Funds raised can be up to $10 million less any capital previously raised and restrictions on advertising do not apply. A small business may elect to raise initial capital under the 20/12 Rule and then look to raise additional capital under an OIS. An OIS also enables listing to a stock exchange before seeking an Initial Public Offering (IPO).

Raising capital from a number of passive investors requires an investor-friendly environment to gain confidence that their funds will be correctly used and that every thing is above board. A Private Company (Pty Ltd) requires only one director, there is no need to produce audited accounts and the majority of shareholders can restrict shares from being transferred, with no reason. For a Passive Shareholder, this is not a satisfactory environment. A more attractive environment is to set up or convert the existing Private Company to an unlisted Public Company. A Public Company depending on its turnover will need to appoint an auditor, have its financial affairs and reports audited annually, a board appointed and Annual General Meeting held with proper notice, agenda and reports.

Having established the right vehicle, it is also necessary to structure the initial share offer to attract investors. For example, what is the composition of the board? What skills can be acquired by creating a board with experienced people who have previous board experience? This will be an additional comfort to shareholders. (Minimum of 3 directors are required) A well-selected board with relevant industry knowledge, experience and a network of contacts will greatly assist in attracting early stage investors.

Unlisted companies using a matching service such as ASSOB can become listed for around $5,000. However a business will need in the order of $15,000 to $30,000 to cover other costs including: governance fess, consultants, creation of prospectus and investment documents, business plan, budgets, board creation, investment events, listing fees etc.  Most of these companies also take a commission of funds raised in the order of 5% to 8%

Listing on a stock exchange requires the issue of a prospectus and a whole new compliance regime. The most well known exchange is the ASX (Australian Securities Exchange). It has the biggest Australia marketplace, but a company probably needs to be capitalised at around $50 million to attract broker interest and cover the listing and compliance costs.

The NSX (National Stock Exchange) is a stock exchange for SMEs (small to medium enterprises) and is often regarded as a precursor to an ASX listing. The NSX has lower listing requirements and is certainly cheaper. In both cases, shares must be traded through a broker and, in the case of the NSX, a nominated adviser will be needed to guide the company through the process. 

Pros
  • Passive shareholders have no involvement in the strategy or day-to-day running of the business.
  • Under the provisions of Class Order 02/273, small business owners can raise up $2 million from up to twenty ‘retail’ investors in a twelve-month period without a prospectus.
  • More than twenty potential investors can be approached by approaching investors such as existing owners, people resident overseas and ‘Sophisticated Investors’.
  • Raising funds using an OIS, the amount raised can be $10 million (less capital previously raised) without restrictions on advertising.
  • New directors into the company can increase knowledge, skills and stability.

Cons

  • Restrictions on how much capital can be raised.
  • The Corporations Act 2001 prohibits small businesses approaching the public for capital without a prospectus.
  • When raising money through passive shareholders, there are restrictions regarding how to promote, and advertised and offers are restricted to personal offers only.
  • Once sold, shares can be very difficult to reacquire.
  • It is better to convert an existing private company to an unlisted public company.
  • Can be an expensive and time-consuming process.

Prospectus

A formal legal document, which is required by and filed with ASIC, that provides details about an investment offering for sale to the public. A prospectus should contain the facts that an investor needs to make an informed investment decision.  Click here to download the ASIC RG228 Perspective disclosure for retail investors.

Getting Help

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