The Essential Guide to Capital Raising

In many respects, there has never been a better time for companies to raise capital.

Interest rates are hovering close to zero for a longer period than at any stage of history, the government has just made a historic cash injection into the economy, and there is an ever-growing number of funding sources to choose from.

DealRoom works with hundreds of companies both seeking and providing capital on an ongoing basis, providing them with a virtual deal room that is designed to smoothen the process of raising funds, whichever side of the transaction they’re on.

In this article, we share some of the insights we’ve gathered from helping companies through their capital raise process.

Types of Capital Raising

In broad terms, there are 3 ways how companies can raise capital: debt, equity, or a combination of the two, otherwise known as hybrids.

Debt Raising

Debt raising involves raising funds through loans provided by third parties. The lenders of the debt have traditionally been banks and public debt markets (i.e. the bond markets) but now include a host of financial institutions and increasingly private equity funds. In its simplest form, debt raising involves paying the lender back its principal and an agreed amount of interest over the duration of the loan.

The size of the debt market (in 2021, the global debt market was valued at $303 trillion) means that anyone debt raising can avail of multiple forms of debt. Lenders can include a range of terms and conditions on their loan that protect them on the downside in the event that your company cannot (or will not) repay the money.

In broad terms, there are four forms of debt that companies can avail of:

• Secured debt: Where collateral is used to secure the loan, thus enabling the company to avail of lower interest rates (as the risk is lower for the lender);
• Unsecured debt: This form of debt includes no borrower collateral, so the interest rate depends on the company’s credit history;
• Tax-exempt corporate debt: Some debt may be eligible for tax exemption. For example, projects related to sustainability;
• Convertible debt: Usually considered a hybrid (i.e. a mixture of debt and equity), whereby the debt can be converted into equity if the borrower prefers.

Which type of debt a company raises depends on a number of different factors - primarily the condition of their financial statements (and in particular, the amount of debt outstanding on the balance sheet), their credit (rating) history, quality of the collateral, and borrowers’ and lenders’ own appetite for risk. At most points of an economic cycle, debt is possible for a company to raise, but the cost of interest is not always attractive.

Pros and Cons of Debt Raising

Pros:

• Relatively fast access to cash for companies that require it;
• In low interest rate environments, debt offers a cheap way to access liquidity;
• Debt repayments (in interest) can be forecasted accurately for budgeting purposes;
• The interest paid is tax deductible

Cons:

• Generally, raising debt reduces a company’s credit rating;
• There mere availability of debt may induce managers to raise it when it is not required;
• The money has to be repaid, even if the business isn’t performing well;
• Debt on a balance sheet reduces management’s strategic options.

Equity raising

Equity raising occurs when a company seeks to raise funds through the sale of its equity - i.e. a share in the ownership of the company. The equity investors can generally be anyone that possesses the cash required and is willing to meet the company’s owners on its valuation. A company that overvalues its equity risks alienating most investors, who will fear not seeing an adequate  return on their investment.

Most companies with positive outlooks (i.e.their equity is attractive to investors) can avail of equity funding. Like debt raising, certain equity raising agreements can have different conditions attached, and when this happens, it is usually referred to as ‘preferred equity.’ The stock market is the largest and most well-known method of equity raising, where publicly listed companies sell their equity to raise funds and maintain liquidity.

Pros and Cons of Equity Raising

Pros:

• Access to the management advice of seasoned equity investors;
• No requirement for regular interest repayments(as with debt raising);
• Possibility for company management to set the company valuation;
• Technically, a lower risk solution than debt raising.

Cons:

• Company management is giving up (some) controlling the business;
• The equity may come with some provisions on consulting the investors on big decisions;
• The presence of external investors may lead to friction within the company;
• The upside potential of the company now has to be shared with outsiders.

Equity Raising Examples

There are several kinds of raising equity, with the big differentiator between them being the stage of a company’s evolution to which it applies to. In broad terms, the different types of equity raising - in chronological order, from early companies to mature companies, are:

• Crowdfunding
• Seed financing
• Angel financing
• Venture Capital
• Private Equity
• Public Capital Markets

Hybrids of debt and equity

A hybrid of debt and equity gives the advantages(and disadvantages) of debt and equity raising and tends to be seen as a compromise between the two. Depending on how the hybrid capital raising agreement is written up, it could benefit either the company or the owner moreover the course of the debt. In essence, if the company thrives and the debt is convertible to equity, investors win. Otherwise, the benefits tend to be derived by the company.

Pros and Cons of Hybrids of Debt and Equity

Pros

• More flexible arrangements are possible for the company and investors;
• Can provide both sides of the transaction with a lower risk proposition;
• May give companies access to a broader range of investors;
• May enable investors to diversify across a broader number of companies by combining fixed income (debt) with equity investments.

Cons

• Hybrid capital raising tends to be more complex than either debt or equity raising;
• Tends to favor investors at the expense of companies.

How to Raise Capital for Your Business

Whether a company is raising debt or equity capital, it essentially faces a sell-side investor equation similar to that faced by owners looking to divest their companies (ultimately, what is equity raising aside from selling a part of a business).

On this basis, company managers face many of the same challenges as they would in M&A: providing investors with the right documentation, valuing the company correctly, and getting their house in order.

For this same reason, managers at these companies would be well advised to use data room due diligence software like DealRoom or an alternative.

Not only does DealRoom enable companies to efficiently organize their capital raising process, but it can also show where weaknesses in the company’s value proposition might exist before making the initial approach to investors for their debt or equity raise.

Here is a step-by-step approach to raising capital for your business:

Step 1: Clean up your financials

Most lenders will focus on two things: The executive summary of your business plan (see next bullet point) and your financial statements. Ensure both are as good as they can be. That means paying off credit card debt so that it’s not on the balance sheet, becoming more aggressive in the short term about credit terms so that your receivables are lower, and maybe even cutting back on some operating expenses.

Step 2: Write a business plan

Whether the funds are coming from a financial institution, a private equity-style fund, independent investors, or even the SBA, it pays to have a strong business plan that shows exactly why you need to raise capital, and why the lender can be sure that they’ll receive the principal with interest within an agreed timeframe.

Step 3: Emphasize the sources and uses

As part of the business plan, know exactly where the funds will be used. If you’re acquiring a new piece of equipment, make it explicit. If you’re hiring for sales and marketing, show how the funds will be used (what percentage on social media, what percentage on a sales team, etc.). Show as much detail as possible - this also serves to give you insight into your own business.

Step 4: Make a long-list

When looking to raise capital, it’s useful to keep in mind that you’re not the only one. Everybody wants more money. People who are providing it are typically overrun with requests for capital. Most businesses will be trying to convince them that theirs is better than all the others, so don’t be surprised when the first ten companies don’t jump. The capital raising process can take a significant amount of time. Buckle up.

"From data storage and sharing to investor communication and progress reports, DealRoom helped readily execute Pax8’s entire investor management process." -- Jefferson Keith SVP, Corporate Development at Pax8

The process of raising funds is easier said than done, however.

Interested in learning more about the capital raising process? Utilize the Capital Raise Playbook tailored to outline and walk you through the process of raising capital for your specific business.

Why do Companies Raise Capital?

Growth is, for all intent and purposes, the major reason why companies raise capital.

Whether it’s a younger firm looking to raise capital with a venture capital firm to hire more programmers, a mature industrial firm looking to acquire an industry rival, or a distressed company looking to restructure in some manner, the underlying motive in almost all cases for raising capital is growth.

Growth being the implicit motive, the explicit motives for raising capital are as follows:

_{Read also: Venture Capital Deal Structures: Complete Guide}

Who Does the Capital Come From?

Traditionally, banks were the go-to destination for companies looking for debt but the universal need to raise capital has led to a plethora of options for companies of all sizes.

Most of the following outlets for raising capital will cater to both debt and equity raising, with specifics depending on the institution in question.

Banks

Banks remain one of the most common sources of capital for companies, particularly when a company has a good track record with the bank. Equity raises can also occur with banks but tend to be far less common.

Private debt

Private debt - that is, debt-funded by non-public financial institutions - has seen huge growth over the past decade, with the caveat for businesses that interest rates on loans usually begin at the 6-7% mark.

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Listen to private equity podcasts to improve your understanding of how private equity firms operate.

Private equity

With private equity companies sitting on an estimated $2 trillion of ‘’dry powder’ (funds waiting to be used), private equity currently offers an excellent way for companies of all sizes to raise equity capital.

Angel Investors/Seed Investors/Venture Capital

These funds usually seek an equity share of a small, fast-growing business and can build in a debt component. A major advantage here is the ability to tap into their network and expertise. Learn more about how venture capital work here.

Public markets

The main reason that companies go public is to raise equity capital: Selling off slices of the company on a publicly traded index to fund the company’s expansion.

Small Business Association (SBA)

SBA loans are a hugely popular means for small companies to access significant amounts of capital at very attractive rates, the only drawback being the time it can take to access funds.

Ways of Capital Raise for Different Business Sizes

Depending on the size of your business, there are different ways you can raise capital. The process of raising capital for a private company will for example be different than for a public company.

Following are typical routes of capital raising for different business sizes:

Startups

• Friends and family
• Public or private business incubators
• Seed investors
• VC funds

Small and medium-sized enterprises (SMEs)

• Private equity investors (those aimed at SMEs)
• Family offices

Large Companies

• Initial Public Offering (IPO)
• Private equity investors (those aimed at larger companies)
• Family offices
• Wealth funds and asset managers

How To Get Ready for the Capital Raising Process?

The capital raising process can be complex and overwhelming, especially if it's your first time.

To raise capital, at the very least, a company will require a business plan or pitch deck.

The aim of these documents is to show investors that the cash flows generated by the company are sustainable enough to ensure that it will get its money back with interest (in the case of a debt raise) or achieve what they deem to be an attractive return on investment (in the case of an equity raise).

Offering Memorandum

Offering memorandums are used by companies seeking to raise equity capital. It has to comply with securities laws designated by the SEC.

This formal document provides registered investors with a detailed overview of the company’s financials and operations.

This process is called venture capital due diligence.

This document also invariably features a subscription agreement that defines the terms of the investor’s participation in the company’s equity offering.

To streamline this otherwise complex process, we put together a Capital Raising Playbook that helps you tick all the boxes. Grab your copy now!

Conclusion

There have never been as many options for companies seeking to raise debt or equity capital.

At the time of writing, private equity funds hold close to $2 trillion in ‘dry power’ (capital ready to be distributed to companies either through debt or direct equity investments). But the fact that they’re not distributing it says something about companies - primarily, that they’re not adequately prepared in these investors’ eyes.

Talk to DealRoom today about the essential role that our lifecycle management tool plays in enabling companies to take this leap.