All Businesses Need Capital

Capital is the lifeblood of a business.  It is true that to make money you have to spend some - and to spend it you have to have it. Without capital you can’t buy the equipment you need, lease the factory/shop/office you need or hire the people necessary to help you do whatever it is you do. New capital underwrites innovation and the take up of new technology and the development of new ideas.

It is commonly thought that lack of capital is one of the major reasons for small business failure in Australia, yet access to capital has always been difficult for Small to Medium Enterprises (SME’s) and a limiting factor to their growth.

What is equity capital?

Equity capital is the money, time and other assets that the owners contribute to the business.  Generally the originators of the business put in what they can, they borrow against personal assets and work very hard to build the business up over a long period of time by reinvesting profits as they go.  The idea of bringing others into the business to provide a stronger asset backing (more money) is foreign to most.

A large percentage of Australian companies are set up under the advice of accountants and Solicitors to save tax and protect assets but the issue of share ownership and share management is rarely discussed.

The use of share issues and share management (equity capital) is a significant business strategy for growth that is understood and used by the big listed companies. Most think that it is beyond SME’s, but it is not.  It is a powerful tool that can provide significant benefits to SME’s as well – if you get the right advice and the process is managed properly.

Why raise equity capital?

Does your business have the potential to grow?

What could you do with another $500k?  What about $1 or $2million? Would this give your business the ability to get to the next level? Would that be enough to double the business? Maybe more than that?  If there is this possibility, you should be thinking about how bringing in new investors can help to make it happen. Maybe you can develop that new product, add capacity to the production line, open more outlets, expand interstate or overseas, and build the prototype you’ve been dreaming about.

Equity capital is not repayable; it demands no provision of security (other than issued shares) and bears no interest. In essence, a business can print its own currency by issuing shares not unlike the way that Barrack Obama and Kevin Rudd are printing money.   In one sense you can even think of it as being another  product line that you create and sell.

 Where do you get it?

Early stage funding is “relationship” based and generally comes from family, friends, relatives or clients and/or suppliers wishing to firm up their relationship with the issuing company.

Even amongst these groups it has traditionally been difficult to attract investors as there has been little or no liquidity, returns are uncertain and there is often little transparency in the way the business is operated.

A well structured offer however can address all these issues and provide potential investors with demonstrable capital gains, a planned exit strategy, regular company reporting and communications. Couple this with a secondary market platform and many of the obstacles to finding investors disappear.

Corporations Act restrictions

It is illegal for any person (or company) to ask a number of people to invest in a shared business venture, property or other investment without following the fundraising rules set down by the Corporations Act 2001, or without utilizing the exemptive relief such as that provided by an independent ASSOB Sponsor.

The commonly referred to 20/12 rule stipulates that it is an offence to issue or transfer securities without disclosure to investors once 20 issues or transfers have occurred or $2million has been raised (Subsection 727 (4).  Disclosure means an expensive Prospectus – which could cost as much as $100,000 to prepare and might take as long as 6 or 12 months to be completed.

Section 708 defines offers that do not need disclosure – no expensive prospectus!  These are defined as small scale offerings made as personal offers (they can’t be made to the public!). A personal offer is one that can only be accepted by the person to whom it is made, and made to a person who is likely to be interested in the offer, having regard to previous contact, some professional connection or statements or actions that indicate they are interested in receiving offers of that kind.

The following investors are classed as “excluded” from the 20/12 rule – overseas investors, direct family, executive officers of the company, gifted shares for nil consideration, existing shareholders on a pro-rata offer, sophisticated investors and professional investors.

Penalties for breach

Failing to consider the consequences of non-compliance can lead to a fine of up to $22,000 for individuals and $110,000 for companies and up to 5 years jail.  Further, ASIC can place a stop order that prevents the offer, issue, sale or transfer of securities and is likely to make an application to wind up the company.

More scary is the fact that if one investor complains (say 2 years later) and it is found that the capital raising was inbreach of the Act, ASIC will request that ALL the money raised be refunded.  Given that a disgruntled investor is not likely to emerge when the business is booming, the repayment direction probably means a very nasty situation for all concerned.

Class Order 02/273

Class Order 02/273 provides an exemption from the fundraising provisions of the Corporations Act for persons involved in making or calling attention to offers of securities through a business introduction service.

This increases the limit of personal offers to $5million and allows considerably more scope in promoting the offer.  The exemption allows, under certain conditions, an offer to issue or sell securities to be advertised in ASSOB’s subscription-based publications. By appointing an ASSOB Sponsor the issuer is then also covered by this exemption.

ASSOB

The Australian Small Scale Offerings Board was formed in 2004 to originate, aggregate and sell securities for unlisted companies so they can raise capital.

The proven ASSOB platform is a sophisticated system of documentation, policy, procedures, operating processes and infrastructure developed specifically to comply with Section 708 of the Corporations Act and the exemptions available under Class Order 02/273.  ASSOB operates 3 Boards for the listing of Offer Documents:

Primary Issue Board – for the origination, aggregation and sale of ordinary shares to investors on behalf of issuers to enable them to raise capital; Secondary Sales Board – which facilitates the sale or transfer of existing shareholdings to other investors; Disclosure Board – under which Offers under Prospectus, Offer Information Statements or Product Disclosure Statements are distributed to its list of private investors and the general public.

ASSOB Sponsors are highly trained individuals who play an important role in capital markets.  The ASSOB Sponsor is the “originator” of debt and equity securities for the SME client.

An ASSOB Sponsor provides the SME with 2 main facilities – the legal exemption to issue or sell securities or scheme interests and the appropriate framework for doing so without breaching the share hawking provisions of the Corporations Act 2001

Valuation

The real key to finding investors for your business lies in being able to offer them realistic value in return for the risk they are sharing with you.  One of the reasons for the difficulty of raising equity capital has been the over-optimistic valuations that many owners place on their business.

Typical valuation metrics include a range of 6 to 8 times earnings for an Initial Public Offering on a stock market listing, or 3 to 5 times earnings for a trade sale.  In other words, if a company has an EBIT of $1m, then in a public float it might be valued at $6 to $8million, or $3 to $5 million on a trade sale.

These are the valuations that you expect to achieve in say, 3 or 4 years time. Investors will pay a premium over today’s valuation if they have confidence that the business will grow significantly.

These are the maximum valuation ranges and investors won’t pay that sort of valuation 3 or 4 years in advance.  They want to see a substantial discount in return for the risk they carry, or to put it another way, they expect to earn a much higher return from this investment than they would get from other competing investment options. 

On a 3 year time horizon, these types of investors will typically pay 1/4 or less of the valuation that is expected at the point of exit.  In the above example, this would mean a company valuation of $1.5 to $2 million on an expected IPO or $750k to $1.25m on a trade sale exit.

Note that without an exit plan, they may not be interested at all!

Investor Ready Businesses

Before investors can be approached, the business needs to be investor ready. This means that it should have a clear and concise business plan, which is then translated into an easy to understand Offer Document. It needs to convey to potential investors just what the business is all about, where its customers and revenues will come from, why it is better than its competitors and how it will achieve the growth necessary for the positive results that everybody is hoping for.

It should be a public unlisted company as this means 3 Directors (more eyes watching the shop), an auditor (an independent expert checking the books), with regular reporting and guaranteed share transfers.

A proprietary limited company lacks transparency and is not a suitable investment vehicle.

Management processes and reporting/compliance procedures need to be implemented to accommodate the requirements of multiple shareholders. This includes a Shareholders Registry, quarterly reporting and use of funds reports as well as audited accounts.

Finding Investors

There is an art to sourcing equity investors – an art that specialists such as Transition Capital and ASSOB are well practiced in.  In begins with a viable, vibrant business and enthusiastic, energetic owners and management.  Add some expertise to structure an attractive offer to investors and the funds can be found, all within the requirements of the Corporations Act.

Most companies will only have one chance at this – so doing it right the first time makes a lot of sense.

Written by David Shelton, Director of Transition Capital (www.transitioncapital.com.au).

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