As a business grows and matures, the need to raise outside capital often occurs. This article explains the capital raising process for private companies and the services investment banks provide.
What is the Difference Between Raising Capital for a Private vs. Public Company?
First, there is a distinction between raising capital for private companies vs. public companies. Public companies are large and have publicly traded stock via the Initial Public Offering (IPO). They have institutional shareholders and investors that invest in the company's debt and equity. Also, they have a cadre of commercial banks, which lend to the company.
On the other hand, private companies are less visible, typically much smaller than public companies. They have no publicly traded securities. The equity is often closely-held. The majority of debt is through a credit facility with a local bank or small syndication of banks that specialize in working with private companies.
The distinction is important because raising capital for a private company is quite different than raising capital for a public company.
For private companies, the capital sources are geared toward working with smaller, privately-held companies. Most of these capital sources are not household names. The deal sizes are smaller than for public companies and the deal structures and terms are suited for the needs and risks of private companies. Because these are privately negotiated transactions, they can be quite creative. Last, the process and timing required to raise private capital is generally longer than that required by public companies.
Why Do Private Companies Raise Capital?
The reasons private companies raise capital is myriad. Below are several of the main drivers:
Funding a Growth Opportunity
A company may face a significant and appealing opportunity that will propel its growth into the future. But, it needs to begin pursuing the opportunity in the near term before it goes away. However, the opportunity requires upfront capital investment - more capital than the company can generate internally. Examples include the need to build out a large facility, hire a large workforce, open new branches or purchase substantial equipment. Since the company has limited financial resources, it can raise capital from outside sources to support its growth plan.
Refinancing and Recapitalizing the Balance Sheet
As a company matures, it may outgrow its capital structure and the ability of its capital sources to continue supporting its growth. Or the attendant terms may be somewhat restrictive, thereby hampering its growth and putting a limit on its ability to create equity value. Possibly, the business went through a slow-down or faced other issues that caused the debt provider to want out. In these cases, refinancing the debt and recapitalizing the business with a new capital structure and capital providers may be the best solution to give the company a fresh re-start.
Buyout of a Partner or Management Buyout
Suppose there are two owners of a privately-held business. One desires to exit the business relatively quickly. The other desires to remain involved. The business does not have enough internal funding to buyout the exiting owner. Therefore, the company can raise capital from outside sources. This investment by the new capital effectively replaces the equity held by the exiting owner. This scenario is similar to when a management team elects to buyout the existing ownership group.
Acquisition Financing
A private company may have a great opportunity to acquire another for strategic reasons. However, the purchase price of the seller requires more funding than the buyer can generate internally. Raising additional capital from outside sources plugs the gap and enables the buyer to consummate the transaction.
What Are the Types of Capital Available to Private Companies?
Based on the unique circumstances, the types of capital private companies raise come in many forms with varied terms, structures and investors. Below are the basic types of capital we see private companies accessing:
Senior Debt
Senior debt is the simplest and cheapest capital to obtain. It is the most heavily secured and maintains a priority position over all other capital. Providers are often commercial banks or private funds that specialize in this arena.
Commercial Bank Credit Facility
Many companies already have a commercial bank relationship. Once a company can show a successful history with satisfactory financial performance, a commercial bank credit facility is good for financing daily operations, working capital lines of credit, letters of credit and certain types of equipment and real estate purchases.
Asset-Based Lender
Lenders underwrite the accounts receivable and inventory of the business and make advances based on collateral value.
Subordinated Debt
Subordinated debt ranks junior to the senior debt and senior to equity. Unlike senior lenders, these are willing to take on more risk. But, they also require a higher interest rate, charge higher fees and maintain certain special terms and provisions. Regular subordinated debt requires the borrower to repay the principal and interest. There are a number of private funds and business development companies (BDCs) that specialize in providing subordinated debt.
Mezzanine Debt
Mezzanine debt is a form of subordinated debt, but often has an equity enhancement or “kicker.” This allows the lender to participate in any equity upside. For example, warrants may be attached to the debt that can be converted into equity depending on certain triggers and events. Because of the equity “kicker” opportunity, the interest may be less than the interest associated with straight subordinated debt.
Hybrid Debt
This category is a catch-all. It includes lenders that provide unitranche debt, which combines the senior and subordinated debt into one credit facility. Also, It includes lenders that focus on special situations, companies that are facing circumstances that typical lenders avoid, such as risk of bankruptcy or unique assets.
Preferred Equity
Represents ownership of the equity of a company and has a priority over common equity in terms of distributions/dividends and claims on assets in the event of liquidation. Preferred stock is junior to any debt. Holders usually have no or limited voting rights for corporate governance. Preferred equity has a stated distribution rate, redemption provisions and often can be converted to common equity.
Common Equity
Represents ownership in a company. Holders of common equity elect the board and vote on corporate policies. Common equity often generates higher rates of return than any other security, but it maintains the highest level of risk. In the event of liquidation, equity holders have rights to a company's assets only after debtholders and preferred shareholders are paid in full. Equity investors include private equity funds, family offices, high net worth individuals and hedge funds. Some require majority ownership and control while others provide equity in exchange for minority ownership.
What Capital Raising Services Do Investment Bankers Provide?
Investment bankers play an important role in advising and helping a private company raise capital:
- Evaluate the company’s circumstances, objectives and capital needs, supported by financial analysis, and assist in determining the appropriate type and size of capital raise.
- Identify and target the most suitable capital sources and investors by matching deal size, opportunity, industry focus and social issues with the “right” groups.
- Create selling materials, such as executive summaries and pitchdecks, and market the opportunity to capital sources, clearly communicating the story.
- Organize and manage the virtual data room.
- Manage all communications between client and prospective capital sources.
- Conduct meetings and presentations with prospective capital sources.
- Create interest among multiple capital sources in order to generate competition and provide deal options.
- Negotiate the best possible deal structure, terms, pricing and timing.
- Manage all steps of the transaction and guide deal execution through closing and funding.
- Provide professionalism and credibility to the process so that clients will receive attention from the appropriate capital sources.
What Fees Do Investment Bankers Charge for Providing Capital Raising Services?
Success Fees
The fees investment bankers charge for raising capital are most often contingent, based on successfully completing the transaction, and paid at closing. Generally, they are calculated as a percentage of the amount of capital raised. The percentage varies based on type of capital being raised, perceived risk, probability of deal success and deal size. Most fees fall within 1% for senior debt to 6% for equity. All other things equal, the fee for raising senior debt is a smaller percentage than the percentage charged for raising equity.
Retaining Fees
Investment banks also charge work or retainer fees. These may be in the form of up-front payments at the time of engagement or monthly recurring fees or a combination of the two.
Conclusion: A Private Company Has Many Options for Raising Capital
A private company has many options for raising capital based on its circumstances and need. With trillions directed toward private companies and a multitude of capital sources proactively looking for deal opportunities, the trick is determining the correct form of capital and the “right” capital provider. An investment banker can play a critical role in helping a private company obtain the capital it needs.
