Raising capital and investing in private companies involves an intricate process for companies and investors that is governed by stringent regulatory requirements. While the introduction of Rule 506(c) under the JOBS Act does potentially address some of the issues around advertising and broader reach, the Regulation D offering process remains a complex mix of compliance, marketing, and due diligence. [For more on the stages of a private placement see this post]. Read More
Traditional versus New Models of Capital Raising
Private capital raising has typically hinged on companies and funds being able to connect to a narrow base of large institutional investors. This historical focus on only tapping a select group of large investors is largely a byproduct of a regulatory and technological framework in which the costs—whether in time, money, or compliance risk—of accessing more investors outweighs the benefit of receiving more numerous smaller checks. New innovation and new regulation are changing this paradigm. [See ‘Fundraising Post JOBS Act‘ for more] As this space evolves, I believe the new “normal” in private capital raising will include substantial funds being raised by a larger pool of smaller investors that have been aggregated via low-cost and scalable technology solutions.
A traditional private placement for a standard Reg D offering generally follows a series of well-worn steps which are outlined here.
If a person is sick, they see a doctor. If a person has legal troubles, they see an attorney. Logic would then suggest that a person in need of financial planning would seek the assistance of an investment professional.
This maxim however is not always adhered to within the anomaly that is the capital markets. Rather, it is tested each and every time technological innovations are made. From day-trading to house-flipping, technology advancements seeking to improve market efficiencies often drive an unintended corollary whereby individuals are tempted to disrupt or replace the entire market infrastructure. Call it hubris or ignorance, but there is something deep in the American psyche that murmurs “I am a savvy investor or entrepreneur and I don’t need professional help engaging the market!” Read More
Reports of how leading asset-allocators such as the Yale endowment have increased their returns while lowering risk has generated widespread investor interest in alternative asset classes. This should come as no surprise: the concept of achieving superior risk-reward combinations through diversification into different, uncorrelated asset classes certainly extends to adding private investments to one’s portfolio.
But understanding that alternative investments might benefit your portfolio is very different than actually investing in them. Even on the more macro/portfolio level thinking through exactly what percentage of your portfolio to allocate to alternative investment opportunities is a very complicated endeavor. Why?
Want to hear a very poorly kept secret? Access to private investment opportunities is extremely limited and inequitable. This has been true on Wall Street for decades due to some rather stringent regulatory hurdles governing the marketing of private offerings, as well as the critical need to keep private deal information, well, private. Historically this has meant that investment banks hired on behalf of private companies and funds to raise capital have been left to manage closed, manually-driven processes where only their small roster of “known investors” were even contacted about the opportunities. Given the size of the new issue private markets (roughly $1 trillion per annum), this is quite remarkable. Fortunately, the tides are now turning.
Traditional Capital Raising is Old School
Traditional capital raising is an old school process. This means that succeeding in raising funds has typically depended on two criteria—a strong track record of success and/or a dense network of connections. Real world connections, whether professional or personal, help create the right meetings, draw the right attention, and get funds committed.
While the capital raising environment is in a transformative state (see below) it’s not all “out with the old.” A history of success and a well-developed network will always remain important.
Whether you are a new entrepreneur or a seasoned executive, you are familiar with the challenge of allocating scarce resources. You make choices everyday based on perceived costs and benefits on where to invest your time and where to seek assistance. Accessing the private capital markets is no different. Thanks to new legislation under the JOBS Act, as well as some innovative technology, the private capital markets are opening up. This creates new choices for companies seeking to raise private capital through the advent of online fundraising platforms.
On one end of the spectrum lies the DIY model where companies are free to go it alone and directly control the capital raising process with potential investors. Professional intermediaries are cut out, which in theory should result in lower transaction costs. The argument goes something like this: “I only pay an agent to introduce me to investors, so thanks to the online platform, I don’t need them anymore”. Such may be the case if targeted investor introductions were the only value offered by a placement agent.
One of the biggest differences between investing in private companies versus public companies is the amount of information readily available. Publically traded equities have far more verified data available then private securities. The prevalence of this information together with the low-cost of obtaining it forms the very basis for the creation of efficient public markets because it facilitates comparing the risk/return profiles of different securities.
Agree or disagree with the market structure argument, few would dispute the micro-argument that without credible disclosure between company managers and prospective investors the efficient flow of capital would be impeded. After all, most investors do not invest in something without knowing something about the opportunity. But for various reasons information flows within the private markets are often constrained. The end result can include more expensive capital for companies and a severely tilted information playing field for investors relative to management (or even relative to one another).
In order for the private capital markets to continue to become more liquid and more efficient (and thereby benefiting all involved parties) a standard for minimum acceptable information disclosure should be fostered.