LEARN HOW TO INVEST
GUIDE FOR BEGINNERS: Module 5Michael Santos Presents
HOW TO RAISE CAPITAL
Learning how to raise capital is necessary for any investor. Use ingenuity and become more successful.
How to Raise Capital to Fund Your Investments
To raise capital, we need to have some basic understanding of business. For that reason, I’ll continue building upon the case study from the previous chapter, with Liberty Hot Dogs.
We can make more informed decisions by understanding:
- How a business gets started
- How a business raises capital
- How a business operates, and
- How business owners cash out
Let’s continue learning with our case study on Liberty Hot Dogs.
Becoming a business owner
As a business owner, I need to raise capital for Liberty Hot Dogs. In the previous chapter, I started the process by registering Liberty Hot Dogs as a corporation with the secretary of state and with the Internal Revenue Service. Liberty Hot Dogs now has its own EIN number and a business bank account. The only problem is that the business doesn’t have the “assets” it needs to start selling hot dogs.
In this chapter, we’ll learn:
- How to Understand Corporate Shares
- How to Raise Capital by Selling Equity
- How to Raise Capital by Borrowing Money
CORPORATE SHARES
I formed Liberty Hot Dogs as a corporation because I knew that I would need to raise working capital. Corporations are divided into shares. At the start, I formed the corporation with 1,500 shares. Each share is valued exactly the same—but any investment is only worth what the next person is willing to pay for it.
When I formed Liberty Hot Dogs with 1,500 shares, I used an arbitrary number. I could have just as easily divided the corporation into 100 shares, or 1 million shares, or any number that would serve my purpose.
At the start, I owned all of the shares. Since I owned the shares, I could have said they were worth any amount that I selected. As stated previously, corporate shares are only worth what the next person is willing to pay.
Since I knew I would need working capital to operate Liberty Hot Dogs, I intended to sell 500 shares of the corporation. By selling 500 shares, I would still own 1,000 shares. By selling the 500 shares to an investor, I intended to raise working capital that I would need to start the business.
how to raise capital
To raise capital, I needed to craft a story, or business plan. If that business plan persuaded an investor, the investor would buy the shares. With money from the investor, Liberty Hot Dogs would generate working capital to build a business.
My business plan showed that I would need to raise a total of $750. If I could raise $750, I would be able to invest in equipment and inventory that would allow me to start selling hot dogs. As I sold hot dogs, I would generate revenues to sustain the business. I also anticipated that I would generate additional working capital to grow the business over time.
Create Your Business Plan:
It was a simple business plan, with a potential for upside to an investor. In exchange for coming up with the idea and operating the business, I would keep 1,000 shares of Liberty Hot Dogs. I would raise $750 from investors. With that $750, I would invest in a hot dog stand and inventory I needed to sell hot dogs. Revenues from those sales would fund future growth of the business.
RAISING CAPITAL BY SELLING EQUITY
I hoped to sell 500 shares for $1.50 each to investors. By selling 500 shares of Liberty Hot Dogs for $1.50 each, I would raise the $750 I needed to get the business off the ground.
Note that although I was only selling 500 shares of Liberty Hot Dogs, the corporation was divided into 1,500 shares—and each share was valued at the same amount. By selling shares for $1.50 each to investors, I was also valuing the 1,000 shares that I was going to retain at $1.50.
If I succeeded at selling 500 shares for $1.50 a share, the entire company would have a market valuation of $2,250:
- My 1,000 shares valued at $1.50 each equals $1,500
- Investors 500 shares valued at $1.50 each equals $750
- Total Value of Liberty Hot Dogs: $2,250
As an entrepreneur, I went out into the business community and tried to raise capital. I presented investors with my idea and I offered 500 shares of Liberty Hot Dogs for $1.50 each.
Unfortunately, I didn’t find any investors willing to pay $1.50 a share. Instead, I found one investor who said that he believed in me. A key component for any entrepreneur is to persuade people to believe in the vision. Frank, an investor, said he would invest with me, at a lower valuation.
Frank agreed to pay $1 per share to buy Liberty Hot Dogs. As the founder of Liberty Hot Dogs, I had to consider Frank’s offer and make a decision.
- My 1,000 shares would be valued at $1.00 each, equaling $1,000
- Frank’s 500 shares would be valued at $1.00 each, equaling $500
- Total Value of Liberty Hot Dogs: $1,500
What Will the Market Bear?
After considering Frank’s offer, I agreed that Liberty Hot Dogs was an unproven concept. And I couldn’t deny that I was an unproven entrepreneur. I agreed to accept Frank’s offer and I sold him 500 shares of equity in Liberty Hot Dogs for $1 per share. He issued me a check for $500 that I deposited into the corporate bank account.
This $500 was not my money. It belonged to the corporation—a completely separate entity from me. I owned 1,000 shares of the corporation, and Frank own 500 shares of the corporation.
When Frank wrote the check for $500, the company had some liquidity. But as the business owner, I didn’t consider $500 to be sufficient to launch the company. After depositing the $500 into the bank, I had to think about how I could go about raising the rest of the capital I would need to start business operations.
RAISING CAPITAL WITH DEBT
I didn’t want to reduce my equity in the company by selling more of my shares. So I had to consider other alternatives on how to raise capital. I decided to raise capital by borrowing money.
Since the company did not have a track record, and I did not have any personal credit, I had to turn to unconventional financing sources. No big deal. I would go out into the market place and present my business plan to potential investors. But instead of asking the investors to buy equity in Liberty Hot Dogs, I would ask the investors to lend Liberty Hot Dogs the money. The lenders would become “Debt holders” of the corporation.
When an investor lends money to a corporation, he receives a “note” from the corporation. The note becomes an asset for the investor, and a liability for the corporation. The debt holder is placed in a higher position than the equity investor. That means that all of the assets of the corporation will guarantee repayment of the note. If for any reason the business did not succeed, the debt holder could turn to the assets of the corporation for repayment.
We will cover corporate assets and liabilities in the next chapter.
Tom, an investor, reviewed the business plan. He agreed to lend Liberty Hot Dogs $250, with an interest-only loan. Tom required Liberty Hot Dogs to pay 10% each year in interest, or $25 per year, in exchange for the use of the $250 in working capital.
With $500 from the equity investor, and $250 from the debt investor, Liberty Hot Dogs was fully funded and ready to begin business operations.
Now that Liberty Hot Dogs has the money it needs to get started, I must take action and begin executing the business plan. Let’s go over where we stand in the next chapter, where we discuss how we use financial statements to track the progress of our investment.
