Here’s how unlisted companies raise funds on private capital markets
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When it comes to finding the best companies to invest in, a lot of the action takes place on publicly listed exchanges.
There’s good reasons for that: the regulatory backdrop is well established and investors can usually rely on ample levels of liquidity.
However, investment activity in the market for unlisted companies can be just as interesting.
Historically, it’s been the domain of well-connected high net-worth individuals and sophisticated investors, but as the technology and regulatory developments progress, retail investors now have more opportunities to get involved from the ground up.
Changes to the ecosystem have given rise to growing demand in secondary markets that offer exposure to unlisted companies, either through direct investments or loan financing.
Stockhead spoke to a number of industry players to get an understanding how different funding strategies work, and the market mechanics behind them.
Crowdfunding is a relative newcomer to the capital-raising landscape — particularly in Australia. But a recent run of successful raises has generated more interest in the sector.
The format provides a vehicle for companies to raise capital from a large pool of investors. That stands in contrast to other techniques of raising early-stage capital, which are pitched at a smaller number of sophisticated investors.
By its nature, crowdfunding creates a regulatory challenge to ensure the correct frameworks for investor protection. As a result, the legislation that permits crowdfunding in its current form was only passed in Australia last year.
For companies to raise money in this way, they still need a platform to do it — effectively, a middle-man service with the necessary financial licenses to facilitate the transaction. Leading platforms in Australia include Birchal, Equitise and OnMarket.
To invest, it’s a pretty straightforward direct debit process. When a company launches a crowdfunding drive, the platform will typically set minimum and maximum targets for funds raised (if the minimum target isn’t reached, investor money is returned).
“What we’re doing is managing the application and facilitating all of the payments,” Birchal’s Matt Vitale explained to Stockhead.
“Then we ask the company to issue shares to the investors, and once we’ve confirmed that shares have been issued then we’ll release the funds. Prior to that, the funds are held in our trust account.”
Once the deal is live, investors have access to an online register where they can view the value of their holdings.
Like most early-stage capital investments, equity crowdfunding is a relatively illiquid asset class.
The infrastructure around secondary markets for crowd-funded securities is still in its infancy, so it’s still largely pitched at investors with a longer time horizon.
As part of their offer document, companies can refer to various exit strategies such as trade sales or public listings. But given the early-stage nature of their business, any crowdfunding investment comes with no guarantee those scenarios will eventuate.
With that liquidity risk though, also comes the possibility of a higher reward.
“I think the general understanding is that investing in companies at this stage carries higher risk, but you’re typically getting much lower valuations than investing in companies that are at pre-IPO or IPO stage. And there’s a liquidity premium that comes with those types of opportunities,” Mr Vitale said.
VC firms provide financing to help businesses scale, usually in return for an equity stake.
The standard VC investment model is to take concentrated bets on a small number of companies. And as part of that process, the VC staff often provide their own consulting expertise to those companies once the investment has been made.
Compared to equity crowdfunding, venture capital is a much more established sector within the field of early-stage capital raises.
But Australia still lags a long way behind the US, where VC is accepted as a viable alternative asset class by large-scale, conservative investment vehicles such as pension funds.
Howard Leibman, the founder of Australian VC firm EVP Partners, told Stockhead that the US ecosystem is a by-product of the Silicon Valley tech system that’s evolved over more than 30 years.
“Australia was much later to the party in terms of technology and innovation, and then a nascent VC industry began to spring up around that but only over the last 10-15 years,” Mr Leibman explained.
“It’s really only been in the last 6-8 years that the VC sector has gained a degree of scale, and in terms of scale the biggest VC funds are in the order of $200m. By US standards that’s a very small fund.”
With the rise of different platforms such as equity crowdfunding, companies now have more than one way to access early-stage capital.
So how does VC differ, and what circumstances make it a more attractive option to business owners on the hunt for cash?
Mr Leibman says the value-add proposition is clearer for companies that benefit from a more hands-on approach.
“When a startup looks to a VC for funding, they’re looking not just for cash to be honest,” he told Stockhead.
“They’re looking for expertise, advice, adequate board representation, operational input, strategic assistance etc.
“I think that’s perhaps the difference — the nature of VC, it’s less transactional and it’s more focused on the long-term and relationship based.
“So our investments are very high conviction, very concentrated bets. And we’ll be rolling our sleeves up and becoming as active as we possibly can to see those companies succeed, because our franchise depends on it.”
Within the unlisted capital space, it helps to have a working knowledge of series funding rounds.
The core funding rounds in private capital markets are comprised of seed capital, followed by Series A, B and C funding rounds.
Each round carries out a different function related to a specific stage of a company’s initial life-cycle. Here’s a summarised overview:
Who are the investors? Usually the company founders themselves (along with family and friends), high net-worth investors who have expertise in the relevant industry, and early-stage venture capital firms/corporate advisory firms.
How much money is raised? Amounts vary significantly. Smaller companies look for anywhere from $10-$500k, while red-hot Australian tech unicorn Canva raised $6.6m in its seed round.
How are the funds used? Determining the viability of a commercial product/service. That means financing market research and product development, along with applications for patents and regulatory approval.
Who are the investors? Once a commercial product or service has been developed, VC firms often step up their engagement with larger investments.
How much money is raised? Again, the amount can vary but Series A rounds typically exceed seven figures, up to around $10m. Companies can also carry out multiple Series A rounds, which can boost funds raised as latter amounts are typically higher.
How are the funds used? Series A investors are looking for evidence that a viable business model exists, such as promising early sales growth. At that point, cashflow is king for the business to scale up. Funds are often used to boost distribution channels and establish a critical mass of customers.
Who are the investors? Usually similar players to Series A. An additional number of VC firms may come on board — typically companies whose expertise is focused on the later-stage capital rounds.
How much money is raised? Once a company has demonstrated its product use-case and built a customer base, amounts invested increase substantially. Cross-border payments platform AirWallex made headlines last year when it raised a Series B round of more than $100m — one of the largest in Australian history.
How are the funds used? More staff, for starters. A company with a winning product will need to join the battle for talented workers to help maximise growth. The focus also shifts from product development to business development; getting the product to more customers in more countries.
Who are the investors? By this stage, the company is already successful which makes it a less risky investment proposition. In addition to existing VC contributors, groups including investment banks, private equity firms and even some pension funds will allocate funds to assist expansion.
How much money is raised? Amounts are usually in the tens of millions. For example, workplace safety platform Safety Culture raised $60m in a Series C round in May 2018, led by US hedge fund Tiger Global Management.
How are the funds used? By this stage of its life-cycle, the company has met all of its early targets in terms of sales growth and product expansion. So Series C funds are used to consolidate exisiting market positioning, such as acquisition opportunities.