Raising Capital from Customers

Selling shares in your business to customers via a private placement can be a great way to raise capital. And there are other benefits

If you run an independent company and are looking for ways to raise capital, consider selling shares to your customers via a private placement. A private placement is a streamlined way to raise capital from a group of investors, whether individuals or companies. There is no need to get approval for a private placement from the Securities & Exchange Commission, though you do have to comply with other federal requirements and will need an experienced lawyer to help you with the process. Why try this seemingly unconventional way instead of just approaching traditional sources like banks and venture capitalists? Here are some reasons:

Branding potential. Raising capital this way provides your company with more exposure to your best customers. And they will likely be excited to be a part of the venture.

Increased loyalty. As shareholders, customers will be less inclined to buy from the competition. If anything, they will probably recommend your company to other people.

Increased understanding. Your customers understand your business and the value proposition of your product. This can make it easier to explain the investment opportunity.

Bear in mind that it's important that your product or service engenders a devoted following if you want to try a private placement. Businesses that sell directly to consumers have a better chance than businesses that sell to other businesses. There may be less emotional attachment to the brand when your customer is another large business (though there may also be an opportunity to get a strategic investment (BusinessWeek.com, 7/2/08) if the major customer feels it is important to build a stronger relationship). Private placement successes often involve businesses offering products that improve the environment, niche online communities, or a unique service concept.

Take the Paw House Inns & Resorts, which has several locations at Vermont ski resorts. The small company caters to a unique demographic; vacationers who are dog lovers. Recently, Mitch Frankenberg, the owner, wanted to add a fine dining restaurant. But because of the credit crunch, he said there was no bank financing available. Frankenberg approached his customers about investing in the Paw House via private placement. "The response was overwhelming," he said. In all, he was able to raise $325,000 in a few weeks. There were 13 investors who agreed to amounts ranging from $25,000 to $50,000.

Of course, the process wasn't easy. Frankenberg spent many hours preparing within the following areas in order to be able to sell the shares:

Legal. Even a small financing must meet federal regulations. Violations can be severe (in terms of fines or even having to return investor funds). So Frankenberg hired a qualified securities attorney.

It's a good idea to spend time researching attorneys. There are online services that can help out, such as Avvo and FizzLaw. (And be sure to see my previous column "Hiring the Right Lawyer When Raising Capital" (BusinessWeek.com, 8/28/08)).

Investor Presentation. To put together the private placement memorandum (which details the terms of the investment) and his business plan, Frankenberg used SCORE, a nonprofit organization that offers entrepreneurs business advice from retired executives for free. His SCORE counselor helped him craft a strong business plan that highlighted his financial model, track record, and background of his management team.

Frankenberg also retained a consultant who had extensive experience with private placement memorandums. He spent a lot of time on the Net researching various consultants, conducted thorough interviews with them, and learned about legal issues involved when hiring certain consultants, such as rules regarding fees and regulations. (For more on consultants who help raise capital, see my previous column "Why You Should Avoid Finders" (BusinessWeek.com, 7/25/08)).

Of course, there are pitfalls involved with raising capital from customers via private placement. It may be interpreted as a sign of desperation. Your customers may wonder if you are having difficulties finding money from traditional investors. Then again, in this tough financial environment, this concern may be somewhat muted, since most companies are having trouble raising capital. And if your company runs into trouble, you will need to disclose this to investors. No doubt, this may be discomforting for customers, who may take their business elsewhere.

But for the most part, if your company has loyal customers who want to be part of your venture, then it's definitely worthwhile to approach them. It can be a way to get more exposure and build stronger customer relationships. Besides, it's a creative approach that may expand the amount of capital for your company as well as shorten the fund-raising process. And in these rough economic times, creativity is crucial.

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