Hedge Funds as a Source of Capital

Hedge Funds can be a great source of capital for companies. There are many such funds that specialize in funding small and mid-cap companies. These types of funds are sometimes referred to as Special Situation Funds, Private Placement Funds, PIPE (Private Investment in Public Equity) Funds, Regulation D Funds or even Microcap Funds.

They will frequently fund public companies through an equity line funding that involves the sale of equity/common stock to fund the company. The company and the hedge fund enter into a Standby Equity Purchase Agreement.
I have drafted these documents for hedge fund clients.

With the current credit crisis the U.S. is currently facing, these funds are going to play an even more important role in our economic recovery. As banks tighten up their lending policies, they will be lending less dollars to fewer companies. Hedge funds, as well as private equity funds, will be looking for companies that can't obtain bank financing, but may be good enough credit risks for secured debt financing with a small equity component.

Prior to the market collapse, these funds were funding companies with under $300 Million in market capitalization, although most of the companies that got financed had less than $100 Million in market capitalization. This may change now and we may see larger companies getting financed by hedge funds and private equity firms because they will not be able to obtain significant amounts of bank financing for expansion and acquisitions. They will be using a variety of different structures based on debt, equity or a combination of both.

Visit this section on Hedge Fund Formation if you are interested in starting a fund or want to learn more about them and how they are structured.

Private equity firms are generally a potential source of capital for small to mid-sized private companies, they usually do not invest in start-up companies. They structure their financing as debt, equity or a combination of both. Some private equity firms specialize in a certain industry such as technology, energy or manufacturing. Venture Capital Firms are more commonly used for a source of start-up capital, and that type of capital is generally much more difficult to raise.

Hedge Funds place importance on the Exit Strategy associated with their investment just as much as they focus on the deal terms of their investment. The Exit Strategy is extremely important to them in planning how and when they will be able to liquidate their investment and hopefully show a profit. If they have liquidity in their investments then that helps them to move out of a stock position before it drops too far.

Their preferred Exit Strategy is the sale of free trading stock into the public market. The quickest way to accomplish this is for a private company they have decided to fund, to do a reverse merger with a publicly listed company that already has a stock symbol.

A “reverse merger” is when an existing private company buys an existing public company with a stock symbol, which is usually a “shell company”. A shell company is a public company that although still in existence and having a stock symbol, is no longer operating a business. The business plan obviously failed and that company went out of business, but the public entity or “shell” still exists. This is the key ingredient in the “reverse merger”.

Hedge funds and even some private equity funds provide funding to public companies, but also to private companies followed by a direct public listing or through a Reverse Merger Funding. They will also fund companies through an equity line that involves the sale of equity/common stock to fund the company.

There are many shells currently on the Pink Sheets and over-the-counter Bulletin Board. These shells went out of business because their business models failed and they ran out of capital. Sometimes investors take over these shells from bad investments they made or they buy shells to find good private companies to fund through a reverse merger transaction. This gives them their Exit Strategy and they make use of the shell.

Another effective tool that is used by such investors is a convertible security. The security converts at 15% to 30% below the closing bid of the stock at the time the investor sends a conversion notice to the company. The conversion notice requests that the convertible security be converted into common stock. Convertible Notes and Convertible Preferred Stock are often used. This “hedges” the investment so either way the investor makes a profit on the investment, unless of course the company goes out of business and the stock no longer trades.

A Hedge Fund Attorney can be a good source of information for contacts, leads and referrals. They may know which funds will finance certain types of companies. Saving time when looking for the right investment partner is important and can also help to build a good network for future transactions.

In addition to Hedge Funds, you might want to Check Out Other Funding Sources to Consider for Venture Capital. As I mentioned, it is generally much harder to raise venture capital than it is to raise capital for an existing business. One possible approach you might consider is to raise capital for the purchase of an existing business, and then use that to launch your other idea that is related to that business. For instance, maybe you have developed a new process for making soles for shoes. Since your process hasn't really been sold in the marketplace, maybe you can find an existing sole manufacturing business to purchase. Then, slowly integrate your process to see if it is accepted in the marketplace.

Click here if you want more information on Hedge Funds. Or contact me if you have some specific questions.

You can also visit this section if you are interested in a Hedge Fund Definition.