Rules for Raising Capital
Editor's note: This is the first of a new, ongoing series of columns on financing and growing a small business.
Quick: What does CEO stand for? I say "Cash Extraction Officer." Sure, you can get by for a little while by bootstrapping and running on a shoestring budget. But to achieve rapid and sustained growth, sooner or later you will probably have to attract financiers.
Let's suppose you've got a terrific business plan and you've honed your 20-minute financing pitch. You've built a great team too. Now all you need is cash. When taking outside funding—or when determining if you even want to—you will first have to develop a capital-acquisition strategy. To do so, ask yourself the following questions.
1. How Much Do You Need?
Rule No. 1: Take more than you think you need. Rule No. 2: Only if it's cheap. Cash is cheap, equity is not. Once you sell a percentage of your company, recovering it is very, very difficult and very, very expensive. This is why multiple smaller financing rounds are a great idea, especially in the startup phase, when your company's value is low.
Figure out how much money you have to raise to achieve some specific time-measured milestones, such as: launching your product, expanding your sales force, or implementing new manufacturing methods. Add that number to your overall operational costs. Now add a cushion of six to nine months of operational costs to that. This is roughly how much you need to raise. The point is to have enough money to both keep the company running and achieve specific milestones so you can demonstrate increased value before you're out fundraising again.
2. When Do You Need It?
Rule No. 1: Raise money before you need it. Rule No. 2: You always need it sooner than you think. The financing process always takes longer than anticipated. For bank loans, expect two to three months. For Small Business Administration (SBA) loans, expect four to six months. For angel investment or venture capital, expect three to 12 months. For grants, expect a year. I've seen financings occur in less time, but you must be prepared for the long haul. Start raising money six to nine months before you're either due to run out of cash or expect to need it for expansion.
Have a strong banking relationship already established in the event that you need a bridge loan to tide you over during an extended financing process. Respectable jumps in your company's value are expected between financing rounds. In the early stages, an increase in value of at least two to three times is expected.
You will have to be able to demonstrate evidence that you've hit some milestones, such as more customers, new products/services (or new versions of them), or increased market share. If you schedule your financing rounds for when you can show demonstrable success, you will garner higher valuations and keep your investors and staff happy.
3. From Whom Do You Want It?
Rule No. 1: Only take money from someone you like and respect. Rule No. 2: I'm serious. You will be with your investor for two to seven years. You will go through heaven and hell together. Make sure he will be good company in both situations. In addition, you need a partner who understands the industry sector your company serves.
Make a list of 10 financiers who understand your market or product and have worked with companies at the same stage as yours. If they have a stable of clients that could use your product or service, that's a bonus. To find financiers, search the Internet for "venture capital," "micro loans," "business loans" or "angel investors (in your geographical area)"—I'm assuming you already know your local banks. Approach the top five on your list.
If you've done your homework and you get lucky, you will stop there. If not, approach the other five. Never tell prospective financiers about one another. If one decides they don't want to invest, they may call the others and tank your deal.
If your company isn't winning interest, make sure you locate the problem and are prepared to state your solution to it in a concise, compelling, and complete way. If it's gaining interest, then pursue more investors.
Do you want "active" or "passive" money? Active money is from financiers who will work with you closely. They'll add value by introducing you to sales prospects, influential people, and more. Passive money is just money—no connections, no additional value. If your company is seed or early stage, or if the financier has key contacts you should tap, take active money. If you already have enough active connections and just need cash, take passive. Investor relations can be time-consuming. Plan for this.
4. What Compromises Will You Accept?
Rule No. 1: Don't be greedy. Rule No. 2: But don't be taken advantage of, either. If you're seeking equity financing, you will be selling pieces of your company repeatedly. As the pie gets bigger, the increased number of pieces get smaller. This is called dilution. If you start out by owning 50% of a company, pre-financing, don't be surprised if you own 10% or less at the exit. In the beginning you will sell off big pieces, often 20% to 40% per financing. I personally don't like selling more than 33%. I figure if you're going to sell a big piece, sell it for a high price.
Loss of equity is one compromise, loss of control is another. Investors should comprise 20% to 40% of the board. More is trouble. I've seen way too many cases where the investors ran the company because they controlled the board. This rarely works out. I've also seen too many cases where the entrepreneur wanted a far higher valuation than he deserved, and either lost valuable time to market or lost the financing altogether by greedily stretching the deal.
And last, it's worth taking a lower valuation to get a stronger group of investors. Strong, active investors can make all the difference—not only in helping build the company but in participating in future financing rounds and helping raise cash when the chips are down.
The higher your company's valuation, the more favorable the financing terms. Always remember that a company's valuation is emotional: It's based on perception. Present your company with great passion, showcase your executive team, explain the realistic plan to make your vision a reality, and the results just might rock your world (see BusinessWeek.com, 3/2/06, "You: The Brand").