After over three decades of being an entrepreneur, serving as a legal and strategic advisor to entrepreneurs and growing companies, and speaking and writing on entrepreneurial finance, I have found one recurrent theme running through all these businesses: Capital is the lifeblood of a growing business.
In an environment where cash is king, no entrepreneur I have ever met or worked with seems to have enough of it. The irony is that the creativity entrepreneurs typically show in starting and building their businesses often seems to fall apart when it comes to the business planning and capital formation process. Many entrepreneurs and leaders of growing companies start their search without really understanding the process and, to paraphrase the old country song, waste a lot of time and resources lookin’ for money in all the wrong places.
4 Elements of Raising Capital
Virtually all capital formation strategies (or, simply put, ways of raising money) revolve around balancing four critical factors: risk, reward, control and capital. You and your source of growth funds will each have your own ideas as to how these factors should be weighted and balanced. Once a meeting of the minds takes place on these key elements, you should be able to do the deal.
Risk. The growth investors want to mitigate its risk, which you can likely do with a strong management team, a well-written business plan and the leadership to execute the plan.
Reward. Each type of growth investor may want a different reward. Your objective should be to preserve your right to a significant share of the growth in your company’s value as well as any subsequent proceeds from the sale or public offering of your business.
Control. It’s often said that the art of venture investing is structuring the deal to have 20 percent of the equity with 80 percent of the control. But control is an elusive goal that can often be overplayed by entrepreneurs. Growth investors have many tools to help them exercise control and mitigate risk. Only you can dictate which levels and types of controls may be acceptable. Remember that higher risk deals are likely to come with higher degrees of control.
Capital. Negotiations with the growth investor often focus on how much capital will be provided, when it will be provided, what types of securities will be purchased and at what valuation, what special rights will attach to the securities, and what mandatory returns will be built into the securities. You should think about how much capital you really need, when you really need it and whether there are any alternative ways of obtaining these resources.
A Natural Tension
Another way to look at how these four components must be balanced is to consider the natural tension between growth investors and entrepreneurs in arriving at a mutually acceptable deal structure.
Virtually all equity and convertible debt deals, regardless of the source of capital or stage of the company’s growth, may require a balancing of this risk/return/control/capital matrix. The better prepared you are by fully understanding this process and determining how to balance these four factors, the more likely it is that you can strike a balance that meets your needs and objectives.
These components include: a focused and realistic business plan (which is based on a viable, defensible and durable business and revenue model); a strong and balanced management team that has an impressive individual and group track record; wide and deep targeted markets that are rich with customers who want and need (and can afford) your company’s products and services; and some sustainable competitive advantage, which can be supported by real barriers to entry, particularly those created by proprietary products or brands owned exclusively by your company.
Finally, there should be some “sizzle to go with the steak,” which may include excited and loyal customers and employees, favorable media coverage, nervous competitors who are genuinely concerned that you may be changing the industry, and a clearly defined exit strategy that can reward your investors for taking the risks of investment within a reasonable period of time.
Understanding Private Equity Markets
In many ways, the private equity markets can mimic the conditions of the public stock market, much like the behavior of a little brother copying the mannerisms of an admired big brother. When the bar to access has been raised by the public markets, as it has been for many moons, so, too, moves the bar to access private equity markets.
When the bar is raised, Darwinian principles begin to strongly apply. It can be survival of the fittest. The “fittest” companies are most likely those with the strongest management teams, the largest potential markets, the most loyal and established customers, the most defendable market positions and the clearest path to profitability.
The Different Types of Investors
Most investors fall into at least one of three categories: emotional investors, who invest in you out of love or a preexisting relationship; strategic investors, who invest in the synergies offered by your business (based primarily on some non-financial objective, such as access to research and development, or a vendor-customer relationship—though financial return may still be a factor); and financial investors, whose primary or exclusive motivation is a return on capital and who invest in the financial rewards that your business plan, if properly executed, will produce.
Your approach, plan and deal terms may vary depending on the type of investor you’re dealing with, so it’s important for you to understand the investor and its objectives well in advance. Then your goal should be to meet those objectives without compromising the long-term best interests of your company.
Achieving that goal is challenging, but it can be easier than you might think if your team of advisors has extensive experience in meeting everyone’s objectives to get deals done properly and fairly. The more preparation, creativity and pragmatism your team shows, the more likely the deal can get done on a timely and affordable basis.
Read more articles about raising capital.