Everything You (Don’t) Want to Know About Raising Capital
Most entrepreneurs understand that if the fundamentals of a business idea—the management team, the market opportunities, the operating systems and controls—are sound, chances are there’s money out there. The challenge of landing that capital to grow a company can be exhilarating. But as exciting as the money search may be, it is equally threatening. Built into the process are certain harsh realities that can seriously damage a business. Entrepreneurs cannot escape them but, by knowing what they are, can at least prepare for them.
After ten years of hard work and sleepless nights to get the company to $5 million in sales, the founder of Seattle Software (the disguised name of a real company) was convinced he could hit $11 million in the next three years. All he needed was cash. Ten banks refused to extend his credit line and advised him to get more equity. He met a lawyer at a seminar for entrepreneurs who said he would take the company public in Vancouver or London and raise $2.5 million fast. The founder was tempted to sign him on.
Texas Industrial (again, disguised) had grown from an idea to a $50-million-a-year leader in the industrial mowing-equipment business. The company wanted to keep growing and in 1987 decided it was time for an initial public offering. The underwriters agreed. They started the paperwork and scheduled a road show for early November.
The founders of both these companies thought they were prepared for the fund-raising process. They put together business plans and hired advisers. But that isn’t enough. Every fund-raising strategy and every source of money implies certain out-of-pocket expenses and commitments of various kinds. Unless the entrepreneur has thought them through and decided how to handle them ahead of time, he or she may end up with a poorly structured deal or an inefficient search for capital.
Entrepreneurs should not be afraid to seek the money they need. Though they may be setting sail on dark waters and will always be at a disadvantage when negotiating with people who make deals every day, they can take steps to ensure that they get the capital they need, when they need it, on terms that do not sacrifice their future options. The first of those steps is knowing the downside of the fund-raising process.
Raising Money Costs a Lot
The lure of money leads founders to grossly underestimate the time, effort, and creative energy required to get the cash in the bank. This is perhaps the least appreciated aspect of raising money. In emerging companies, during the fund-raising cycle, managers commonly devote as much as half their time and most of their creative energy trying to raise outside capital. We have seen founders drop nearly everything else they were working on to find potential money sources and tell their story.
The process is stressful and can drag on for months as interested investors engage in “due diligence” examinations of the founder and the proposed business. Getting a yes can easily take six months; a no can take up to a year. All the while, the emotional and physical drain leaves little energy for running the business, and cash is flowing out rather than in. Young companies can go broke while the founders are trying to get capital to fund the next growth spurt.
Performance invariably suffers. Customers sense neglect, however subtle and unintended; employees and managers get less attention than they need and are accustomed to; small problems are overlooked. As a result, sales flatten or drop off, cash collections slow, and profits dwindle. And if the fund-raising effort ultimately fails, morale suffers and key people may even leave. The effects can cripple a struggling young business.
One start-up began its search for venture capital when, after nearly ten years of acquiring the relevant experience and developing a track record in their industry niche, the founders sensed an opportunity to launch a company in a field related to telecommunications. The three partners put up $100,000 of their own hard-earned cash as seed money to develop a business plan, and they set out to raise another $750,000. Eight months later, their seed money was spent, and every possible source of funding they could think of—including more than 25 venture capital firms and some investment bankers—had failed to deliver. The would-be founders had quit their good jobs, invested their nest eggs, and worked night and day for a venture that was failing before it even had a chance to get started.
The entrepreneurs might have spent their time and money differently. We asked them what their sales would have been if they had spent the $100,000 seed money over the previous 12 months to generate their first customers. Their answer? One million dollars. The founders had not been prepared to divert so much of their attention away from getting the operations up and running. Raising money was actually less important to the company’s viability than closing orders and collecting cash.
Even when the search for capital is successful, out-of-pocket costs can be surprisingly high. The costs of going public—fees to lawyers, underwriters, accountants, printers, and regulators—can run 15% to 20% of a smaller offering and can go as high as 35% in some instances. And a public company faces certain incremental costs after the issue, like administration costs and legal fees that increase with the need for more extensive reporting to comply with the SEC. In addition, there are directors’ fees and liability insurance premiums that will also probably rise. These expenses often add up to $100,000 a year or more.
Similarly, bank loans over $1 million may require stringent audits and independent reviews to ensure that the values of inventory and receivables are bona fide. The recipient of the funds shoulders all these costs.
The demands on time and money are unavoidable. What entrepreneurs can avoid is the tendency to underestimate these costs and the failure to plan for them.
You Have No Privacy
Convincing a financial backer to part with money takes a good sales job—and information. When seeking funds, you must be prepared to tell 5, 10, even 50 different people whether you are dependent on one brilliant technician or engineer, what management’s capabilities and shortcomings are, how much of the company you own, how you’re compensated, and what your marketing and competitive strategies are. And you will have to hand over your personal and corporate financial statements.
Revealing such guarded secrets makes entrepreneurs uneasy, and understandably so. Although most potential sources respect the venture’s confidentiality, information sometimes leaks inadvertently—and with destructive consequences. In one instance, a startup team in Britain had devised a new automatic coin-counting device for banks and large retailers. The product had a lot of promise, and the business plan was sound. When the lead investor was seeking coinvestors, he shared the business plan with a prospective investor who ultimately declined to participate. The deal came together anyway, but months later the entrepreneurs discovered that the investor, who had decided not to join, had shared the business plan with a competitor.
In another instance, an adviser was helping an entrepreneur sell his business to a Midwestern company. Sitting in the office of a senior bank officer who was considering financing the purchase, the seller asked for more information about the buyer’s personal financial position. The bank officer called the buyer’s bank a thousand miles away, got a low-level assistant on the line, and listened in amazement as the clerk said, “Yes, I’ve got his personal balance sheet right here,” and proceeded to read it line by line.
The chance that information will get into the wrong hands is an inherent risk in the search for capital—and is one reason to make sure you really need the money and are getting it from highly reputable sources. While you cannot eliminate the risk, you can minimize it, by discussing the issue with the lead investor, avoiding some sources that are close to competitors, and talking to only reputable sources. You should in effect do your own “due diligence” on the sources by talking with entrepreneurs and reputable professional advisers who have dealt with them.
Experts Can Blow It
Decisions about how much money to raise, from what sources, in debt or equity, under what terms—all limit management in some way and create commitments that must be fulfilled. These commitments can cripple a growing business, yet managers are quick to delegate their fund-raising strategies to financial advisers. Unfortunately, not all advisers are equally skilled. And of course, it’s the entrepreneur—not the outside expert—who must live or die by the consequences.
Opti-Com (the fictitious name of a real company) was a start-up spun off from a public company in the fiber optics industry. Though not considered super-stars, the start-up managers were strong and credible. Their ambition was to take the company to $50 million in sales in five years (the “5-to-50 fantasy”), and they enlisted the help of a large, reputable accounting firm and a law firm to advise them, help prepare their business plan, and forge a fund-raising strategy. The resultant plan proposed to raise $750,000 for about 10% of the common stock.
The adviser urged Opti-Com’s founders to submit the business plan to 16 blue-ribbon, mainstream venture capital firms in the Boston area; four months later, they had received 16 rejections. Next they were told to see venture capital firms of the same quality in New York, since—contrary to conventional money-raising wisdom—the others were “too close to home.” A year later, the founders were still unsuccessful—and nearly out of money.
Opti-Com’s problem was that the entrepreneurs blindly believed that the advisers knew the terrain and would get results. The fact is, the business proposal was not a mainstream venture capital deal, yet the search included none of the smaller, more specialized venture capital funds, private investors, or strategic partners that were more likely to fund that type of business. Furthermore, the deal was overvalued by three to four times, which undoubtedly turned off investors.
Opti-Com eventually changed its adviser. Under different guidance, the company approached a small Massachusetts fund specifically created to provide risk capital to emerging companies not robust enough to attract conventional venture capital but important to the state’s economic renewal. This was the right fit. Opti-Com raised the capital it needed and at a valuation more in line with the market for start-up deals: about 40% of the company instead of the 10% that the founders had offered.
The point is not to avoid using outside advisers but to be selective about them. One rule of thumb is to choose individuals who are actively involved in raising money for companies at your stage of growth, in your industry or area of technology, and with similar capital requirements.
Money Isn’t All the Same
Although money drives your fund-raising effort, it is not the only thing potential financial partners have to offer. If you overlook considerations such as whether the partner has experience in the industry, contacts with potential suppliers or customers, and a good reputation, you may shortchange yourself.
How fast the investor can respond is sometimes another crucial variable. One management group had four weeks to raise $150 million to buy a car phone business before it would be auctioned on the open market. It did not have enough time to put together a detailed business plan but presented a summary plan to five top venture capital and LBO firms.
One of the firms asked a revealing question: “How do you prevent these phones from being stolen? You can’t penetrate the market unless you solve that problem.” The founders soon concluded that this source was not worth pursuing. The firm obviously knew little about the business: at that time, car phones weren’t stolen like CB radios because they couldn’t be used until they’d gone through an authorized installation and activation. The entrepreneurs didn’t have time to wait for the investor to get up to speed. They focused their efforts on two investors with experience in telecommunications and got a commitment expediently.
Yet another entrepreneur had a patented, innovative device for use by manufacturers of semiconductors. He was running out of cash from an earlier round of venture capital and needed more to get the product into production. His backers would not invest further since he was nearly two years behind his business plan.
When the well-known venture capital firms turned him down, he sought alternatives. He listed the device’s most likely customers and approached the venture capital firms that backed those companies. The theory was that they would be able to recognize the technology’s merit and the business opportunity. From a list of 12 active investors in the customer’s industry, the entrepreneur landed three offers within three months, and the financing was closed soon thereafter.
The Search Is Endless
After months of hard work and tough negotiations, cash hungry and unwary entrepreneurs are quick to conclude that the deal is closed with the handshake and letter-of-intent or executed-terms sheet. They relax the street-wise caution they have exercised so far and cut off discussions with alternative sources of funds. This can be a big mistake.
An entrepreneur and one of his vice presidents held simultaneous negotiations with several venture capitalists, three or four strategic partners, and the source of a bridge capital loan. After about six months, the company was down to 60 days of cash, and the prospective backer most interested in the deal knew it. It made a take-it-or-leave-it offer of a $10 million loan of 12% with warrants to acquire 10% of the company. The managers felt that while the deal was not cheap, it was less expensive than conventional venture capital, and they had few alternatives since none of the other negotiations had gotten that serious.
Yet the entrepreneurs were able to hide their bargaining weakness. Each time a round of negotiations was scheduled, the company founder made sure he scheduled another meeting that same afternoon several hours away. He created the effect of more intense discussion elsewhere than in fact existed. By saying that he had to get to Chicago to continue discussions with venture capitalist XYZ, the founder kept the investors wondering just how strong their position was.
The founder finally struck a deal with the one investor that was interested and on terms he was quite comfortable with. The company has since gone public and is a leader in its industry.
The lead entrepreneur understood what many others do not: you must assume the deal will never close and keep looking for investors even when one is seriously interested. While it is tempting to end the hard work of finding money, continuing the search not only saves time if the deal falls through but also strengthens your negotiating position.
Lawyers Can’t Protect You
Why should you have to get involved in the minutiae of legal and accounting documents when you pay professionals big fees to handle them? Because you are the one who has to live with them.
Deals are structured many different ways. The legal documentation spells out the terms, covenants, conditions, responsibilities, and rights of the parties in the transaction. The money sources make deals every day, so naturally they are more comfortable with the process than the entrepreneur who is going through it for the first or second time. Covenants can deprive a company of the flexibility it needs to respond to unexpected situations, and lawyers, however competent and conscientious, cannot know for sure what conditions and terms the business is unable to withstand.
Consider a small public company we’ll call Com-Comp. After more than two months of tough negotiations with its bank to convert an unsecured demand bank note of over $1.5 million to a one-year term note, the final documentation arrived. Among the many covenants and conditions was one clause buried deep in the agreement: “Said loan will be due and payable on demand in the event there are any material events of any kind that could affect adversely the performance of the company.”
The clause was so open to interpretation that it gave the bank, which was already adversarial, a loaded gun. Any unexpected event could be used to call the loan, thereby throwing an already troubled company into such turmoil that it probably would have been forced into bankruptcy. When the founders read the fine print, they knew instantly that the terms were unacceptable, and the agreement was then revised.
An infusion of capital—be it debt or equity, from private or institutional sources—can drive a company to new heights, or at least carry it through a trying period. Many financing alternatives exist for small enterprises, and entrepreneurs should not be afraid to use them.
They should however, be prepared to invest the time and money to do a thorough and careful search for capital. The very process of raising money is costly and cumbersome. It cannot be done casually, nor can it be delegated. And it has inherent risks.
Since no deal is perfect and since even the most savvy entrepreneurs are at a disadvantage in negotiating with people who strike deals for a living, there is strong incentive for entrepreneurs to learn as much as they can about the process—including the very things they are probably least interested in knowing.
Until Next Time,