Are you aware of the following statistics:
1. 77% of small businesses rely on personal savings for their initial funds (based on a Gallup poll),
2. 33% of small businesses start with less than $5,000 (according to a study run by Kabbage),
3. The average small business requires about $10,000 of startup capital (based on a poll run by the Wells Fargo Small Business Index), and
4. Only 0.05% (or 1 in every 2,000) of startups raise venture capital (according to an Entrepreneur article).
What would it mean to you, to be one of the few businesses that defied these odds and actually got your business funded?
As a business owner who works with entrepreneurs on a daily basis, one of the questions most frequently asked of me is “How do you raise capital?”. While this seems to be a relatively simple question, the only way to truly answer this question is to raise and answer several related questions. These questions are as follows:
1. Why do I need capital?,
2. How much capital do I need?,
3. What type of capital do I want (ex. Debt versus Equity)?,
4. Who should I raise capital from?,
5. What do I need to provide the investor?, and
6. How do I convince the investor to do my deal?
Let’s address these questions one at a time. First, why do I need capital? Answering this question is important, because investors tend to invest in what they know. Therefore, knowing what you’ll use investment funds for will determine who you reach out to for investment capital. For instance, are you raising capital to buy another company (investors refer to this as a roll-up, or acquisition)? Are you looking for capital to cover losses, due to your expenses exceeding your revenues (investors refer to this as working capital)? Are you looking to buy an asset, like a building or equipment? Or are you looking to raise capital to hire staff to accommodate business growth? Whatever your reason for wanting to raise capital, knowing this reason will help narrow who you approach for capital.
Investors tend to advertise on their websites why they’ll lend or invest their capital (ex. For acquisitions, working capital, building/equipment purchases, hiring staff, etc.), so a quick internet search of a potential investor’s website will help make sure you’re approaching an investor who is willing to invest for the reasons you need capital. In the rare case that an investor doesn’t have a website, you’ll want to ask if they invest in businesses who use capital in the way you desire to use investment capital.
Knowing why you need capital actually helps you determine the answer to the second question: How much capital do I need? If for instance, you were raising capital to buy another business, discussions you’d have with the seller would let you know the amount of capital they desired to sell their business to you. If you needed working capital to cover losses, you’d want to raise enough capital to cover the sum of your losses until you reached profitability. To cover any unforeseen circumstances, it’s advisable to increase the amount of working capital you’ll need by 10-20%. If on the other hand you were looking to raise capital to buy a building or equipment, or add staff, negotiating with the building seller would let you know the selling price of the building. Quotes from the vendor you intended to purchase equipment from would tell you how much you needed to buy the equipment. And adding the annual salaries of all of the people you intended to hire would tell you the amount of capital you’d need to raise to cover payroll for your new hires.
Knowing how much capital you need is important, since any investor will have a range of capital that they’re willing to invest. For instance, a bank or credit union will typically have a number of different types of loans that can each be used for a specific purpose. As an example, there could be one type of loan for a maximum amount of money that could be used for working capital. There could be a different type of loan for acquisitions, and another type of loan for asset purchases. Each of these loans would have a limit on the amount of money that could be borrowed, the annual interest rate that would be charged, and the maximum length of time that the money would be lent out before it would have to be repaid. Angel investors, venture capitalists, and private equity firms also have ranges of capital that they’ll invest in a business for different purposes. Since investors aren’t receiving monthly payments over an extended period of time to recover their investment (like a bank or credit union), their investment is at much greater risk of not getting repaid. As a result, angel investors, venture capitalists, and private equity firms expect much higher rates of return on their investment, and tend not to want to tie up their money for more than 5-7 years before exercising their option to recover their investment.
Determining the amount of capital you need can help you answer the third question: What type of capital do I want? An entrepreneur would normally attempt to raise debt capital for smaller amounts of money (typically less than $5 million), and if they didn’t want to give up equity in their company (something you typically don’t want to do until your target market has validated your business model, which will be reflected in total sales in the millions of dollars). An entrepreneur should typically attempt to raise equity capital for larger amounts of money (typically more than $5 million), however there are avenues for raising equity from investors who specialize in smaller capital raises (for example, friends and family, equity crowdfunding platforms, angel investors, and venture capital firms can all be sources of raising smaller amounts of capital). While debt and equity normally is repaid in 5-7 years, debt loans can be taken out for longer period of times (for example, a bank loan might be up to 10 years in length for the purchase of a building). Since debt loans require monthly payments over a period of time, loan capital is at less risk of not being repaid (thus a bank loan will typically charge less than 10% in annual interest on the amount borrowed). Since an equity investment has a much greater chance of not being repaid, equity investors demand much higher rates of return on their invested capital. For instance venture capitalists and private equity firms (who tend to be the most aggressive equity investors), expect to receive 10-20 times what they invest in an entrepreneurial business (thus averaging 40-85% in annual interest on the amount invested).
Having successfully answered the first three questions, an entrepreneur now has the ammunition to answer the fourth question: Who should I raise capital from? If you’re willing to take on debt, a commercial bank is who you’ll want to reach out to for funding. If you’re looking for less than $50,000, there are any number of micro-lenders who specialize in lending these small sums of money (a simple internet search of micro-lenders will uncover firms in an entrepreneur’s local geographic area who do this type of lending). Micro-lenders also tend to receive some of their funding from the Federal government, and are therefore better able to lend to entrepreneurs with lower credit scores. For less than $100,000, credit unions or community development financial institutions (CDFI’s) are a good source of funding (particularly if you are a depositor at the credit union or CDFI you are looking to borrow from). For amounts in excess of $100,000, regional or national commercial banks are going to be your best source of debt capital (however, there are some private investment companies who prefer to do debt lending as well).
If you have no qualms about giving out equity in your entrepreneurial venture, there are a number of sources for equity investment. If you’re looking to raise less than $100,000, friends and family are the best source to get this type of funding (since friends and family tend not to be sophisticated investors, you’re more likely to get more favorable repayment terms from these investors). If you just happen to have a friend or family member who has amassed a great amount of personal wealth, you may be able to raise more than $100,000 from your friendly investor. For amounts between $100,000-$1 million, angel investors (or angel investment groups) and equity crowdfunding platforms are going to be the best source for this level of equity funding (however, there are a limited number of venture capital firms who will invest at this level as well). Above $1 million, venture capital and private equity firms are going to be your best sources for equity investment (even though with recently enacted changes in laws regulating equity crowdfunding, it’s now possible to raise tens and hundreds of millions of dollars in funding through this channel). Finding out who potential debt or equity investors are for your entrepreneurial venture is as easy as doing a quick internet search for each type of investor.
Once you know whether you intend to raise debt or equity capital (and from whom), you can now answer the fifth question: What do I need to provide the investor? Debt investors tend to be risk-averse, therefore they require the most documentation from an entrepreneur. Every debt investor has their own unique requests for documentation, but typical documentation requested can include any of the following: the loan application, senior management resumes, articles of incorporation, copies of any business licenses, business insurance certificates, prior year tax returns, prior and current year financial statements (profit & loss, balance sheet, cash flow, accounts payable and receivable aging, sales by customer, and use of funds statements), owners’ personal financial statements, owners’ credit reports, copies of major contracts, bank financing agreements (if you have any prior unpaid loans), bank statements, and your business plan.
Equity investors tend to take on more risk, and therefore require less documentation. Entrepreneurs will capture the interest of an equity investor through the use of a pitch deck (usually 7-10 Powerpoint slides) that cover the following information: Overview of the business opportunity, size and growth rate of the target market, description of leadership team and outside advisors, product/service description, overview of historical achievements, marketing/distribution plan, competitive analysis, and financial projections and use of funds. If an investor expresses an interest in learning more about an entrepreneur’s business, they’ll next want a copy of the business plan. My advice to entrepreneurs is that they always prepare the business plan themselves, since an equity investor will challenge most (if not all) of the assumptions in the plan (and the inability to intelligently defend the assumptions in a plan will have an adverse effect on whether or not an investor decides to invest in an entrepreneur’s business). It is also essential that the financial projections in a business plan be consistent with all the other verbiage in the plan. An entrepreneur will therefore benefit from having several individuals (including someone with an advanced background in accounting or finance) review the business plan before it’s distributed to anyone.
Armed with answers to all of the preceding questions, an entrepreneur can now answer the final question: How do I convince the investor to do my deal? As I stated at the beginning of this article, investors tend to invest in what they know. Most investors invest in their immediate geographic vicinity, in industries they’ve previously worked in, and in whatever deal sizes their available capital permits them to invest in. For example, if an individual angel investor had $10 million in personal wealth, they might risk half of their personal wealth on small business investments (or $5 million). To limit risks, the investor would typically invest this capital in up to 20 different companies (approximately $250,000 per invested company). This investor would be looking to invest their money in any given company for 5-7 years on average, and would be looking for each investment to repay between $2.5-5 million (the first thing an investor will do in reviewing a business plan is skip to the financial projections, to see if the entrepreneur has projected sufficient business growth to permit paying the investor their desired return when the investor desires to be repaid, based on the amount of equity that’s being offered to the investor). By either going to this investor’s website or having a conversation with the investor, an entrepreneur would be able to determine what industries and geographic regions the investor invested in. In order to convince the investor to do a deal, the entrepreneur needs to first ensure that their deal is aligned with the investor’s interests. For instance, if the investor only invests in companies on the West Coast, the entrepreneur would need to be located on the West Coast to gain the interest of the investor. Likewise, if the investor only invested in companies in the information technology space, the entrepreneur’s business would also need to be in this space. Finally, if the investor only has the capacity to do deals up to $250,000, the entrepreneur’s deal could not exceed $250,000. Assuming that all of the above criteria are in alignment with the interests of the investor, the entrepreneur has to then provide all of the documentation required by the investor. In the investor’s review of the required documentation, the investor is looking to determine five things:
1. Is the entrepreneur’s company and product/service unique,
2. Is the entrepreneur targeting a niche of a large, fast growing market that they can dominate,
3. Does the entrepreneur’s financial projections show sustained revenue and profitability growth over time, with cash flow positivity early in the company’s history,
4. Has the entrepreneur identified strategic allies who can assist in opening markets and obtaining customers, and
5. Has the entrepreneur assembled a team of world-class leaders and advisors with complementary skills, who can execute the business plan.
Assuming the answer to each of the above five questions is a resounding yes, an entrepreneur has unlocked the mystery to successfully raising capital.
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