Raising capital to start or fund an existing business is more science than art. It takes careful planning and great stewardship to ensure the investors get their capital back including a reasonable return on their investment. Investors who evaluate companies seek opportunities where the risks are mitigated, comprehensive fiscal forecasts are prepared and the management and directors bring the relevant expertise to execute on the strategic plan.
Many startups raise the seed capital to get their business started. Then concern hits when the initial capital has been consumed and the business has either got the product ready for market but no capital to expand or when the product or service model is not yet fully built out.
Capital markets are very aware of the risk of investing. Investors are seeking a higher likelihood of a full return of capital plus the multiple promised and that only occurs when the company has performed the due diligence, supervision and forecasting to overcome reasonable roadblocks to success. Therefore, you need a strong management team, talented and seasoned board of directors and well vetted research to validate the market for your products or services. There are three key issues you must address:
- Determine the full amount of capital required to get to revenue generation and profitability to sustain the company.
The worst result for the founders and investors is running out of capital before achieving the objectives stated at funding. This is usually a result of poor financial forecasting, monitoring the burn rate, execution of the game plan, and unexpected operational or capital expenditures. The ease of creating a forecast in Excel has led to many entities failing due to insufficient rigor in analyzing the cash flow demands on the company during the growth process.
Every company going into capital raising mode must determine the total capital to get to cash flow positive unless they are planning to return to the capital markets. Although many companies have done round after round of raising capital, the longer this process takes the more the board and management become distracted from the objective. I am working with one company that is currently wrapping up its 12th funding round and despite raising over $45 Million, this company is still far from the finish line and will be required to raise at least $25M – $40M to fully execute their plan. This is an exceptional company and most likely will be purchased for their technology or may be able to access additional capital via Wall Street.
Often, I am introduced to companies that want to raise a fixed amount of capital and are seeking help with their goal. Unfortunately, they assume a fixed amount of capital will be something to shoot for without going through the process to determine what is really needed. Although most of these companies are seeking a few million dollars, they don’t understand that they really need double or triple this amount to sufficiently capitalize the company for the growth they are focused on.
Many companies attempt to raise capital without creating a full set of forecasted projections; including the Statement of Operations, Balance Sheet and Cash Flow Statement. Without considering the working capital demands being considered in the Balance Sheet and Cash Flow Statement, it is easy to overlook where cash (the critical component of working capital) will be required.
If you obtain debt funding via convertible notes, ensure that your forecast has a plan with adequate capital to retire the debts if those investors elect not to convert. This is one of the hardest errors to overcome when early investors have the option of debt with a fixed maturity or conversion to equity. When more investment is required, the new investors are typically not interested in funding the repayment of earlier investors convertible debts who are not willing to convert. This puts the company in the “Rock and Hard place” situation.
- Build a comprehensive model that reflects how your investors will get their investment money and a risk warranted return.
To validate the ability of a business plan to move a startup to a fully functioning operational company (or a smaller company to a larger enterprise) takes management, operations, sales, marketing and finance teams that can use the new investment capital to increase the investors’ rate of return. The investor will never invest in a business as indifferent about all the components being in place to ensure that the company has the success forecasted. Investors want to see and validate the assumptions, interview the management team and perform a critical analysis of the financial forecasts.
The key for startup entities and operational entities who are seeking capital from investors is to build a comprehensive business plan that addresses all phases of the risks that threaten the financial objectives of the plan. Stewardship of investors’ capital is a serious undertaking that means you don’t allow investors’ money to be wasted and you provide safeguards to preserve the financial integrity of the company.
Investors recoup their investment by selling their stock. If they obtain their original investment there is no return for the risk of the investment. If they obtain an amount greater than their investment, the return on investment (ROI) can be calculated and can range from a fraction to multiples of their original investment. The key to attracting investors is to have a model that demonstrates the ability to create value and the opportunity to liquidate the investment in a reasonable period of time. Some investors target 3-5 years, 5-10 years or, on rare occasion, a longer hold period.
I find that some entrepreneurial founders don’t provide the comprehensive model that demonstrates how investors will be rewarded with a strong return. Make sure you don’t promise the “hockey stick” ramp of sales, profits and cash accumulation that is rarely ever achieved. Take the time and conservative view of sales growth, gross margins, operating costs and efficiency which will serve you well. Nobody creates forecasts that are accurate in all phases but any time to outperform your forecast you create confidence and respect from all parties concerned; bankers, investors, employees and management.
- Don’t assume more capital will be available as you may need it, so fund with contingencies.
Raising capital is a long painful process and a major distraction to the organization. Most companies wish to minimize this drill. The most important consideration is how to perform this routine the least amount of times by raising a sufficient amount of capital to assure the success of the business plan. The private capital market is a cyclical market that follows the economy. This means there are times when capital is pent up and ready to flow into companies and there are times when capital is scarce and options favor the investor. Therefore, don’t assume more capital will be available later and that you can dip your bucket into the cash later when you need more.
You would be better served, as would your investors, if you raise the right amount to ensure success or at least minimize the chance that additional capital will be needed to get the company cash flowing through operations. I have heard founders say naively that they will just get what they need at the next round at a higher price. What often happens is that if any capital is available, it becomes a down round where price per share is actually lower. This frustrates initial shareholders since the new investors see more risk and therefore discount the value to the equity. I am not saying that every company should only raise capital once, but the chances of successive rounds with increasing value is the exception and not the norm when considering all companies that enter the equity market.