Most entrepreneurs and small business owners have a need at some stage to raise capital in order to realise an idea or expand their current business operations.
The first port of call is normally the traditional source of finance – the bank.
But most banks are usually reluctant to lend to small businesses without the security of property – often the business owner’s home. It is very difficult to get banks to lend on the strength of the business opportunity if it is in its start up or early development phase. Financing start-ups is basically not what the banks do.
There is a fundamental difference between the business of mainstream banks and venture capitalists. The bank wants to provide loans that are relatively secure, on a long term basis. Business investors and venture capitalists want to put money into something that will provide an above average return and then get out.
It is important to understand the differences between the various types of start-up and venture finance, and to understand what potential investors are looking for and how to approach them.
We often hear it said that the Australian investment market is conservative and will not back the creative and entrepreneurial talent that exists in business. Without wishing to debate that proposition one way or the other, it is fair to say in defence of the investors that they are often presented with propositions that would not inspire anyone to part with their money. Research has shown that only 0.12% of deals that get put in front of venture capitalists actually attract funding.
To improve the chances of successfully attracting finance for your business start up or business expansion, there are a number of things that you as the promoter of the business should consider and address.
First, ask yourself, what is the stage of development that the business has reached? It is very difficult to attract other people’s money when your business is still just in the idea stage.
The most common mistake business promoters make when looking for funds is they do not look at their proposition from the point of view of the investor.
Investors are exactly that – they invest for a return, they are not punters. Nor are they entrepreneurs who want the thrill of developing a good idea. For them, developing the idea is a means to an end of achieving a return on an investment.
So, if there is no cashflow, there is no business, and the chances of attracting business investment are slim. In these very early stages, the only place that money is likely to come from will be the promoter’s own assets, or family and friends. The other alternative is to look at the various state and federal government grants available to assist with the very early stage of development but there are not many of these either.
Once the idea starts to turn itself into a revenue generator, it is at the stage that it might be able to attract some seed capital. This would typically be in the range of $100,000 to $300,000 and come from an individual investor or business angel. It is still fairly speculative from the investor’s perspective, but if the investor can see that the idea has merit and has a chance to become a good business, they may put money into it. This form of finance is often by way of a loan rather than equity and will be at an interest rate commensurate with the risk. The investor in this scenario will probably only invest an amount that he or she is prepared to lose and is not likely to put in anything at all if the promoter does not have their own money at risk.
The next stage of development for the business is where it has become established and has the potential to expand. At this point, it can start to look for venture capital which will typically be in the range of $2.5 to $5million. The venture capitalist is only interested in investing in a business that will deliver a return and will not back something based only on the potential of an idea.
This is a critical point that business owners need to understand. While the entrepreneur is focused on the potential of the technology or product or service, the venture capitalist is really interested in the quality of the business and the management.
The venture capitalist wants to know who is going to be responsible for his or her money and how will they achieve a return for him or her.
If the business survives these early stages and continues to develop, it will reach a point at which it becomes attractive to the mainstream banking industry for long term debt finance and possibly public listing if it needs to raise further capital.
All of this suggests a few things that a business owner who is seeking capital should take into account.
1. Do it in stages
Even if the idea or product has the potential to change the world as we know it (which many entrepreneurs passionately believe their pet project will do), it is better to start by trying to attract a smaller amount to get it off the ground, rather than the amount required to take on the world.
2. Present the pitch from the perspective of the investor
The investor will want to know how much is needed, what he or she gets in return, when does he or she get it and how and when will he or she exit. (A typical venture capital supplier will normally look to exit the enterprise within 5 to 7 years). Of course, the investor will also need to be convinced that the business has a good chance of succeeding and thus deliver the promised return.
It will require a fair amount of homework to produce:
- A business plan that shows an effective business and revenue model. It needs to demonstrate a quantifiable need in the market that the business is capable of fulfilling. It should also show how the business compares with competitors on relevant industry indicators and the sensitivity that the projected outcomes have to key assumptions.
- An investment summary and business valuation model together with an exit strategy.
- A strategic marketing plan that demonstrates exactly how the potential will be turned into reality. The plan must address the value proposition of the business and the branding strategy that will deliver above average profits.
- Evidence that there is adequate protection of any intellectual property involved.
- Evidence of a management team with the credentials and credibility to deliver the result.
- A clean ownership structure where the assets of the business are clearly distinguishable from the assets of the owner.
All of the above will need to be available in two forms:
- A brief presentation that will capture the attention of the investor and answer his or her critical questions.
- A detailed set of documents that will stand up to the scrutiny of the third party that the potential investor will inevitably engage to carry out due diligence on his or her behalf.
Remember, the investor is highly unlikely to slash his or her wrists if an investment gets away from them because it was poorly presented. There is always someone else waiting outside the door to pitch the next opportunity.
Here is a checklist of things to consider for small businesses looking for funding.
1) What stage of development is the business at?
|STAGE OF DEVELOPMENT
|TYPE OF FUNDING REQUIRED
|i) It is a new product or idea with potential.
|Self-funding, family and friends, government grants.
|ii) It is starting to generate a cash flow.
|Self-funding, family and friends, government grants.
|iii) It has a consistent cashflow, the potential to grow and needs $100,000 to $300,000 to go to the next level.
|Seed capital from private investors and business angels.
|iv) It is self-sustaining and profitable with a positive cashflow and requires $1 million to $5 million to continue growing.
|Venture capital from private equity firms.
|v) It is a substantial company with strong asset backing that needs a large amount of money for further growth.
|Debt finance from an investment bank or commercial bank. Partial trade sale or private equity placement through an investment bank. IPO.
2) If the business is at stage (iii) or beyond, ensure the following are in place:
- A business plan that details the business model, demonstrates a viable opportunity and contains competitive bench marks.
- A strategic marketing plan that demonstrates exactly how the revenue and profitability targets will be achieved.
- Evidence that the intellectual property is adequately protected.
- A management team with the know how to deliver the plan.
- Evidence that the business owner or promoter has a serious financial interest in the venture.
- An investment summary and business valuation model.
- A viable exit strategy.
Having an awareness of what investors are typically looking for and doing your homework ahead of time will significantly increase the chances of you successfully attracting funding for your business venture.