Financing Entrepreneurial Ventures, Part 1

Stephen DeAngelis

July 5, 2011

During this shortened holiday week, I’ve decided to concentrate on entrepreneurism. For many entrepreneurs, finding sufficient capital to finance their dreams is difficult. Mike Southon reports that the process is generally “lengthy” and “dispiriting.” [“Seek and you will find,” Financial Times, 22 May 2011] As I noted in a previous post, the primary reason that most start-up businesses fail is because they run out of operating capital. Few companies become instant and profitable successes; hence, raising capital is critical if the business is going to have a reasonable chance of surviving. Southon reports, “Few people who do the rounds of venture capital and private equity investors speak fondly about the experience.” To learn more about this topic, read my posts entitled “Through the Looking Glass: Two Sides of Start-Up Financing,” Part 1 and Part 2.

 

Venture capitalists and private equity investors are only two potential sources of financing. In this two-part series on financing entrepreneurial ventures, I’ll discuss a number of articles that describe those and other avenues entrepreneurs can use to raise money. Entrepreneurs should remember that there is a difference between debt and investment capital. Although lenders and investors both want their   money back, investors generally willing to accept more risk when they put money in the hands of entrepreneurs. For accepting those risks, investors expect a stake in your venture. Borrowing from a bank is a different matter. The bank is unlikely to want a piece of your business. It wants collateral in other forms — like your house. Southon, in another article, cautions entrepreneurs to “avoid debt wherever possible.” [“The seven stages of finance,” Financial Times, 14 February 2011] He writes:

“While there are many people who are expert at taking on debt and leveraging their businesses, this is a dangerous game for the unwary or overconfident, who can over-extend themselves with disastrous effect. This might not even be their fault, but a by-product of the recession – an external event caused by some very unpleasant people, many of whom seem to have exited with large personal fortunes. The best financial advice I give would-be entrepreneurs is to start by running a cash-positive service business.”

Despite Southon’s advice about avoiding debt, it’s a subject that deserves to be addressed. Colleen DeBaise indicates that small businesses with no track record “are still struggling and failing to secure loans or lines of credit.” [“So, How Do I Get a Loan?The Wall Street Journal, 8 February 2011] Unfortunately, she doesn’t offer any answers about how small start-up businesses can improve their chances of getting a loan. The best advice I can give is to generate a business plan that makes a compelling case for why your business loan won’t end up in a bank’s pile of toxic debt. Because bank loans are still difficult to obtain, Angus Loten indicates that entrepreneurs are turning to peer-to-peer loans. [“More Start-Ups Seek Peer-to-Peer Loans,” The Wall Street Journal, 31 May 2011] He writes:

“Peer-to-peer lending sites match borrowers with a network of online lenders, who typically each put up anywhere from $20 to $1,000 in return for interest on the loan. Most borrowers use the money to consolidate debt or pay off credit-card balances. Launched five years ago, [Prosper.com] has more than one million members and has generated a total of $233 million in loans. Earlier in the month, LendingClub.com, a similar site based in Redwood City, Calif., reported a total of $17.5 million in loans in April, with about 7% being used by small businesses. The average loan was $13,000. Last year, small-business lending on the site rose by 24%, and is forecast to grow by 80% this year, according to Scott Sanborn, the site’s chief marketing officer. Prosper Chief Executive Chris Larsen says small businesses are turning to peer-to-peer sites as an alternative to banks, many of which have raised lending standards and interest rates in the wake of the financial crisis.”

You can tell by the size of the loans obtained from peer-to-peer sites that they are not the best source for obtaining multi-year operational capital. To raise that kind of cash, you need to obtain investment capital not take out a loan. Since Southon brought up the subject of venture capitalists, let’s begin the discussion with them. Venture capitalists didn’t get rich by making stupid investments. They are a hardnosed and business-savvy group. Harshdeep Rapal, a Managing Consultant with HCL-Axon, provides his views about what venture capitalists are looking for when a business idea is pitched to them. [“What Venture Capitalists Want,” The Wall Street Journal, 24 May 2011]. He writes:

“A venture capitalist will, on average, receive hundreds, if not thousands, of business plans every year, but just a handful make it to a detailed review and even fewer get funding. Investment decisions vary from one venture capitalist to another. To a large extent, they depend on the portfolio the venture capitalist is building. Still, there are a few things that every venture capitalist would like to see in a business plan.”

Before looking at what Rapal suggests should be in a business plan, I would like to underscore the point that successful ventures begin with a business plan not simply an idea. Having said that, Rapal starts his list by talking about ideas. He writes:

Idea, its Viability and Sustainability: The most important ingredient of a business plan is the idea. The combination of a unique idea and an identified and expanding market is something that interests every investor. The entrepreneur should be able to prove how to make the idea viable and sustainable, and include an execution plan and timelines for achieving major milestones. A venture capitalist would be much more comfortable funding a venture if it is clear how the money will be spent.”

One way of convincing an investor that money will be spent well is by showing that money has been spent wisely in the past. That is the second of Rapal’s points. He continues:

Progress till date: A venture capitalist is always more interested in projects where some groundwork has already been done. If you have a running prototype of the business, share the data on investment, customers, revenues, products, services and challenges faced. This would give a fair idea about the returns the venture capitalist can expect from an investment. Generally, businesses that are up and running, or even pilot projects, have a greater chance of attracting funding than plans that have yet to take off.”

The next topic addressed by Rapal is a company’s team. Southon writes, “Good ideas grow on trees. What makes the difference is the team involved. I have always thought that a better approach is to form the team first and look for the right idea later. Many successful entrepreneurs attribute their success to starting with a passion or obsession and discovering later that they were the right people at the right time.” Rapal believes that venture capitalists will also open their wallets wider if they like the team involved. He writes:

The Team and Business: A venture capitalist would like to see and meet the people who will actually handle an investment. To some venture capitalists, the people are more important than the plan itself because market conditions might change, meaning the plan might change. What is less likely to change is the team involved, and their passion, drive and expertise. If the venture is planning to have partnerships and collaborations (which any venture should) they need to be spelled out clearly. The success of a venture also depends on what kind of partnerships it has in place.”

Of course, the bottom line for venture capitalists is the bottom line. What kind of return on investment are they likely to see? Rapal writes:

Value Proposition for the Investor: It doesn’t matter how much money the investor has, a venture capitalist still wants to invest in attractive propositions. Understand that the venture capitalist is investing for returns, so it’s well worth demonstrating what the assured and practical returns will be.”

Nobody likes contemplating failure; but, venture capitalists know that most start-up ventures don’t succeed. So even if you’re reluctant to face reality, venture capitalists will force you do so. That means you need to be realistic in your assessments and comprehensive in your approach. Rapal continues:

Challenges and Risks: Entrepreneurs rarely expose weaknesses in their business plans, but it is still very important to identify the challenges and risks the business might face. This also helps assure the venture capitalist that you have thought about the factors affecting and influencing the plan. If possible, share a mitigation plan for these identified risks.”

Venture capitalists also know that entrepreneurs are generally restless and full of ideas. They know that entrepreneurs are seldom satisfied with building just one company. Knowing this, venture capitalists are going to want to know what your ultimate goal is (e.g., IPO or sale) and how the reins of the business are going to be passed to a new leadership team when that time comes. Rapal writes:

“Exit Strategy: The venture capitalist will want to know about the founding team’s exit strategy. An initial public offering would generally be the best way to exit an investment, but not many ventures reach that stage. If you have a plan to sell out of the business, the venture capitalist would be interested in knowing when you might make such a move.”

Rapal concludes, “There is no Holy Grail to make your business plan succeed in getting funding. If there was, every plan would have evolved into a multi-billion-dollar business.” He’s pretty certain, however, that if your plan fails to address the items he discussed your chances of getting funding aren’t very good. Another source of investment capital is the angel investor. To read more about this topic, see my post entitled Angels Investing in America. David Gill, managing director of St John’s Innovation Center in the UK, and Alex Hoye, chief executive of the UK digital marketing agency Latitude, offer some tips about to obtain angel funding [“Tips on angel funding,” Financial Times, 22 May 2011] Gill’s recommendations include:

“● Get an introduction. Angels, on the whole, are getting a lot of referrals. They want deals from people who have given them good deals in the past.

“● Network. I do not mean generic networking, just turning up to an evening talk, but getting to those events where you are likely to meet investors and to be able to get a sense of what they are looking for.

“● Use the investment readiness programs. If the guys running these are marketing their programs properly, they will provide the opportunity to meet real investors.

“● Know your pitch. Don’t go out unless you have the elevator pitch rehearsed properly and you have the two to three-page proposal in your back pocket. Your pitch has to be a compelling read, not a stream-of-consciousness.

“● Never talk about giving up equity. You are selling your idea.

“● Treat the deal as a partnership. You choose your angel as much as your angel chooses you. There has to be a chemistry because, almost certainly, you will be spending time working together on the board.

“● Once the deal is done, be open and upfront about the problems. Angels are like bank managers in that they don’t like surprises.”

Gill is spot on when he talks about the importance of networking. I plan on writing a post on networking in the future. He’s also correct that networking won’t do you any good if can’t make a convincing case about your business proposal in a very short speech. Part of your elevator pitch should be the fact that you have a comprehensive business plan that contains the elements discussed by Rapal. Hoye provides his recommendations about attracting angel investors. He writes:

“● Use investors you trust. These are ones who can help or get out of the way, but not ones who take lots of time and cannot help.

“● Simple is better when it comes to structuring deals. If not, you will spend too much time on legals. An equity deal is great as it does not set mixed incentives, but convertible notes can often break the logjam of valuation discussions and be very rapid.

“● Generate traction. Have at least two angels come to the table. This creates an auction.

“● A lead or value-add investor can be great on a board. But the board needs to stay flexible for future financings as the company evolves.

“● Be wary of milestone or performance targets. In my view, milestone deals are overlegislating into the unknown. I would prefer letting the market decide the next phase of capital, but an entrepreneur or investor can use it to lock in a free option with minimal friction.”

One final source of capital I’d like to discuss in this segment is crowd-funding. Angus Loten reports that sites that “facilitate ‘crowd-funding’ have taken off in the past few years.” [“Crowd-Fund Sites Eye Boom,” The Wall Street Journal, 12 May 2011] He continues:

“With regulators considering easing fund-raising rules for start-ups, social-networking sites that link entrepreneurs to large pools of donors are gearing up for a boom. … Small businesses pitch ideas to people in a site’s online network, who decide whether to donate. The sites typically make money by charging the small business a fee. Until now, U.S. regulations permitted these sites only to facilitate donations—not purchases of equity stakes. The Securities and Exchange Commission now is reviewing those rules, and many crowd-funding sites are pushing to axe the stake ban. The sites hope that the incentive of an equity stake will draw more donors, prompting a surge in business for the companies that run the sites.”

Loten reports that “crowd-funding emerged about a decade ago as a way for artists, filmmakers and musicians to raise donations from a community of online supporters. The idea has since spread to small businesses, who sought other sources of financing in the past couple of years as traditional credit dried up.” If the rules are changed to allow equity investing, it could be a game changer for entrepreneurs. Loten concludes:

“‘This isn’t about de-regulation, it’s about modernizing regulations,’ says Karen Kerrigan, president of the Small Business and Entrepreneurship Council, a beltway lobby group. But others fear the move would weaken investor protections and lead to fraud. Instead, they want to limit online investing to ‘accredited’ investors—those who have a $1 million in net worth excluding the value of their primary residence. Arkansas Securities Commissioner Heath Abshure says in an interview that crowd-funding sites advertise start-ups to a broad audience, and could easily attract people who shouldn’t be involved in speculative offerings.”

Tomorrow I will discuss opportunities and perils of obtaining capital from sources closer to home and how bootstrapping may be the better way to go.