The other day I spoke with a gentleman and his partner. One of them had purchased my book “Secrets to Raising Capital” and he had some questions about raising money for their business. He and his partner, a computer programmer, had developed a product (service) that would be of interest to a specific target market. I won’t give any more details than that for confidentiality purposes, but I can tell you the idea sounded great and if I were part of their target market, I think I would subscribe to the service.
Many of the people who buy my book reach out to me and for those that do I am always happy to spend some time on the phone talking about their businesses and helping them. I’ve even had a couple of my readers buy me a beer – that’s even better! So, I spent about an hour on the phone with them, talking about everything from raising capital to effective marketing. During our conversation I asked them three questions. These two gentlemen stumbled in answering all three. Now I know all these questions are covered in my book, but I think in the next edition I will have to devote an entire chapter on how to answer these questions.
The first question I asked is “How much money do you need?” They started off with $500,000, changed their mind to $200,000 and then admitted they really were not sure of how much money they would need. If you are looking for money, you must be able to tell a prospective investor the amount of money you want to raise. Now I have had entrepreneurs tell me they don’t want to name an amount because if they say need $2 million, they don’t want to scare off someone who can only put in say $250,000. That is illogical thinking. You must figure out how much you need and be able to articulate that amount.
Now I understand figuring out how much you need is not always easy. You must develop a set of projections and you must estimate the costs you will incur, including capital expenditures, product development, operating costs, and marketing, until that point when you may need another capital infusion, or alternatively until your business is cash flowing enough to cover its operating costs. But if you can’t take the time to put together a good set of financial projections for your business, then why would anyone want to give you money anyway?
If you really are worried about scaring away someone by asking for too much money, then another approach is what I call staging. Basically, what you say is something along the lines of “Over a period we’d really like to raise $2 million, but we’ve planned out our business in a number of stages. We can take the whole $2 million, but right now $250,000 would get us through stage one, which would see us achieving three important milestones.” I think you get the idea, and this is a good way to approach your business anyway because investors can be hesitant to invest in a business where if the business cannot raise a specific target dollar amount (such as $2 million) then the business just can’t be launched.
Sometimes when you ask for money from an investor, based on that investor’s perspective or experience, the investor will suggest you are asking for the wrong amount of money. I was working with a client who was looking for about $1 million (an amount which I thought was sufficient to launch the business) but one investor thought he needed $2 million, another $5 million and one thought $10 million. So, each time he had his team redo the business plan and redo the projections to meet what these investors thought should be put into the company. However, when presented with the revised business plan and projections not one of these investors funded the company. He wasted a lot of his time and the time of his team thinking that if he just tailored his plan to the thinking of these investors, he would get the money. He was wrong.
The next question asked is “What will you do with money when you get it? These two gentlemen didn’t have a clue other than “we need some more programming” and “we need to use social media to market our products.”
The benefit of having detailed financial projections (which I talked about above) is that those projections not only tell how much money the business will need, but also tell you how the business will spend the money. The key here is “detailed.” Many investors are savvy businesspeople, and they will be evaluating you as a businessperson when you answer this question. If you say you’re going to spend $100,000 for social media, you’d better be prepared to explain how that money will be spent. Will it be on pay-per-clicks, on content writers, on video producers, on social media managers or photographers? If you haven’t taken the time to develop a detailed plan for your spending, then many investors will be hesitant to fund you.
I’ve met a lot of entrepreneurs over the years who have the “we’ll figure that out once we get money” attitude. I understand that a certain amount of what you might spend the money on is hard to predict or might change at the last minute, but that does not absolve you of the responsibility of developing a detailed plan anyway. The more detailed your plan, and the better you can articulate how you will spend the money, the greater will be the chances of funding your business.
The final question was “What do I get for my money?” Again, the two partners didn’t have a clue how to answer this question.
The answer to this question really has two components. The first one relates to the structure of the deal. Will this be an equity investment, loan, or combination thereof? Will there be monthly payments or balloon payments? And finally, how much of the business do the investors get? The proverbial question you should be able to answer is when the investor says, “If I give you one million dollars today, what do I get?” Remember investors can do math so if you say they will get 10% of your business for the one million investment, that means you are valuing your business at $10 million. That’s okay if you can in any way justify a $10 million valuation but so many times I have seen business owners answer this question in a way that the valuation looks way too high. I give an example of this situation in the chapter in Secrets to Raising Capital titled “Worth Every Penny.”
So how do you determine valuation? Coming up with an enterprise value for an early stage or start-up business can be difficult but there are ways to do it. I like discounted cash flow with the discount rate high enough to pay back a venture capital investment, of say 40% to 50%. Of course, if you can avoid going to the venture capital folks in the first place even better, but that is another post. Another good way is to find some comparables. Recently I was working to help a small electric boat manufacturer raise capital. We found another electric boat manufacturer that had gone public. Our argument on valuation was that our business had more revenues, more profits and had been in business longer than the company that had just gone public, so therefore were we worth at least as much, and probably more. Most of the investors looking at the deal accepted that valuation as reasonable.
The other part of the answer to this question should answer the questions “How do I get my money back? If it is a loan, obviously there is a payment schedule and a term to the debt. If it is an equity investment, at some point there must be a liquidity event which could include a buy-back of equity at a significant premium, sale of the company or taking the company public. Even if you are not sure which of these alternatives you should pursue, you should be able to answer this question by thinking a little bit about your own plans, the business you are in and the equity markets. Do you plan to run the business for the next twenty years or is there a three-to-five-year project and then you’re out? Is the nature of the business attractive to public markets or would be business be better of being a division of another company?
In summary, if you want to substantially increase your chances of raising capital for your start-up or early-stage business, be prepared to answer these three questions. You will get asked these questions and the better you answer them the greater your chance of getting funding. As for the two partners, they have some work to do.