Turning to Investors for Funding

Turning to Investors for Funding

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One of the hardest things you will do when starting a business is raising money. The cold hard truth is that it is almost impossible to get a business loan. Research shows that as few as 3% of applicants worldwide are successful at securing a business loan.

Small businesses, especially those in the early stages struggle to borrow money from banks or to find private investors. Funding institutions are inundated with applications, so a business has to really stand out from the thousands of other applicants, and the business owner needs a good credit record. Your business plan should also be well structured to appeal to investors. One common reason for rejections is when a business does not suit the funding institution’s mandate. Make sure the organisation you are applying to does fund businesses in your industry.

If you are determined to obtain external funding, there are a few avenues you can explore. Funding institutions include banks, government funds, venture capital companies and private equity investors. Entrepreneurs can also turn to angel investors for help, but most will rely on family and friends for help.

Raising finance is tough, but it is not impossible, provided you are willing to do the legwork.

Venture Capital

Venture capital (VC) companies usually favour early stage companies that show high growth potential. Venture capital is usually associated with a new business or venture, particularly with new technology projects. VC companies however, fund a minimal percentage of businesses who apply for financing.

When approaching a VC company, it is vital to learn as much as possible about the VC’s investment mandate to be sure that your company and business plan fits within its scope. Most VC companies shy away from start-ups in favour of companies that are able to demonstrate revenue for anything from six months to two years. There are very strict criteria that VC companies use, including a viable current business model, aggressive growth strategy, and international expansion opportunities amongst other things.

How they operate:

Venture capitalists raise funds from external institutions with a mandate to put those funds in relatively high-risk, high-return investments. The life of a venture capital fund is usually 10 years, meaning that they have 10 years to find investments, invest in a new venture, exit from the investment and return the capital and profits to the institutions that provided the initial capital for the fund.

Venture capital partnerships take a percentage of the profits and a management fee for their services. Because of the timeframes under which they operate and the returns they are seeking, venture capitalists typically look to invest in companies that have the potential to get really big, really fast.

What they look for:

1. Value creation

Above and beyond everything else, they want to know that the enterprise they are investing in has a realistic chance of being worth substantially more in five years time than when they invest in it. VCs and angels characteristically invest in technology related businesses which can generate the returns they seek.

They recognise that value within a technology business comes from one of three things:

  1. Strong cash flow,
  2. Patented technology
  3. The development of a very large user base.

A business that has more than one of these three elements will be worth even more. Therefore, if you are preparing a business plan to attract venture capital investment, you would be advised to focus on how you plan to create significant value through these three mechanisms: cash flow, patented technology and/or a large user base.

2. Exit options

Venture capitalists and angels need to know that there is some way they can liquidate their investment in approximately five years time. The two most valuable ways to exit an investment are a listing on the stock exchange or the sale of the company, usually to a larger corporation. If you want to make VCs and angels interested in a business, you need to allude to the likelihood of a valuable exit in approximately five years from the time they invest. You cannot be explicit about the exit in the business plan, but you do need to be aware of this and make passing reference to exit possibilities.

3. Technology versus people

The preference for all VCs is to invest in a business with world-class technology managed by world-class people. But if they can’t have both, different VC firms will have different preferences. Some prefer to invest in strong people, believing they will figure out a good product over time; others opt for investing in strong technology, believing they can hire good people to help manage the business.

It is important for an entrepreneur to find out the investment preferences of a VC and to emphasise the right things in the business plan. The way to find out what these are is to look at the VC firm’s portfolio of investments and how those were managed after they first invested in them. Were new people quickly brought on board or was the entrepreneurial team left alone to figure out a product over time?

Banks

Banks are unlikely to finance a start-up or very young firm without collateral due to the high risk involved. They normally prefer to provide expansion capital for a business that has a healthy track record. That being said, banks do provide credit cards, overdrafts and home loan advances which can give you access to finance. Before you apply for any type of funding from banks, make sure you have a good credit history and record. You will also need strong financials that are consistent with your credit history, a verifiable income and profit, and sufficient assets to use as collateral.

Some of the criteria banks use when evaluating a business plan include a comprehensive breakdown of what needs to be financed, the entrepreneur’s own contribution, evidence that the entrepreneur has done extensive research, the barriers to entry and the target market.

How they operate:

If a bank does get involved with a start-up business, they seek enterprises that adopt a tried and tested approach to doing business, such as a franchise. Banks may however be willing to fund certain assets for a start-up business, such as plant and machinery, and they will also be willing to provide capital to a small business that wants to grow.

When developing a business plan for a bank, the three most important things to focus on are:

1. Risk mitigation

Bankers granting a loan to any organisation want to know that they are minimising their risk. They are not looking for the hefty returns demanded by VCs, but they are looking for assurance that the loan they grant will be paid back with the requisite interest. They also seek to make loans where they will have an opportunity to recover the value of the loan with the sale of assets or surety if the company does fail.

2. Cash flow

For a loan to be repaid, a business needs to generate cash flow. Bankers will therefore pay a great deal of attention to the cash flow forecasts of a business. They will ask themselves these questions:

  • Are the assumptions underlying this forecast reasonable?
  • What is the probability of this forecast coming true?
  • What is the worst-case scenario?

3. Familiarity, understandability and verifiability

To feel comfortable providing a loan to a new business, a banker has to recognise and understand the proposed operation of the new business. The more radical or disruptive your ideas, the less likely they are to look favourably on the venture. In a business plan for loan funding use recognisable examples and familiar language to explain what you are doing.

Bankers also like things that can be verified, such as reference to a commitment for a long-term customer contract – if they can see a signed copy of the contract and corroborate it with the customer, all the better for the entrepreneur seeking the capital.

What they look for:

1. Character

Personal character is important. The bank’s experience with you is critical. The judgement of the character of an individual is based on past performance. Personal and business credit histories will be reviewed.

2. Capacity

This is figured on the amount of debt load your business can support. The debt-to-net-worth (debt/net worth) ratio is often used to justify a credit decision. A highly leveraged business with a high debt/net worth ratio is perceived as less creditworthy than a company with low leverage.

Your business plan can make a difference. Suppose it shows that the loan will increase earnings and lead to a swift reduction in the debt/net worth ratio. Your chances of a positive answer would increase. Keep in mind that a good banker is the ultimate realist. Don’t try to snow your banker with numbers.

3. Conditions

Economic conditions have a profound effect on credit decisions. If the bank is persuaded that a depression is coming, it won’t extend credit easily.

4. Collateral

Collateral is a secondary source of loan repayment. They want the loan repaid from operating profits and inventory so you become a bigger, better borrower and depositor. But just in case things go sour, a bit of collateral makes your banker sleep better at night.

5. Credibility

Do you know your business? Can you be counted on to be level-headed? How credible are your plans? A business plan helps you answer the banker’s questions without hesitation, sending your credibility rating soaring.

6. Contingency plan

A contingency plan is a useful financing tool. Bankers like to see that you look ahead. A contingency plan is a short worst-case business plan that examines the options that would be open to the business and how those options would be treated. Decisions made in panic are poor decisions.

Private Equity

Private equity is the umbrella term for a broad range of funds that pool investors’ money together to increase their buying power. Unlike most mutual funds, in which fund shares trade on active public securities exchanges, private equity funds attract investors who are willing to hold shares in privately held, non-traded funds (hence the term private equity).

If you choose to go the private equity route, you have to be prepared for the private investor to become a partner or direct owner of your business. Private equity capital is provided to companies for the development of new products or technologies, strengthening the capital base or for acquisitions.

How they operate:

Equity financing is a method of financing in which a company issues shares of its stock and receives money in return. Depending on how you raise equity capital, you may relinquish anywhere from 25 to 75% of the business.

What they look for:

The approval rate for start-ups is fairly low. Investors usually look for business plans that are well thought through and realistic, as well as the contribution an entrepreneur has made to the business from their own money. If a business cannot afford the repayments for the finance, their application will be rejected. Other reasons include a poor credit history, lack of experience in the specialised field and unrealistic financial projections.

What’s most important for business owners to know about private equity investors is that they are financial investors. Unlike corporations that might buy all or part of a business for strategic operating advantages, financial investors make their decisions based solely upon their projected return on invested money. They may be sensitive to a founder’s wishes, but not sentimental in negotiating final deal terms.

Angel Investors

Angel investors are wealthy individuals who invest their own money into start-ups. Angels come in two varieties, those you know and those you don’t know. Unlike venture capitalists and bankers, many angels are not motivated only by profit.

When seeking angel investors, look to your networks and the people you know. Your network includes professionals like doctors, dentists, lawyers and accountants; business associates who are people you come in contact with during the normal course of your business day.

How they operate:

Angels vary quite significantly, but they are usually willing to accept risk and demand little or no control in return for owning a piece of a business they consider to be valuable some day. There are two categories of angel investors: affiliated and non-affiliated. An affiliated angel is some who has some sort of connection to you or your business. It makes sense to start your investor search by seeking an affiliated angel since they will already be familiar with you or your business.

To look for non-affiliated angels, try these proven methods:

  • Advertising
  • Business brokers
  • Telemarketing
  • Networking
  • Intermediaries (Firms that find angels for entrepreneurial companies.)

Angels tend to find most of their investment opportunities through friends and business associates, so whatever method you use to search for angels, it’s also important to spread the word. Tell your advisors and people you meet at networking events, or anyone who could be a good source of referrals.

What they look for:

Here’s what you need to know to increase your chances of securing angel funding:

  • Not only tech companies get funding, and not all tech companies do either – most entrepreneurs tend to focus on technology, but in truth angels simply look for high-growth businesses in any industry.
  • Get your elevator pitch right – one way of gauging this is to try and fit it into a tweet (140 characters). Make it understandable (would anyone re-tweet it?); many angels do not know that much about the industry they invest in.
  • Avoid targeting advertising as your primary revenue model. At best, advertising must be an additional income.
  • Be selective about your management team – if you’re a technology company, you need technologists as founders. Having skills in-house is preferable to engaging external consultants at market-related rates.
  • Be flexible and approachable – many investors want to be hands-on. If this means relocating to Cape Town to invest in a better relationship, you may have to suck it up.
  • It’s not just about ‘idea meets money’ – you need to form a genuine relationship and regard the investor as a team member. Investors often place more faith in the individual than the idea (although the idea is crucially important); they may back someone through a few failures if they believe in them.
  • Don’t expect unrealistic amounts – look within the range of R1 million to R10 million. Anything less than that and investors will consider the barrier to entry too low. Anything higher and you may need a VC.
  • The business model must accommodate a viable revenue projection for the angel – angels target a return of roughly 10 times their investment within five years, because of the high likelihood of failure (perhaps one in 10 succeeds). It’s an aggressive investment path – ideas must be able to get to prototype quickly and have high growth potential.
  • Don’t hide your ideas until they’re perfect. Act quickly.
  • Don’t annoy investors with unnecessary non-disclosure agreements. Unless something is absolutely unique, like a formula or some other intellectual property, don’t bother. Most investors see many different start-ups in a day, and forcing them to do too much leaves a bad impression. Don’t leave out ideas that are crucial to the venture’s success either, for fear of it being copied. That is prohibitive to getting funding.

Family and Friends

Many businesses obtain funding from more than one source. The most popular source after self-financing is friends and family. The people you have relationships with know what your strengths are, so it is a little easier to ask for help than approaching a bank. However, one thing to keep in mind is when you bring money into a personal relationship, it can harm the relationship if not handled properly. Specifically if the business fails, the issue of paying the money back can be a problem.

The first step in getting financing from friends or family is finding the right person to borrow money from. Once you determine who this is, approach the person initially in an informal situation. Tell them a little about your business, and if they show interest requesting more information set up a more professional meeting with them. You need to present your business plan to them and get the other person as excited as you are about the possibilities of your business.

You must be prepared to accept rejection gracefully, don’t put emotional pressure on the person. If they agree to contribute to your business, you must state how much money you need, what you’ll use it for and how you’ll pay it back. Then you need to draw up the legal papers, which is an agreement stating that the person will put the money into the business. The agreement should also contain the terms of the loan – including what the role of the investor will be in your company.

How to approach friends and family:

Friends and family remain the best shot that many entrepreneurs have to raise outside money to launch a business, here are five tips for approaching friends and family properly.

1. Choose a strategy

Do you want to solicit large chunks of money from a few investors, or small amounts from many?

There’s less pressure associated with small sums.

You’re less likely to ruin a relationship over R100. Many fundraisers target a few dozen people for sums between R400 and R2000 apiece. But typically only 10% to 20% percent people asked will contribute. So if you want to raise, say, R20 000 at R400 per backer, you’ll need to woo 50 people. This means reaching out to 250 to 500 people. Contacting a smaller, more targeted group for larger sums may require more gumption and planning upfront, it could be easier for the time-strapped.

2. Choose an investment type

When you accept money from others, strings will be attached, no matter how you structure the transaction. Consider whether you want to accept and pay back loans, have your friends and family own an equity stake, or offer up a token of thanks e.g. some amount of free access to your product or service in exchange for a gift.

If you take on investors, you may have to give up a portion of your company, and perhaps make one or more board members. Even friends and family will want a return, which can mean eventually selling the company, buying back shares or paying dividends. Loans have to be paid back on schedule, which can have an impact on cash flow and profitability. If you go the micro-funding route, you could be juggling 50 of them.

Even gifts aren’t free of strings. If you do accept them, thank the giver profusely in writing and acknowledge that the money is a gift rather than an investment or promissory note.

3. Write down your pitch

Unless your friends and family are professional investors, they probably don’t want to read a 50-page business plan. More likely, they’ll prefer to sit down with you over coffee and hear you explain your idea. To avoid being too informal, draw up a five to ten page document that sums up what you want to do, how you’ll do it and what you’ll apply the money toward. Such a summary ensures you’ve made important disclosures, such as the key challenges, risks and competition the business faces, and that your backers understand what their money is going toward.

4. Keep your documents and communications business-like

When you’re dealing with people you know well, it’s easy to want to keep agreements informal out of concern that official documents might make things feel less friendly. But don’t be too casual.

5. Manage expectations

Another upside of bringing in friends and family is that they are typically more patient than professional investors. It’s a good idea to send a monthly email update to your backers, even if they’ve given money as a gift. Be honest about what’s going well and what could be better. You might want to raise more money later, and it can be easier if your backers have been able to watch your progress.

If things aren’t going well, friends who have a stake in your success are more likely than others to provide the advice, contacts or referrals you need to turn things around.

Entrepreneur
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