Over the past several years, we have watched hundreds of companies solicit angel and institutional financing in cities throughout the U.S. We have helped a hundred of them present their value proposition to the marketplace. During that time, the market responsiveness to those companies has shifted. We have seen too many companies spend valuable resources in search of interested investors, only to discover, many months and dollars later, that the current market didn’t see their value proposition as clearly as they did. Some of these companies deserved serious market consideration, while others approached funding sources with unproven technologies, idealistic management teams, or an immediate financial need that dissuaded financiers. Still others had small, profitable ventures that might have better invested their time in sales development than in investor marketing, including the service providers they paid along the way.
We recommend that companies undergo a four-part self-assessment process before spending money in search of private equity. (They can do so without spending a dime, or they can hire professionals to help them.) The companies most realistic and prepared for financing options know the answers to the following four questions. Do you?
How do financiers see our company?
Financiers of any kind, whether banks, angels, institutional investors or factoring firms, will expect certain documentation of “corporate readiness.” These items are included in a rather daunting list of about 50 due diligence requirements. Assembling and organizing this information is useful for any management team, whether or not it is seeking funding.
Observations: We have been surprised to encounter executives who could not state their profit margin or what their patent covered. Such companies are not ready to approach finance sources. We’ve also heard conflicting answers by various members of management teams. Not good. Many companies rely on the “atta boy” cheers of paid service providers who write and rewrite business plans, patent applications, and SEC documents, but are, themselves, not funding sources.
Whom does the market see as our competitors?
A company should NEVER say that it has no competitors. That sounds naïve. What companies and products does the market perceive to be competitive? While customers care about product or service superiority, financiers care about competitive profitability. To attract financing, a company should know whether it is able to deliver its value cheaper, faster, better, and more profitably than the other guys, and how it plans to preserve its competitive edge or be attractive enough to be acquired.
Observations: Particularly, but not only, in technical companies, we have seen entrepreneurs spend personal and investors’ funds to develop fine products before asking relevant commercial questions, like “will people buy it?” and “at what price?” and “what is our profit/loss above/below certain prices.” Business school case studies are littered with examples of superior products that did not sell because they were too expensive or ahead of their time and not marketed well enough to educate and then attract the customer base they needed to stay in business.
What is the cost of outside funding?
Financing options have different costs, based on risk to the financier. Debt based loans or investments are cheaper because of they are based on identified collateral or receivables. Equity based investment is more expensive because it relies on a company’s unproven potential. Investors who lost money in far more established companies are shying away from start-ups now, and are taking more time to scrutinize due diligence. This means that the better organized a company’s records are, the faster it can get a “yea” or a “nay,” and for any company, time saved is money earned if well spent elsewhere. Disorganized companies, or ones that choose to obfuscate unattractive financials or management history will definitely prolong the funding process and may doom it.
Observations: (1) It is a buyer’s not a seller’s market. We have seen companies turn down investors who asked for a larger piece of the company than the principals were willing to give or turned down a price lower than they were willing to accept. (2) Some management teams overvalue their company due to sentimental attachment. Others base valuation formulas on future earnings estimates that cynical buyers don’t believe, rather than current revenues and assets that are easier to defend. Step into the buyers’ shoes before engaging in negotiations. What’s obvious in the spread sheets and resumes and background checks? (3) Companies should carefully read the financing terms. We’ve seen companies brag about a term sheet until someone in their firm read it carefully and saw that it is contingent on achieving certain milestones that the company was hoping an investor would help pay them to achieve or sometimes a surreptitious service provider contract, masked as an investor. If one manager tends to be optimistic, make sure that others more cynical read the terms before signing. Taking too little to accomplish a required goal, while giving up a hefty percentage of the company if that goal is unmet is often shorthand for selling it at a deep discount.
What do investors want?
Investors are not philanthropists. They are interested in profit, sometimes in particular industries and sometimes in diversification. Since capital is scarcer than companies seeking it, it is the job of any company seeking funding to target the appropriate funding source and address this understandable self-interest. While the questions may vary, the gist is, “why should I invest my money with you instead of with the other companies clamoring for my attention? About twenty frequently asked questions (FAQs) should be anticipated by companies, and answered well. For example, “Who owns the intellectual property?“ “What are the terms for first and second round investors?” “What’s your burn rate?”
Observations: We have seen companies spend all of their initial investment on product development and wait for second round funding to assess the commercial prospects. This requires several “leaps of faith” by investors and bankers. Unless the company has a management with a track record of start-up brilliance in similar endeavors, this is often a death knell.
Seeking equity is not for the faint-hearted company. It requires more time and more money than companies often expect, often paid to service providers who earn money whether or not the company gets the funding it seeks. Knowing the answers to the four questions above will enable management to differentiate between realistic funding sources or funding finders and time wasters, and to allocate their own time to customer development, cost cutting, or financier wooing, as appropriate.