Financing Strategies - Some Basic Rules for Entrepreneurs

Financing Strategies – Some Basic Rules

When launching a new venture it is important for the founders to understand how to finance the enterprise.  The founding entrepreneur’s principal responsibility in this process is to make sure that the correct financing strategies are in place and well focused.

The founders should make sure that the financing strategies employed meet, at minimum, the following eight criteria:

1.     Now is the appropriate time to seek the financing desired

2.     The financing being pursued is adequate to meet the needs of the company

3.     All the materials required to support the financing request are professional and completed to a high quality level

4.     You have assembled an experienced and competent management team that can deliver on the plan

5.     The right financial instruments are being used and conform to all necessary securities laws and regulations

6.     The right sources being approached

7.     The optimum capital structure is being put in place to sustain the company and allow for future capital raises if they are required

8.     The company must be able to afford the financing being sought

There are many financing options available to most new enterprises.  In fact, in our experience the range of available options is generally much broader than the focus of most early stage management teams.

Many entrepreneurs complain to us of their difficulty in obtaining the financing they desire.  We have often heard from entrepreneurs expressions of not only frustration in obtaining the financing they desire, but also doubt that sufficient capital is allocated by investors to early stage opportunities.  While we understand their frustration, we would like to point out that there is no shortage of available capital.  In fact, in our experience the shortage is actually one of good ideas, pointed at viable markets, with a sound plan on how to tap those market opportunities, and surrounded by talented management teams that can seize those opportunities and execute well.  Even when all of those funding criteria exist, we often encounter entrepreneurs that have unrealistic valuation expectations and are unwilling to surrender sufficient equity to attract the capital they require.  It seems many would prefer to own 100% of a failed enterprise than a smaller percentage of a very successful one,

Our regular conversations with both institutional and angel investors confirm these observations.  We are aware of over a score of investment funds that have liquidated in the last 12 months, returning capital to their limited partners due to a shortage of qualified, attractive investment opportunities.  We regularly speak with VC groups who tell us about their difficulty in finding attractive deals that meet their funding criteria.

Financing Rules for Entrepreneurs:

1. Get the Timing Right

Is now the right time to seek financing?  As in so many things in life, timing is all-important.  Is the first generation of the product or solution complete and market ready?  Is the product or solution market validated?  Have the first clients been obtained and are they enthusiastic supporters?  Is the company still in pre-revenue mode, or have you obtained some revenues, even if you are not yet cash flow positive?  Has the company built sufficient real valuation to support the financing being sought?  Do you have a sufficiently detailed and professional business plan and financing package to support the financing you seek?  Does your progress and achievement of milestones to date match the projections first described in the business plan?  Does the founding group have sufficient “skin in the game” or are you looking to have your investors absorb all or most of the risk?  We advise entrepreneurs to carefully evaluate the answers to all of the above questions before seeking financing.

In our experience, many entrepreneurs approach financing sources before they are truly prepared for either the conversations required with investors or lenders, or to properly employ the funds being sought to build the valuation of the enterprise at acceptable levels of risk to the investor or lender.  Alternatively, we also see entrepreneurial ventures wait too long to seek financing with the hope that they can bootstrap their way to success.  These entrepreneurs are sometimes victimized by the “hidden flaw” or simply too slow to launch to “break the pull of gravity” and fail to achieve “escape velocity.”  The need for financing suddenly becomes desperate and there is an insufficient fuse on the pending financial or cash flow crisis to allow time to complete a financing.  As a consequence the company fails.  Both of these scenarios are ones we have unfortunately seen promising entrepreneurial fall prey to many times.  Being careful to get the timing of your financing correct can help to assure not only the success of obtaining the financing on attractive terms to all parties but also help assure the success of the company.

2. Amount of Financing Sought is Adequate

We often find entrepreneurs significantly underestimate the amount of capital required to drive the enterprise to the next level.  This happens for a number of reasons including the following:

·     The financial projections in the business plan are often overly optimistic and assume that everything will go according to plan – which is seldom the case.  We generally encourage entrepreneurs to build three sets of financial projections – best case, worst case, and most likely scenario, along with documented assumptions supporting each scenario.  When determining the financing required we will generally advice using something between with worst case and most likely scenario with a contingency factor built on top of that requirement to deal with unidentified risks.

·     The entrepreneur is reluctant to “give away” so much of his company and therefore desires to finance the business with as little capital as possible.  If the initial capital sought proves insufficient to reach “escape velocity,” it is often much more difficult to obtain subsequent financing on attractive terms.  This often results in a “down round” of financing, dilution of original investors, and ill feelings and unrest among the early investors and founders.

·     The natural and innate optimism of entrepreneurs causes them to assume that everything will go according to plan.  This is seldom the case in the real world.  As we have already said, we commonly advise the addition of a contingency amount to the financing being sought to accommodate unforeseen risks.

·     We have heard many times from entrepreneurs that “I can always get more money, if I need it.”  In fact, if the initial capital obtained is insufficient, the likelihood that more will be available is significantly lower.  In our experience it is always less difficult to raise somewhat more financing than you think will likely be required in the initial raise, than to have to go back a second time to get more capital after missing the targets set initially.

·     Be realistic, but think BIG.  We often see entrepreneurs seeking to build a “nice family-size business” providing a comfortable living for the founders and company management team.  These plans are unlikely to attract any form of serious financing other than a small, personally guaranteed, and secured loan from a bank.  Investors want to see a business with significant upside potential, not just one likely to afford a comfortable living for the founders.  At the same time it is important to be realistic.  You will be held accountable for the performance and projections in your business plan.  You should have a high degree of confidence if the company’s ability to achieve these results.

3. The Package Supporting the Financing is Complete and of a High Quality

First impressions are very important when seeking financing from either investors or lenders.  If you make a poor first impression, you are unlikely to get a second chance with that source.  The materials supporting the financing request represent your enterprise to the prospective investor or lender.  If they are incomplete, lack sufficient detail, fail to answer the investors’ questions, inadequately explain the business and why it will be successful, fail to identify competition and explain what makes your company’s value propositions different, do not adequately explain your go-to-market plan, or identify risks and appropriate contingency and risk mitigation strategies; you are unlikely to get expressions of interest from either investors or lenders.  Entrepreneurial teams inexperienced in assembling a high quality package to support a financing request should seek professional assistance.  Once the package is assembled we strongly encourage it be reviewed and critiqued by experienced outside third parties prior to being provided to any prospective financing source.  This ensures that the package represents your opportunity well and has the best chance of success.  We also suggest that the presenting team be rehearsed and critiqued prior to the first presentations to ensure they are prepared to put your best foot forward in an effective manner.

4. The Team to Make It Happen is in Place

Experienced investors place great emphasis on the importance of an experienced and proven management team.  The presence on the team of the “been there, done that” crowd of proven management talent will go a long way to reassuring the investors that the enterprise has the best chance of success come what may.  Don’t leave holes in key positions in the organization chart to be filled later.  Let the prospective investors meet the management team and be sure to point out their prior record of success.  Recruit a strong advisory board and team of professional advisors to support the company from the beginning.

5. Use the Right Tools for the Job

Seek and take competent professional advice on building a capital plan for the business that not only meets the current needs but also allows for future financing if necessary to support growth.  There are many different forms of both debt and equity that can be used to finance an enterprise.  Additionally, there are many other forms of financing often ignored by entrepreneurs as well.  Among these other forms of financing are favorable terms from suppliers, customer deposits, proper management of accounts receivable and accounts payable, grants, NGOs, asset based financing, outsourcing and solution partnerships, distribution partnerships, and on and on.  We urge entrepreneurs to seek professional advice and broaden their horizons when building the capital plan for the business.  Likewise, it is very important to take guidance from competent advisors to make certain that all financing documents comply with all legal and regulatory requirements.  We have seen many instances where entrepreneurs have done early financing without competent advisors and as a consequence have used non-compliant documents or procedures in the financing.  This may make it virtually impossible or at least very difficult and expensive to correct those mistakes in order to seek or accept later financing for growth even if the enterprise is successful.

6. Go to the Right Sources for Funding

In our experience, many entrepreneurs waste a lot of time and effort in seeking financing from the wrong sources.  This failure takes many forms.  Often they seek funding from VCs when they are not yet ready to seek institutional capital.  If you have already been turned down by five or six venture capital groups, it is unlikely the seventh or eighth is going to say yes.  Do seek to understand why a request is turned down.  Address these observations in future approaches.  Understand what stage of maturity the company is in and match the funding source to the stage of maturity.  Are you in the founders round, a friends and family round, an angel investor round, or a VC or private equity raise.   Should you seek assistance from an investment-banking firm?  The sources you approach should be appropriate for the size of the raise being conducted, the company’s stage of maturity, and the nature of the business being financed.

We also urge entrepreneurs to remember that all money is not equal.  Some capital is just dollars, other capital comes from sources that bring strategic value or synergy.  The source may have relationships with the market you are targeting, experience in your field or a closely related field, relationships with other potential investors, or some other form of potential value to the enterprise.  Strategic dollars are always more valuable than just investor dollars.  Try to identify funding sources with an interest in your business or market sector, or other form of strategic value.  VCs who do not invest primarily in technology or healthcare opportunities are unlikely to be interested in a retail or manufacturing business opportunity.

7. Use the Optimum Capital Structure and Allow for Later Financing

We often see initial investors get “crushed” in later financing rounds due to poor structuring of initial financing rounds.  This happens with great frequency, not simply because incorrect valuations were used in the initial allocation of equity, but often because of a lack of sophistication and experience of both the founding entrepreneurial team and the early investors as well.  A company with prospects for significant growth seldom will almost always require additional capital after the initial financing round.  In fact, the more successful the company, the more likely it will require later financing for growth capital.  It is therefore unwise to fail to anticipate these later rounds when structuring the company’s capital base and establishing terms for the initial investors.  This is another area where competent professional advisors can be most helpful to the entrepreneurial team.

8. Live Within Your Means

Be certain that the company can afford the financing being sought.  Make certain that all debt and equity financing costs, both initial and carrying costs, are included in the financial forecasts, and then allow for contingencies.  Time and time again we have seen instances in our Turnaround Management engagements where the company did not account for all of its financing costs in its budgets or allow for appropriate contingency levels and performance shortfalls.

Entrepreneurs who follow the basic rules in this discussion are likely not only to be much more successful at obtaining financing on attractive terms to both the entrepreneur and the investor or lender, but also more likely to find their company a successful enterprise.

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