The four most common questions I am asked by entrepreneurs seeking to grow their businesses are:
- What do I need to do to get ready for external financing?
- How do I persuade the investor my business is viable?
- How much should I ask for initially?
- When should I ask for more?
The answers to all of these are interrelated, and I will answer each in turn.
Today I want to talk about What do I need to do to get ready for external financing?
There are two important things to do when asking for an external equity investment. First, you need to look at the opportunity from the perspective of a potential investor to see if investing makes sense. Second, you need to consider the consequences of having a long-term investor as a partner. To look at the deal from the point of view of the investor you need to ask if they are going to make an adequate return on their investment. This requires you to persuade them that they can make a return of between 25 – 35% per annum.
Over six years, a $100,000 investment would require a return of about $380,000 (note that the average investment period for an initial investor is five – seven years). You need to show them that such a return is likely, and that there are potential exit strategies (such as an IPO or acquisition by a third part) that will realize this return. Many great opportunities fail to raise money, because there is no viable exit strategy for the investor. This is why thinking about the opportunity from the perspective of the investor is so important.
Justifying the amount the investor will receive at exit
The money the investor will receive is based on the estimated value of the business at the time, multiplied by the percentage of equity the investor owns. While the percentage of equity has other implications, which we shall discuss subsequently, it is a critical component in the investment decision.
For example, if you can justify a business valuation in the future, based on a multiplier of future profit or revenue, then it is relatively simple to calculate how much equity the investor should have. Typically, a multiplier might be one times revenue or 10 times profit (multiplier can be calculated based on industry standard multipliers on public exchanges). A company with revenue of $1.9 million in six years could be valued at $1.9 million. Using our calculation above, that the investor would require $380,000, would mean that the investor needs 20% of the equity.
Identifying the exit strategy
In Canada, most successful exits are based on the acquisition of the business by a third-party, that believes they can manage the business for greater growth or profitability, whether directly, or by integrating it with their other business. The identification of potential third-party acquirers is thus important for the entrepreneur raising capital. It both helps the investor see a potential exit strategy, and can increase the value of the business by creating a bidding war between potential acquirers. Acquirers are likely to be interested if:
- The business is large or strategic enough to impact their business
- They see a defensive opportunity that reduces your ability to hurt them
- They see an offensive opportunity to leverage both companies existing resources
Embedding potential exit strategy into the business plan can be critical. For example, if a large company only makes acquisitions of companies with greater than $10 million revenues, obtaining this level of revenue is critical. This may require the company to purse a more aggressive sales strategy, which may involve attracting a higher level of initial equity. In addition, getting your business on the “radar screen” of a potential acquirer may be important.
In fact, many acquisitions are done by companies who initially collaborate with the smaller company, for example as a supplier or channel partner. Alternately, many acquisitions have been stimulated by an aggressive action by a small company that makes the potential acquirer take notice, for example by taking a strategic customer away from them. Importantly, the potential acquirer must be able to see how integrating your business with their own enhances shareholder value.
Reducing the investment risks
Investors are also concerned about the risks of failure and need to know there is a reasonable probability that the venture will not fail. Risks are viewed in three categories:
- Market risk, that customers will not want the product, or that competitor actions will inhibit your success
- Performance risk, that the technology does not work, or there are production or other operational issues
- Financial risk, that the company will run out of money, or require too much money to get the point where it can attract additional funds (revenue, debt, equity or from the government)
An entrepreneur seeking investment needs to show the potential investor that each of these risks have been identified and mitigated. We will discuss each in turn, in the next blog.
Andy is currently working at the Canadian Innovation Centre and pursuing a Ph.D. in the area of new venture creation at the University of Waterloo. In his spare time, he enjoys teaching technology entrepreneurship at UTM and the University of Waterloo.
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