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6 Things You Need to Know About Raising Capital for a Small Business

06/23/2013 06:42 pm ET | Updated Aug 23, 2013

"Money makes the world go around, of that we can be sure," sang Alan Cummings in the popular stage play "Cabaret." Certainly, the half-million Americans starting new businesses in 2012 have reason to suspect the truth of those lyrics since raising capital, whether to fund a new technological marvel or open a franchised restaurant, is one of the most challenging aspects of starting a new business.

Unfortunately, the need for capital never ends. This means that understanding how to find and shake the "money tree" is critical. And before you begin your search, there are a number of crucial questions you must ask yourself - and answer.

Questions to Ask When Raising Business Capital


1. How Much Capital Do I Need?


Although many resources provide information on starting a business with no or little money in the bank, remember that if something sounds too good to be true, it probably is. Don't be misled by the popular literature - having little or no capital is a primary reason why businesses fail.

"Bootstrapping a business when you're not drawing a salary and depleting whatever savings you have is one of the most difficult things to do," says Toby Stuart, professor at the Haas School of Business at the University of California, Berkeley. Even an independent cell phone app developer has to eat until the application has been designed, programmed, and marketed before any revenues begin. If your startup business requires even minimal outlays for offices, equipment, or employees, the amount of capital needed before opening your doors for business is likely to be significant.

Being Realistic
Entrepreneurs are often wild-eyed optimists, an often necessary attitude to get their ventures off the ground. But instead of a unique product, record sales, and slow competitors they usually envision, the real world is quite different.

The truth is that no new business succeeds without a detailed and thorough business plan that recognizes where you are today, where you want to be tomorrow, what problems might arise, and how you are going to resolve them. The value of a business plan is that you are forced to think about your potential business critically, challenge your assumptions, and research when you're not sure of your facts. A complete plan identifies and quantifies the capital that is likely to be required to reach break-even and beyond. It is absolutely essential when soliciting investors.

While  planning is often tedious and time consuming, executing a plan means several things:

  • You will get a better understand of your market and the competitors you will face
  • You may avoid costly disastrous mistakes in the future
  • You will have a realistic view of the capital needed to start your business and keep it alive until it can stand on its own
Furthermore, bankers and potential investors generally evaluate entrepreneurs and the potential of their ability to deliver success on the quality and completeness of their business plan.

Asking for Enough Money
The most egregious, indefensible mistake an entrepreneur can make when seeking capital is asking for too little to have a chance at success. Lacking sufficient capital in the beginning is akin to starting a long journey with empty pockets, a broken-down vehicle, and a half-tank of gas; the odds that you will reach your destination are slim to none.

When calculating the capital you need, plan that everything will take twice as long and cost twice as much as you expect. Figure that your worst-case scenario will occur, not your best-case. Don't assume instant profitability, a common mistake of many first-time entrepreneurs according to the National Federation of Business. And remember, if you don't raise enough capital initially to cushion your company if sales are slow or emergencies occur, it will be nearly impossible to raise more money just to keep the business going.

According to Canadian banker and blogger Roger Downie, startup capital should, at a minimum, cover all plant, equipment, and leasehold costs - plus at least six months' worth of projected operating costs, including the owner's salary. John Reddish, a management consultant who specializes in helping companies achieve high growth, says, "After developing personal and business budgets that can sustain the company for the time you think it'll take to break even, add at least 50%." Like intelligence and good looks, it is virtually impossible to have too much money.

2. How Do I Raise New Capital?


The most common source of startup capital is the business owner him- or herself in the form of credit card advances, home equity loans, and loans from family members. Federal and state governments sponsor numerous subsidized loans and grants for startups through the Small Business Administration and its counterparts on the state level.

When these sources are exhausted or unavailable for some reason, entrepreneurs usually seek capital from private sources such as commercial and investment banks, groups established by private investors to exploit such opportunities, wealthy individuals, and venture capital funds. Their proposed investment is usually styled in the form of debt, equity, or a combination of each:

  • Debt. The most common form of capital used by startups is debt, and it is secured by the assets of the company including the possible personal guarantee of the owners. As time goes by, the company repays the principal with interest from cash flow. If the business fails, the lenders foreclose and liquidate the assets for repayment, possibly seeking any deficiency from the owners. Asset lenders are concerned with the market value of the assets, not the business enterprise, lending only a proportion of the asset's value to the company in order to ensure repayment. Lenders are not normally in the business of taking risks. While the interest rate on borrowed money may be high, using debt allows you to maintain 100% ownership.
  • Equity. When utilizing equity, investors become owners of the business with the entrepreneur, the amount of ownership held by each is dependent upon a negotiation, which in turn is based upon the funds invested and the agreed-upon value of the business (as it is at present, and as it may be in the future). Business valuation is an art, not a science; the conclusion is always subjective depending upon the perspective of the valuator. Entrepreneurs typically want as much money as possible for as little equity as acceptable; investors are the opposite, wanting as much equity as possible for as little money as possible. The final equity proportions and amount of money raised is generally a compromise based upon the eagerness of the investor to invest and the desperation of the entrepreneur looking for money.
Delaying capital infusions from non-affiliated third parties as long as possible (until you can prove the business concept and show revenues) is always the best approach. Investors typically require that entrepreneurs have "skin in the game" before being willing to invest their own money, and prefer you've made progress toward implementing your business plan as well.

3. What Is the Value of My Company?

The value of a company is important because it is the basis for determining the "cost" of the new capital when seeking equity additions to the capital structure. Simply explained, a company with a $1 million valuation and no debt seeking a new capital of $1 million would be worth $2 million after the investment. The old owners would own 50% of the new $2 million company (for their contribution of the old company with a $1 million value), while the new investors would also own 50% interest for their contribution of $1 million cash.

Generally, a valuation considers four questions:

  1. How much is the company worth today?
  2. How much could it be worth in the future?
  3. How long will it take to create the future value?
  4. What is the likelihood of achieving success?
There are a number of different methods used to value startup companies. Bill Payne, a prominent angel investor with the Angel Capital Association describes four popular methods to value pre-revenue companies, asserting that entrepreneurial projections are "too imprecise" and optimistic to be reliable. Professor Ian Giddy of New York University focuses on more traditional methods of corporate valuation, while a popular YouTube video provides business valuation 101 explanation. Prospective business owners seeking capital must understand the basic concepts of discounted cash flow and the use of market multiples before establishing or negotiating a value for their company.

Understanding how your company will be evaluated and being able to affect the valuation positively can enable you to get higher valuations and retain greater ownership of your company when the investment is funded.

4. Who Might Be Interested in Investing in My Company?


As the amount of funds needed increases, you will be required to access an increasingly sophisticated investor seeking maximum return for assuming the risk of a new venture. Family and friends are typically the first group sought by business owners seeking capital - they are less discriminating than professional investors, and are more likely to invest due to the relationship than the economics of the business proposal. On the other hand, family investors bring their own set of problems, including the possibility of strained relations if the investment fails.

In the December 2012 issue of Inc., Ilya Pozin identifies and discusses a variety of funding options, in addition to self-funding, business incubators, and government grants.

VCs and Angels Funding Are Rare
While entrepreneurial magazines and websites promote the availability of angel investors and venture capital (VC) firms for capital, very few startup firms interest either type of investors or can survive the rigorous screening process. As a consequence, according to the Kauffman Foundation director of Private Equity and former venture capitalist Diane Mulcahy, VC is the exception, not the norm, for startups. Historically, less than 1% of U.S. companies have raised capital from VCs.

Women Business Owners Face Additional Difficulties
Women generally face more difficulties than men raising startup capital because, according to research by The Clayman Institute for Gender Research at Stanford University, they generally lack contacts within the "old boys' network" of funding sources. Furthermore, many professional investors have less confidence in women than men to penetrate their intended markets.

Internet sites such as WomanOwned.com, established in 1997, provide insights about fundraising, business management, and network assistance to more than 3.5 million women business owners around the world.

Crowdfunding May Be Considered
A new funding mechanism known as "crowdfunding" was created in the Jumpstart Our Business Startups Act of 2012 (JOBS), allowing small companies to raise up $1 million from individuals over the Internet with annual income of less than $100,000 through a simplified registration procedure and limited financial information.

While the bill has attracted powerful critics worried about increased fraudulent transactions, most observers believe the Act will provide needed access to new funds for startup companies. Sites such as Kickstarter and gofundme are allowing entrepreneurs to reach new money sources effectively and inexpensively.

5. What Are My Legal Responsibilities to Potential Investors?


Generally, business owners seeking funds from individual investors are required to provide forms and specific factual information in understandable language to potential investors so that they have the ability to evaluate the investment and determine whether it is right for them. Offerings and continued legal obligations of companies to their investor owner are regulated through the US Securities Act of 1933 and the Securities Exchange Act of 1934.

While JOBS is intended to simplify the procedures, making it easier for small firms to access the equity markets, compliance with the relevant regulations is required. Failure to do so subjects the issuers of securities to punitive civil and criminal acts. Seeking and paying for competent legal advice when soliciting, negotiating, or contracting with investors or lenders is mandatory for prudent business owners. While an attorney may not secure advantages for you on the upside, a lawyer's value in eliminating the possibilities of fraud charges, confusion about the agreements reached, or avoiding future legal problems is considerable.

6. How Do I Negotiate a Win-Win Agreement?


A funding event, whether for a startup or an ongoing operation, involves two parties: the investor and the company. In some cases, there is a single investor; in others, multiple investors. In the latter case, such as a crowdfunding event, the investors participate as a unit, each sharing a proportion of the same investment. In some cases, funding is take-it-or-leave-it; in others, there is intense negotiation. In each case, the parties strive to reach an agreement that accomplishes their respective goals.

Negotiations between investors and business owners involve, at minimum, the following factors:

  • The Amount of Capital Invested. Funding may be a single amount or a combination of investments over a defined period.
  • The Timing of the Investment. A specific sum is invested initially with future investments on specific future dates or when certain contingencies have been met.
  • The Return on Investment. In debt, return, or from the company's perspective, "cost" may be expressed as interest with specific payment periods and principal amortization. In equity, return is the proportionate share of future earnings directed to the investor.
  • The Timing of the Return to the Investor. Prospective payments in the future will be discounted to reflect the investor's opportunity costs and the risk-free return which he would have otherwise earned by forgoing the investment.
  • The Certainty of the Return. Since the return on capital will be in the future, investors are naturally concerned about the likelihood the projected results becoming reality. This "risk" increase is directly proportional to the period between investment and projected return, the size of the return relative to the investment, and the reliability of the underlying financial and operating assumptions.
  • Control. Who makes decisions when things don't go as planned? Investors usually require certain protections to minimize losses or to maximize gains when possible, including majority ownership of the company in the event of certain events. Business owners generally resist direct intervention into company operations, viewing it as a challenge to their authority and capabilities.
Negotiation is a skill that can be learned and practiced. However, learning at the table across from a seasoned professional is usually expensive. Seek advice and assistance before you make an agreement you will regret.

Final Thoughts

Many financing professionals claim that the rigorous, stressful process of raising capital for a new venture ensures that only the best companies (i.e., those most like to succeed) receive funding. Persistence - the willingness to learn from rejection without losing enthusiasm - is critical. Every idea, every company can be analyzed and deconstructed to the point it is unworkable. Jay Turo, founder of the advisory and investment banking firm Growthink, properly advises entrepreneurs to "be irrational," and appeal emotionally rather than intellectually to potential investors.

What other advice can you suggest to those who seek to raise money for a small business?

Michael Lewis is a former business executive and entrepreneur. He writes about business funding, money management, and technology on the popular financial blog, Money Crashers.