Is equity financing right for your small business?

by Reed Richardson

 


Equity financing often poses something of a Catch-22 to a small business owner: To be able to grow your company exactly the way you want to, the fast injection of funding that venture capital firms or angel investors can provide offers obvious advantages. But in order to obtain this vital dose of financing, you must usually relinquish some say over how your company grows. As a result, striking just the right balance between gaining capital and ceding control can be tricky, but it can be done, even in today's economy. To do so, however, entrepreneurs must be armed with realistic expectations and market savvy as well as a clear vision of where they want to take their company and of the creative approach they will need to get there.

Know the customer (investor)

 

No matter the industry or profession, one common thread among most successful small businesses involves a profound understanding of their customers' motivations and turnoffs, likes and dislikes. That same customer-focused approach to selling your company's products or services should likewise be applied when you are selling your business to outsiders in order to raise cash. But beware, using the same tactics that once got you a bank loan won't necessarily work when it comes to equity investors.

"Venture capitalists look much more closely at the features of the product and the size of the market than do commercial banks," explains University of Michigan Business Professor LaRue Hosmer, in the online white paper "A Venture Capital Primer for Small Business." Why? Because VC firms and angel investors, unlike banks or other debt financiers, are seeking a return based on long-term capital, not interest income. "They invest only in firms they believe can rapidly increase sales and generate substantial profits. A common estimate is that they look for three to five times their investment in five or seven years," he writes. "Most venture capital firms are interested in investment projects requiring an investment of $250,000 to $1,500,000. Projects requiring under $250,000 are of limited interest because of the high cost of investigation and administration; however, some venture firms will consider smaller proposals, if the investment is intriguing enough."
(Hosmer's white paper, which is part of the SBA's Financial Management series, is posted in full online here: http://www.sba.gov/idc/groups/public/documents/sba_homepage/pub_fm5.pdf.)

When it comes to how much of a company stake equity investors will want, entrepreneurs must prepare themselves for the reality that there is no such thing as a free lunch. To get something, they must give something up. And that something usually involves a stake in their company's ownership. But just how large of a stake, Hosmer writes, "depends upon the amount of money provided, the success and worth of the business, and the anticipated investment return. It can range from perhaps 10 percent in the case of an established, profitable company to as much as 80 percent or 90 percent for beginning or financially troubled firms." Still, he points out that, contrary to some stereotypes, venture capital firms are rarely eager to gobble large majorities of companies. "They want the owner to have the incentive to keep building the business," he explains. "If additional financing is required to support business growth, the outsiders' stake may exceed 50 percent, but investors realize that small business owner/managers can lose their entrepreneurial zeal under those circumstances."

Know the product (your business)

 

For many entrepreneurs, ceding ownership represents a bitter pill to swallow, but one that they can ultimately accept. Giving up the ability to be their small business's primary day-to-day decision maker, however, is often a deal-breaker.

For Jorge Amorim, co-owner of Madison, New Jersey-based Divine Catering, it was just such a demand that soured his company's first equity investment deal two years ago. "He not only wanted a percentage of the company, he wanted an operational say," Amorim recalls. "That was something we weren't willing to do at that point and it still isn't." Amorim's reluctance to give up day-to-day managing responsibilities, he says, wasn't driven by ego, however. Instead, it stemmed from the fact that his potential equity investor-a former customer who, impressed with the company's services, approached him out of the blue with an offer-had no experience in the food service industry.

Still, Indiana business attorney Brian Powers, who also runs the blog http://Indianastartup.com, points out that such a power-sharing arrangement can work-it just depends upon the individual circumstances of the parties involved. "Investor control is not necessarily a bad thing, especially if you have a young business that will be gaining partners that have greater industry expertise and business connections than you do," he explains. But if a business owner can't take an emotionally detached look at his company's real long-term needs, he or she might be better served by bringing in a third party to help facilitate offers and find the best match. "That's what I often do," Powers explains. "I end up helping companies through the process of figuring out that what they're usually being offered is a pretty good tradeoff for the money."

Know the landscape (market)
What helps Powers assess what is or isn't a pretty good tradeoff is the fact that he's been on the other side of the table. "In 1998, I was part of a dot-com startup company that raised $1 million in capital through an equity round," he explains. "Back then, though, we got ridiculous valuations and didn't have to give up control to get it. Those days are long gone now." For a short primer on these valuations and their role in determining equity investment, check out Powers' blog: http://indianastartup.com/business-funding/raising-venture-capital/raising-venture-capital-how-much-should-you-give-up/.)

Indeed, today's venture capital and angel investment markets are a far cry from those heady Internet bubble days. Even when compared to two or three years ago, the equity markets have shrunk considerably, something that a savvy entrepreneur must take into account when trying to raise equity. In fact, according to the National Venture Capital Association (NVCA), VC investment fell by more than half-from $36.2 billion to $15.8 billion-between 2007 and 2009. And though the equity market's steep slide halted in the latter half of last year, NVCA dollar values for the first quarter of 2010 work out to an annualized pace of just $14.5 billion. This suggests that the equity-financing spigot could remain tightly capped for the rest of the year.

The angel investor market has experienced a similar pullback recently, according to Jeffery Sohl, director at the University of New Hampshire's Center for Venture Research, with the youngest of small businesses feeling the biggest pinch in funding. "Angel investors are committing less dollars resulting from lower valuations and a cautious approach to investing," he noted in a market analysis this past March. "This decrease in seed/start-up stage and first sequence investing is the unfortunate reality of a difficult economy."

Know the limits (and ways to get around them)
Divine Catering's Amorim, who restarted a venture capital search for his six-year-old company earlier this year, says he's seen this retreat in equity financing first-hand. "Things have dramatically changed from 2008," he says of the market he has encountered recently. "The risk tolerance of potential investors has dropped a lot since then." Nevertheless, he has forged ahead in pursuit of equity because he says his small, four-employee company faces a challenge plaguing countless other small businesses.

"Like a lot of others, our business has always been underfunded," he explains. But in this new parsimonious climate, he also realized that simply offering potential investors a 50% ownership stake in his company-while still withholding operational control-wouldn't generate sufficient capital to fuel his planned expansion. So, to get the money he wants, he laid out a new, more ambitious vision of his business to a small group of prospective investors and invited them instead to buy into that.

"Rather than just have them share in our private jet and house party catering business, I targeted a bar and restaurant in a well-to-do nearby town that could be purchased for $3.6 million," Amorim explains. "With the restaurant as part of the company, we could then have enough daily cash flow to turn the in-flight catering side into a 24/7 operation and expand it far beyond the local airports." And from the investor's perspective, he adds, the plan is advantageous because it adds a hard asset to the portfolio that can always be sold off if the company goes under.

"In the end, you have to make the best deal that you're comfortable with when it comes to equity investing," Amorim explains. "But as I told my business partner, it comes down to this: If we don't find a way to get the capital we need, we will ride out what we have now, but we will never grow."

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