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2013

VentureCapital_Body.jpgby Jen Hickey.

 

Before taking on venture capital, entrepreneurs must ask themselves a fundamental question – “Do you want to be rich or be king?” As Harvard Business School Professor Noam Wasserman explains, it’s difficult for founders to maintain control over their businesses once they take on outside investors. However, without them, such businesses like Twitter and Facebook would likely have never have taken off. For those entrepreneurs who have developed a product with a large untapped market and a potential for rapid, high growth, venture capital (VC) funding makes sense if you’re willing to give up some control and most likely sell your business at the end of the investment period, or fund life-cycle (i.e. when the fund becomes due). However, if you would like to build a generational business, an angel investor may offer more favorable terms that will allow you to receive some equity while maintaining a degree of control.

 

Looking for that big return

“A VC firm does not invest in a business,” explains investment banker Jeff Koons of San Francisco-based Vista Point Advisors. Instead, it invests in a company that will sell for a lot more than it’s worth at the time of the initial investment. And such firms are looking for a big return (up to 20 times the initial investment) in a relatively short amount of time (3 to 10 years, depending on the fund life-cycle). “If your business is growing just 20 to 30 percent per year, VC funding is not for you,” notes Koons. Focusing primarily on the tech sector, Vista Point acts as a broker to bootstrapped entrepreneurs entering the VC world for the first time. “We help them think through the process from valuation to exit,” notes Koons.

 

Defending your interests 

Vista Point vets various VC firms for the best valuation and possible outcome for the entrepreneur. Unlike others in their field, Vista Point only works on the “sell side,” meaning their sole clients are entrepreneurs. They do not work with VC firms on other deals. “VC firms sometimes look for a break in the negotiations on these smaller deals for the promise of future work for the investment bank on more lucrative deals down the road,” cautions Koons. So a good rule of thumb is to ask any investment brokers if they work on the “buy side,” with VC firms, as well.

 

Having sound advice makes all the difference when entering the complex world of equity financing. Joshua Mag, CEO of SquareHook, a content management system provider, consulted a former professor who is an operating partner at a large VC firm before taking on equity from an angel investor in June 2012. “Potential investors want to know what market you’re targeting and its size,” notes Mag. “They’re not going to invest in something that doesn’t produce a large return, so there needs to be a big potential market for your product.” The angel investment allowed Mag to quit his full-time job to focus exclusively on building his business, which included hiring a few employees and seeking development assistance. “My decision to take on capital was a choice of acceleration,” explains Mag. “Had I not taken on the capital, this would have been a slower task.”

 

Equity comes at a price

Mag gave up 20 percent of equity of his company in exchange for the angel investment; however, a VC investor typically wants at least 20 percent ownership in addition to a board seat and the ultimate sale or IPO of your company upon exit. Nevertheless, how much ownership an entrepreneur gives up, whether to a VC or angel investor, is largely determined by the amount of equity the entrepreneur needs, the valuation of the business, and whether it’s the first, second, or third round of investment.

 

Aaron Skonnard, CEO of Layton, Utah-based Pluralsight, grew his company’s online training platform for software developers organically for about a decade before taking $27.5 million in Series A funding in 2012. “We saw periodic interest over the years from investors,” notes Skonnard. “But we thought it was too risky to give up too much control in case we needed to change direction.” It was only when Skonnard and his partners felt they had a solid business model and were set to enter a high-growth mode that they decided to take on VC funding.

 

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“It wasn’t so much about the money as forging those strategic relationships,” Skonnard points out. “Once we decided, then it became a financial exercise –– how much do we take, how much do we want to sell, and who’s the right partner to go with.” Skonnard and his partners met with five or six VC firms several times before they decided on one they believed would add the most value to their business. “It was our comfort level with the people and personalities that drove our decision more than the financial metrics,” explains Skonnard. “Make sure you’re happy with the people that will be on your board of directors.”

 

Investors provide more than just cash

While the cash infusion helps grow your company, partnering with a VC firms also gives you access to new players in your industry, which in turn helps attract the top talent and increase your market presence. Pluralsight’s traditional model had been to work directly with content producers to build its online training library. But with the funding, it was able to finance the purchase of two online training companies, which doubled its content library in a matter of months. “The Series A really unlocked our ability to make those acquisitions,” Skonnard points out. “We would have never been able to consider that without such funding.”

 

Beyond their connections in financial and sector-specific industries, some VC investors have an entrepreneurial background as well. Brendan Anderson bought his first business in 1995 and has helped manage and invest in many more since then. In 2006, he co-founded Cleveland, Ohio-based Evolution Capital, which invests in $5- to $6-million companies that have at least $500,000 in free cash flow. “We are point-in-time investors looking for entrepreneurs/founders with a vision creating something compelling in the market,” explains Anderson. He and his partners then work with these entrepreneurs to implement the steps needed for growth.

 

These include getting the entepreneurs’ financials in order to develop a plan for growth, which in turn enables these businesses to attract the best people. Next is transparency, making sure the entrepreneur communicates his vision and shares day-to-day operational data with employees. Finally, holding the entrepreneur and employees accountable for tasks that will move their company forward. “Once these best practices are implemented, they’re happy with the results,” Anderson points out. “But the process of doing it is usually painful.”

 

“The founder/entrepreneur still owns a major piece of the business even after we invest,” Anderson points out. However, Evolution Capital typically controls the majority interest (more than 50%) and maintains the right to change management and control their exit (with a typical investment ranging from 3-7 years). “We want to build businesses that continue to grow long after our ownership,” he says.

 

Understanding terms, conditions, and valuation

If you’re considering taking on equity, it’s critical to understand the terms and conditions of any investment agreement. Whether the entrepreneur maintains some control is largely determined by how the deal is structured. Mag decided to go with an angel investor, who was looking for a longer investment with annual dividends rather than a large payout at the end of a VC fund life-cycle. “Taking on VC means you need to have an exit strategy: IPO, sell, or dividends,” notes Mag. “Most VCs want a full exit to collect on their return within a period that is reasonable.”

 

SBC newsletter logo.gifAnd that’s largely determined by when a business becomes part of the fund. “You want to be invested as soon as possible in the life of the fund,” explains Koons. “If there’s only two years left before the VC firm needs to return capital to their limited partners (i.e. investment occurs in year five of a seven year fund), a company could be sold for a loss or spun out even if it’s achieving its growth projections.” 

 

Typically, investors are looking for preferred terms that will position them better than other parties (e.g. paid first upon exit, right of first refusal, put option, liquidation preference). Pluralsight has a minority interest deal with their VC investment firm, which has allowed Skonnard and his partners to only give up two seats on their seven-seat board. “The founders still control the board and the ultimate direction of our strategy,” notes Skonnard. “While we have a very healthy relationship with our new board members, we didn’t want to give up too much control.” 

 

It’s also important to understand valuation, as you need to know what your company is worth in order to negotiate the best terms. “One way to valuate your business is to look at your competitors to see what they sold for upon exit,” explains Mag. There are a number of public sources and tools that list industry comparables. This will also help figure out how much equity you’ll need to put into your business to achieve your growth plans. “That investment defines what your business will be valued at,” explains Mag. “By taking on more than you need, your business is likely losing equity unnecessarily.”

 

Disclaimer: Since the details of your situation are unique, you should always seek the services of a qualified professional for advice specific to your business.

QAmitchellweiss_Body.jpgby Jen Hickey.

 

 

Business writer Jennifer Hickey recently spoke with author and educator Mitchell Weiss about his latest book Business Happens: A Practical Guide to Entrepreneurial Finance for Small Businesses & Private Practices. Weiss is an adjunct professor of finance at the University of Hartford and co-founder of the University’s Center for Personal Responsibility. He has also owned and operated commercial finance companies, providing financing to businesses of all sizes for over 30 years.

 

JH: What was the inspiration for this book and how did you come up with the structure?

MW: It’s written from two perspectives: From my experience of running businesses as well as that of someone who’s provided financing to businesses. I tried to thread my personal experience along with putting out the basics of how to run a business. Part one goes over all you should do/know before founding a business. Part two covers organizing and managing a business. Part three details how a business seeks financing and how to overcome financial adversity. At the end of each section, there’s a list of questions meant for the reader to synthesize that information and apply it to their own businesses. At the end, I include anecdotes of my 30 years running businesses.

 

 

JH: Discuss the importance of “chemistry” and “cookies” when choosing legal/financial advisors for your business.

MW: I use the example of when one of my partners and I were looking for a law firm. We compiled a list of possible firms based on recommendations from colleagues after researching them. We then began the interview process, visiting these firms a number of times to meet with partners. The firm we ultimately chose was well established and the only one that offered us food! While feeding us didn’t hurt, we decided to go with this firm because we felt the most comfortable with them. Of course, there are costs to consider. But, after several meetings, we felt they could guide us through complex matters with our best interests in mind. They earned our trust. You need to get a sense of the people you’re working with to determine that level of trust. We ultimately went with our gut, and we weren’t disappointed.

 

Another point this story brings up is ‘assignment of credibility.’ We’re pre-disposed to trusting someone a family member/friend/colleague trusts. Those referrals carry a lot of weight and can, as a result of expanding your network, help you find other people you’ll need for your business over time.

 

JH: What are the primary risks and responsibilities every entrepreneur must stay on top of when running a business? 

MW: Business owners are responsible to five constituencies: customers, suppliers, lenders, investors, and employees. If you don’t treat your customers properly, they won’t come back and, worse, may go on Yelp or some other social media site to criticize your business. If you don’t pay your suppliers on time, they’re going to shut you down or raise their prices, which will eat into your profits. If you don’t manage your finances properly, your lender may call the loan. If your business doesn’t perform as promised, you won’t get investment capital, including from family/friends. Finally, if you don’t compensate your employees fairly, they’re not going to stick around long, and when you have high turnover this affects all the rest of your constituencies.

 

All the risks come down to financial risks in the end, as they all affect the bottom line. First, there are ‘market risks’—a market change that you didn’t see coming or worse didn’t respond to it. There are ‘hazard risks,’ which can be mitigated with various insurance products. Finally, the lack of available credit is a serious financial risk when you go into business. Money was easy to get until 2007 and 2008, and then banks reigned in their lending practices. I advocate having more than one way out of the room. Do you have access to other forms of capital? Do you have assets you can sell off? Your business might be harmed without another way out.

 

JH: Explain the difference between a business plan and strategic plan and why it’s necessary to have both?

MW: A business plan is your foundational document: your idea, the concept, why it’s an opportunity. It maps out how you plan to get your business off the ground, who will be involved and how you plan to accomplish this. The business plan is then modified through the strategic plan, which analyzes your business’ strengths, weaknesses, opportunities, and threats, also known as SWOT analysis. Strengths/weaknesses are internal—company’s strong/weak points—and opportunities/threats are external factors that affect your business. A SWOT analysis should be conducted routinely. You need to stay on top of the market to make sure you’re not missing anything. Talk to your sales people. Are there pricing or quality control issues? You should always be sizing up your businesses against others in your industry.

 

JH: What is a cash conversion cycle and why is it important to track?

MW: A cash conversion cycle is an end-to-end evaluation—from production to collection. It helps you figure out how much cash you’ll need to float your business until you can collect on your receivables. As you do that, you’re examining three key areas of your business:

 

  • Inventory-to-sale conversion period: how long it’s taking to produce your product.
  • Sale-to-cash conversion period:  how long it takes to sell the product.
  • Purchase-to-payment conversion period: how long it takes to collect on the product once it’s sold.

 

It gives you a snapshot of so many areas of your business. You can see whether there’s been a slowdown in the product cycle or maybe you’re not collecting from customers as quickly as you should or paying your bills too quickly, which leads to a cash flow shortfall. Maybe too much cash is going toward operating costs or your products are underpriced. It forces you to look at all these different aspects of your business, which are also the same metrics a lender/investor will be evaluating if you seek outside financing.

 

QAmitchellweiss_NEW_PQ.jpgJH: You go into great detail about the ins/outs of taking on debt vs. equity. What should be considered by those seeking cash to grow their business?

MW: Whether you’re considering borrowing from a lender or seeking investor equity, all money has to have a way out. Because debt has a higher priority of payback, it comes at a lower cost than investment capital. Equity costs more because investors are taking on more risk. Suppliers, lenders, employees all get paid first. Because there’s a greater risk, investors want a bigger return, which also includes a percentage of your business. From an entrepreneurial standpoint, you want to borrow as much money as you can so you don’t have to dilute ownership in your company.

 

Lenders will be looking at the overall story arc of your business. That’s where the ‘5c’s of credit’ come into play—capital, capacity, collateral, conditions, and character. Earnings will be assessed to determine your company’s capacity to pay back the loan and collateral available in case you can’t. The condition of your company to weather any shocks or downturns will also be assessed. And because most business loans require a personal guarantee, lenders will not only be looking at your credit scores but also running a Lexis/Nexis search to find out if they can trust you to pay them back.

 

You should also consider the terms and conditions of the loan to make sure you can live with them. What happens if volume falls off? Will you still be able to make your monthly payments? If a security deposit or additional collateral is required, negotiate for a release once you’ve paid down the loan to a certain value. If there are certain guarantees put in place because of a limited operating history, negotiate to have your business reviewed once you’ve paid down the loan to a certain extent so those provisions can be modified or released.

 

JH: What are some of the pitfalls a business can encounter if there’s no clear organizational structure in place?

NM: It’s important to have the right people in the right positions and the appropriate responsibilities for the positions they’re in. You need to make sure the workload is properly distributed when you’re building up the business. I prefer more horizontal organizations, with working managers that have more than one or two people reporting to them. That’s how I ran my businesses. If the hierarchy is too steep, then you run the risk of having to reduce your staff if business drops off.  Such disruption causes instability and fear among your work force, which in turn impacts productivity and can lead to even more turnover. You want to manage your business tightly. It’s more stressful for workers to have too little work than too much. Hire when you need it. Not in advance.

 

You also should have good checks and balances to ensure there’s another set of eyes looking over important matters. This is called ‘segregation of responsibilities.’ While you need to have your people running checks on their own areas, you also need them to cross-check others. This prevents bad things from happening, including fraud. For example, when I was CEO/chairman, I couldn’t authorize payment on my expense reports; my CFO had to sign off, but not until after they’d been audited and approved by our accountant. Likewise, I had to sign off on my CFO’s expenses once audited and approved.

So let’s say you started or even want to start a business and need financing. Where do you get the capital need to start it? There are traditionally two ways to finance a business: Debt financing and equity financing (these days, there is also a third option, crowdfunding, but that is an article for a different day.)

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Debt financing is what it sounds like – you get a loan and take on debt that will need to be paid back. Equity financing is when you get an infusion of cash from an investor in exchange for a share of the business. If you have ever seen the television show Shark Tank, that is equity financing; you sell a percentage of your business for the money.

 

Click here to read more articles from small business expert Steve Strauss

 

One thing that both debt and equity financing have in common is that they make you a better businessperson. In order to get the loan, or induce that investor, you have to have a business plan that makes sense with numbers that are realistic. A good idea and a wild guess will not do. In both cases, lenders and investors want to see that you have a good understanding of your business.

 

The question then becomes, which option is better? The answer depends upon your business, situation and goals.

 

Here are the pros and cons to both debt and equity financing to help you decide which is right for your business.

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Debt Financing:

Some benefits of debt financing include:

 

  • No partners: While a bank or other lender will have a vested interest in your success, they do not become partners per se. If you like being the boss then debt financing is the way to go because you retain 100 percent ownership of your business.
  • Builds credit: Getting a loan builds your credit, and having strong credit is always good for your business.
  • Tax deductible: Interest on the debt is a business expense and tax deduction.

 

The downsides of debt financing are:

 

  • Personal guarantee: Most business loans (but certainly not all) ask you as the entrepreneur to guarantee the loan personally. This then subverts your corporate shield as your personal assets (i.e., home, car, and investments) will be at risk if the business fails.
  • You will be in debt: There is good debt and bad debt, and generally speaking, a loan to help you grow your business is good debt. However, if you can’t pay it back then it becomes bad debt.

 

For most entrepreneurs, the benefits of getting a loan usually far outweigh any negatives.

 

Equity Financing:

As mentioned, equity financing can seem like the perfect solution because you get the money and don’t have to pay it back. But of course, the analysis has to be deeper and more nuanced than that.

 

Aside from the cash infusion, another big benefit to getting an equity partner is that this will in fact be a partner – someone with a vested, financial interest in seeing you succeed. Angel investors therefore often help the entrepreneur in many other ways – with introductions, advice, feedback and so on.

 

But that same fact can also be a negative. As they say: The good news is that you will have a partner. The bad news is that you will have a partner. And investors and entrepreneurs don’t always see eye to eye, so there is always that too. Be prepared to spilt the pie (in many ways) if you seek equity investors.

 

Other factors on the positive side of the ledger include:

 

  • More flexible pay back: Investors will want to see a return on their investment, yes, but that won’t be in the same, rigid timeframe that a loan requires. And if things do unfortunately go south, your personal assets are not at risk and you won’t be on the hook for a loan repayment.
  • Intellectual capital: Angel investors are usually pretty sharp people who have been successful in business and want to stay in the game. Tapping that experience and expertise can be a real advantage.

 

Other negatives include:

 

  • Sharing profits. Just as you will have to repay a loan, so too will you need to split the profits with your equity investor.
  • Time consuming: it is usually a quicker process to get a loan than it is to find the right equity investor.

 

So, whether you decide that debt or equity is better for your business, it is good to know that you have options.

 

Have you recently financed your business using debt or equity financing? Share your story below.

 

About Steve Strauss

Steven D. Strauss is one of the world's leading experts on small business and is a lawyer, writer, and speaker. The senior small business columnist for USA Today, his Ask an Expert column is one of the most highly-syndicated business columns in the country. He is the best-selling author of 17 books, including his latest,The Small Business Bible, now out in a completely updated third edition. You can listen to his weekly podcast, Small Business Success, visit his new website TheSelfEmployed, and follow him on Twitter. ©Steven D. Strauss

http://www.smallbusinessonlinecommunity.bankofamerica.com/people/Steve%20Strauss/content

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