Raising capital for businesses is hard and often misunderstood. As a “recovering” investment banker, I have helped my clients raise 10-figures in capital over the past 15 years, and have witnessed many individuals who failed to present a compelling, fundable story about their businesses (and themselves).
In my unscientific but thorough poll of entrepreneurs, 99% rank raising capital amongst their five least favorite business activities. Hopefully, I can help make sense of the capital-raising process to make it more tolerable – and valuable – for you.
To start this three-part series on raising capital, I’ll focus on the key mistakes you must avoid to save time, money and energy while increasing your chances of success when raising money for your business.
Mistake #1: Putting all Your Eggs in One Basket
The very first capital raising mistake relates to not raising outside capital at all. Statistics show that the typical start-up business in the U.S. is self-funded from the entrepreneur’s own savings and supplemented with some personal credit card debt. However, part of balancing risks and rewards is using diversification.
It is important for you as an entrepreneur to show your commitment to your business by investing some of your own capital. This is a safeguard to ensure that you are incentivized to do everything you can to make the business successful. However, if you are putting every last dime into your business, all of your eggs will be in that one darn basket.
How to avoid this mistake:
- Don’t bet the farm on your business.
- If you don’t have enough money to live on and invest in your business, then: (I) wait until you have more money saved, (II) see if you can revise your budget or (III) consider taking outside capital.
A large percentage of businesses close because they don’t have enough money to survive the rocky first couple of years of business.
I have found that early-stage and new business owners underestimate the cost of starting and running the business virtually every time (usually by a factor of 3).
In each early stage business I have seen, entrepreneurs say their financial projections are conservative in terms of revenue and expenses (and then I roll my eyes). They also tend to claim they are raising more money than they need so they have a cushion. When I tell them that their projections, as with all entrepreneurs’ financial projections, are too aggressive, they lecture me about why they are the “exception to the rule.” Then, a year later, after revenue estimates fall short and expenses were greater than expected, they give me the reasons why they missed their projections.
There has yet to be an exception to this in my personal experience. Note: seasoned investors know this and it is why they always take a “haircut” to the projections; they assume that they are overstated on the revenue line and/or understated on the expense line when they evaluate investments.
Another issue arises when you don’t raise enough capital upfront and you start to run out of money. It is much more difficult—often impossible—to secure capital to stay afloat when things aren’t going so well.
How to avoid this mistake:
- Do yourself a favor when you do your projections: Revise them so the amount of money you actually need is three times the amount you originally planned. If you think you need $10,000, you really need $30,000. If you think you need $1 million, you probably need around $3 million.
Mistake #3: Not Understanding Valuation
When you raise money for your business, you are usually dealing with one of two types of capital: equity, where you give up an ownership stake in your business, or debt, where you can take on an obligation for your business that you agree to pay back instead of giving up ownership.
There are hybrid scenarios that incorporate both equity and debt (as well as options and warrants), but at a basic level, you need to at least understand equity and debt. If you raise equity, you end up setting a value for your business, which is based on the stage of your business, the milestones you have reached and the ultimate potential of your business.
However, many entrepreneurs don’t understand valuation. Imagine that your business is symbolized initially by a small pie. You have 100% of the pie and then you give up a slice (or percentage) of that pie in exchange for equity capital. The hope is that in the future, your business becomes a huge pie, so that even though other people have pieces of the pie, your piece is bigger than when you owned 100% of the small pie (i.e. your stake is worth more in terms of absolute dollars).
Often, entrepreneurs don’t understand how the pie works. They will say that they have a business idea and that they need to raise $200,000. Then arbitrarily, they will decide that they only want to give up 10% of the equity. However, that establishes a value for the business (and a big one!). If 10% of the pie is worth $200,000, then 100% of the pie (the whole pie) is worth $2 million! That $2 million number includes the $200,000 in cash the investor is giving you, so that means before you raise any money, you value your company at $1.8 million ($2 million minus $200,000).
Most established small businesses aren’t worth $1.8 million dollars, let alone a brand-new business.
Setting unrealistic valuations can increase the amount of time it takes for you to raise capital, prevent you from raising money altogether and create credibility issues for you as an entrepreneur. Even if you can find a fool to invest at your crazy valuation, beware: You may have to raise capital again in the future and having a silly upfront valuation can impede your ability to raise capital in the future (again, credibility issues). It can also damage the relationship with your investor who is now, in effect, your business partner.
How to avoid this mistake:
- Make sure you understand what you are implying in terms of valuation – if you need help, ask a professional.
- Think carefully about the pros and cons of a high valuation, even if you can get one.
- Consider an investment structure using debt that either doesn’t require you to set a business valuation or sets one in the future based on achieved metrics and benchmarks.
Mistake #4: Being Greedy
Let’s say there is a treasure chest of gold located several hundred miles away from your house. If you are the first to get to the treasure chest, you can claim it as yours. The problem is that you don’t have a car. You could walk or ride your bike, but by the time you got there, someone else may have claimed the gold. So, you ask a good friend if they can drive you to the gold and you will share some of it with them if you get there first.
In this analogy, the gold stands for the potential upside rewards of your business, and your friend with the car is the investor and investment capital, respectively, that you need to build your business and reach the treasure chest.
So, how much do you give your “friend” for driving you there? Now, many entrepreneurs take the stance, “well I came up with the idea,” and offer to give their friends a token amount, say 10%. However, the reality is that you can’t get to the gold in enough time to claim it without your friend and his car. So, what if you gave him 30%, 40% or even split it? There will still be enough value for it to be worth both of your whiles. True, the friend wouldn’t have known about the gold without you, but you can’t get there without the car.
Valuing a business is an art, not an exact science, and splitting hairs over percentage points is often missing the entire point!
How to avoid this mistake:
- Other than understanding valuation implications (from Mistake #3), don’t get too caught up in the percentages that you give up for raising equity capital. Capital is a necessary component of growing a business which is also a great deal of risk for the investor.
- Be fair and realize that if the opportunity is large enough, there will be enough to go around for everyone – if not, then you should probably rethink the opportunity
Be sure to check back for my next post on capital-raising mistakes to avoid.
Related Articles & Pages:
About Carol Roth
Carol Roth is the creator of the Future File ® legacy planning system, “recovering” investment banker, billion-dollar dealmaker, investor, entrepreneur, national media personality and author of the New York Times bestselling book, The Entrepreneur Equation. She is a judge on the Mark Burnett-produced technology competition show, America’s Greatest Makers and TV host and contributor, including
of Microsoft’s Office Small Business Academy. She is also an advisor to companies ranging from startups to major multi-national corporations and has an action figure made in her own likeness.
Bank of America, N.A. engages with Carol Roth to provide informational materials for your discussion or review purposes only. Carol Roth is a registered trademark, used pursuant to license. The third parties within articles are used under license from Carol Roth. Consult your financial, legal and accounting advisors, as neither Bank of America, its affiliates, nor their employees provide legal, accounting and tax advice.
Bank of America, N.A. Member FDIC. ©2017 Bank of America Corporation