Raising Capital – an overview
I am not an investment banker. Never been one. Never will be. This post is purely some reflections on raising capital from my own experience. Chatting to a number of people in “Start up” territory or in Management Buy Out territory, I have realised how a little bit of insight into capital raising can be very helpful.
1. Why raise capital?
Depending on your idea, your business and growth opportunities, having capital available to aggresively tackle these opportunities can be helpful.
Capital, however, isn’t free. And the more risky your idea, venture or opportunity, the more people are going to expect to get in return for giving you captial (google portfolio theory and securities valuation and learn about the theory).
So, by raising captial, you are either going to have to put up a share in your business in return or agree to repayment terms in the instance of raising debt.
Here is a great article on the different options
There is a strategic trade off here between:
- Bootstrapping: Funding the business yourself as far as possible. The more you can fund and demonstrate before going to investors, the less risky the venture and the “cheaper” the capital becomes. You retain more shareholding the longer you can bootstrap and show business performance
- Raising pure debt: This will come at a price and the riskier you are, the less likely this is going to be an option. You must have demonstrated something
- Convertible debt: this is agreed on pure debt terms. However, if you cannot pay back the debt, it is converted into equity
- Equity: you give away a share in your business in return for capital
Bootstrapping is the best way to protect your interest in the venture as you maintain full shareholding. However, this comes at a cost of not having capital to aggressively market or aggressively staff up, etc. Where first mover advantage is important, bootstrapping could open you up to competition and kill you business in the long term.
Raising debt requires a track record. And comes with clear obligations. If you cant pay back the debt, there are consequences. Although debt is cheaper than equity, you need to manage the risk up front and commit to repayment terms. This can be stressful and result in counter-intuitive business decisions to ensure you are in a position to pay back (from both a profit and liquidity perspective)
Equity means losing some of the shareholding in your business. Sometimes quite a big stake in earlier stages. However, if this capital ensures that the pie is bigger for everyone, then this isn’t a bad trade off (especially if aggressive growth is possible and a competitive advantage in the longer term). Equity is expensive. And giving away 50% of your business now means that there is less to give away later if you need to raise subsequent capital.
Just like strategy, the answer to your funding structure and desires is very dependent on your business model, how and when it will generate profit and if and when you would need subsequent growth capital. Look at the different scenarios and assess the pros and cons of each. Get real advice from people in the industry that can give you a view based on your business model and opportunity.
2. Who to raise capital from?
Well, this is a tough question for a number of reasons. But lets start with nirvana.
In my mind, the perfect funder would:
- Have the right mandate to invest in your business (type of business and stage at which you are looking to fund)
- Have experience or insight into your business model to bolster the business
- Have other businesses in their portfolio that can synergistically help your business from either a growth or risk perspective
- Have an investment view / horizon that suits your business model and growth path
- Have reasonable deal terms and don’t try to screw founders or managers. An investor with a win-win mindset given all of the above is always preferable to shrewd investors.
Some may think that “any money is good money when you don’t have any money” – but remember, this investor is going to take an interest in your business. They will sit on the Board. They will make decisions. They will put pressure. They will disagree. And then they will want to leave while other may not or vice versa!
A funder is like a boyfriend or girlfriend – you are committing to enter into a long term relationship (be it 3 or 15 years); in sickness and in health. And differences between the husband and wife form part of the sicknesses that develop! Choose wisely. Do your homework. Chat to other management teams in their portfolio if possible (often not due to confidentiality of the deal).
This is a two way interview process. If you have a good business model then you also have power. Interview funders as much as they interview you!
3. What is an MBO? What are “funding stages”?
Firstly, a Management Buy Out is a situation where the management team feels that they could unlock greater value from a different set of shareholders. This could happen when:
- A major shareholder or shareholders cannot provide sufficient capital to fund growth initiatives
- Another shareholder or shareholders could provide greater synergies to the business
- Founders with significant control are holding the business back
In this cae, the management team would approach other potential investors with a view to “buy out” current shareholders and take control of the business and future direction.
Funding stages is very market dependent. The mature US market has very clear stages of growth and investment. This YouTube clip explains this pretty well:
And this article:
This is very market and firm dependent. My sense is, ask. Often firms make exceptions.
From what I have seen:
Angel investment – a private individual that covers some or a lot of the start up costs of the business
Seed funding – same thing but from a capital investor; often a seed funder will help shape the idea
Venture capital – provides early stage funding for the venture. Sometime pre-revenue; sometime after revenue has been generated. High risk. Distinction between start up and first stage. Start up an idea. First stage may include a prototype.
Private equity – mostly post-revenue. Not necessarily profitable but a proven product has hit the market and initial take up is positive.
Firms are generally quite explicit in terms of their mandate and what business models they will or will not consider. Read their websites, talk to people. There are few hard and fast rules here and often firms will refer you to other firms if your concept is sound but doesn’t fit into their mandate.
4. The capital raising process
I am going to start here with what a typical investment bank process would look like for funding large transaction or large mergers and acquisitions. The small and medium sized business space is more fluid and informal but using the formal, large-scale framework as an anchor is helpful.
The philosophy behind this stage in the process is:
Give a potential investor enough information for them to guage whether they would be interested in the concept at all.
You don’t want to waste time going through detailed processes with a potential investor where your idea is not exciting to them or doesn't fit into their investment mandate. Give enough information to protect your IP and to allow them to identify conflict and / or gauge interest.
This is the Tinder stage of the process. Give them enough to swipe left or right – and yourself enough information to swipe left or right - without the risk of ending up buried in someones basement!
For a small and medium sized business, this step is seldom formal nor helpful. If you business is not well known, the potential funders will need more detail on your business model and potential upside.
This creates a challenge as you are going to have to give away valuable IP just to see if a party is interested.
This is obviously dangerous. However, if you business idea is truly valuable, it should be able to withstand the sharing of the idea. The world will inevitably find out when you launch or grow – make sure you have the competitive advantage or unique value proposition to withstand copying.
So, given all of that, thinking about your “Teaser” step is very important.
Some key question to consider in this phase:
- Are you going to approach a small number of select investors or are you going to shotgun approach anyone who will listen?
By approaching a small number, you can control the risk to some degree, and you can choose to target funds or investors that may have higher synergy potential.
- How can you quickly test the water to identify any conflicts of interest?
The higher the synergy potential, the higher the chances that they are already working on something similar to your idea or concept! NDA’s are generally a waste of paper. How can you give the headlines to explicitly test for conflict and then walk away if need be?
- How much is enough information at this stage to give a potential investor enough juice to decide whether to take things further or not?
Very business model dependent. My sense is, be ready to share everything if asked.
In smaller transactions in venture capital / seed stage, these are generally initial discussion face to face. An abridged business model document is heloful to hand over as a “Teaser”. However, make sure you have a more comprehensive document behind it that can be shared if you make it through the investors first “gate” and they want to take things forward.
The better your homework on the investors mandate, portfolio, modus operandi, etc, the better prepared you will be to manage risk and share helpful information.
EXPRESSION OF INTEREST
The second step is setting up the first date.
In large scale transactions, this is a formal step where interested parties respond to the Teaser with a Teaser of their own – “this is why I would be a good investment partner or buyer of your business”. The formal processes and confidentiality and sensitivity of large transactions warrants an expression of interest to be fairly detailed and deliberate
The learnings here for me in small and medium sized business is that you don’t really just want to hear a “Yeah, we are interested.” You are looking for a “We are interested because of x, y and z”. If an investor doesn’t give you that, ask for it.
“Mrs X, why do you and your team think that Bob’s Brilliant Buttons would make a good addition to your portfolio? And similarly, why would you make a good investment partner and member of our Board? What are you bringing to the table with your chequebook?”
These are important things to explore. They are looking for an investment and you are looking for a funder. The first date is a two way street. Be ready to interview them too.
Call it an IM. Call it a Business Plan. Call it whatever you want. Once you have received and shown interest in 1 to 5 potential investors, you are going to have to open the hood and kick the tyres. You will need a detailed business plan and financial model to base this on. Or historic financial results, commentary on performance and a solid motivation for growth projections of these results.
In my experience, an Information Memorandum (IM) should consist of 50% concept and risk considerations and 50% financials and commentary on financials.
You want to give a flavour for the concept and competitive advantage, the team, the strategy, etc.
But this must be converted into realistic, grounded financial assumptions and turned into inputs for sound financial model.
Investors need returns as much as they need a story. A great IM weaves a good story and then translates the story into an exciting financial plan of growth and returns.
My proposed IM or Business Plan structure includes:
1. Investment Highlights – concept, unique value proposition, growth, financial, team (1 to 2 pages, make it look sexy)
2. Executive Summary – it has all that is needed if this is all that is read (2 – 3 pages)
3. Concept and Unique Value Proposition – describe the business gap and how it is going to be filled, what does or will your business do? Why is this lucrative? What is the business problem you are solving? Whats in it for your customers and your suppliers?
4. The Market Opportunity – describe the size of the market, market dynamics, profit make up and pools. Show you understand the market value chain and the financial value chain. What market share can you target? Is this reasonable?
5. Parallels to other industries – where has this concept worked? Other geographies or countries in the same or similar shape? In other industries? These examples can be important in risk considerations. If it works in the US, why wouldn’t it work in the UK? If it works in clothing retail, how could it work in beverage retail?
6. Competitors – who are the direct and indirect competitors? How does your UVP form a competitive advantage? You don’t need to demonstrate that you can beat competitors, you need to demonstrate that you can acquire sufficient market share to be a viable, valuable business.
7. Phases of business growth – where everything up to now is backing up the “How big can we be?” question, this section gives consideration into “How are we going to get there?” This should provide context to how you have growth key assumptions and variables in your financials. Who are you hiring when? How many? Office space? Computers? Servers? All of these requirements and costs are variable depending on the size of your organisation.
8. Financial projections – Here are the numbers. Discuss the key variables underlying the model – refer back to earlier discussions in the IM if need be. Show data and parallels to give a sense of where you are being conservative and where you are being aggressive. Build your financial model to be able to run sensitivities on key inputs and drivers that are unknown. Present these sensitivities. Show that even with conservative assumptions (aggressive costs and conservative revenues) the business model still makes sense. Think about what investors want to see: time to profit, time to self funding, valuations at year 3, 5, 8 and 10 (depending on investment horizons). Learn how to model properly (Economist Guide to Business Modelling by Friend and Tennet) or get an expert to do it for you.
9. Exit strategies – where investors have discrete investment horizons (3 – 5 years or 5 – 7 years, etc) it can be helpful to give thought to how they can exit. Are you targeting an IPO? Would the size of the business at that point make it an exciting opportunity for acquisition by an industry player? Would it be an exciting investment opportunity for another financial investor with later-stage mandate? Being aligned on this and showing cognisance of a financial investors need to create liquidity and earn returns is helpful and a critical discussion up front
10. Synergies – where applicable, it is helpful to articulate or give airtime to potential synergies. Your financial projections would not rely on synergies where possible. However, discretely thinking these through and presenting them is, in a way, showing an investor the “cream on the top” for them as a unique funding partner. These synergies can be very valuable for both parties – either accelerating growth, lowering costs or eliminating costs all together
Throughout the IM, think to yourself “How is this information I am presenting providing context that links directly into the core drivers of the financial model and business valuation?”
The document and financial model go along with prototype demonstrations, business walk through, access to data (if the business is running) etc. Expect to spend some time going through the financial model and discussing key variables and assumptions; valuation methodology; etc.
Again, this is an interview process. What is the nature of the engagement like? Are the investors being very aggressive on time milestones? Are they being very aggressive in lowering your revenue projections to get a lower valuation (and hence a bigger stake for their funding input)?
Every step of the process is important input into how your long term working relationship could play out.
Once an investor has determined that they would be interested in investing in the venture, you will need to discuss deal terms. It is always helpful to have 2 or 3 parties in the process. This provides a market based comparitor. Also, indicating that there are multiple parties may also stop investors from putting in offer that are too “cheeky” as you have other options.
Important deal terms generally include:
- Investment amount
- Investment horizon (time to exit)
- Capital structure (shareholding required if equity; convertible debt terms; repayment terms; combinations of debt and equity; etc)
- Shareholder rights (blocking rights; voting rights; etc)
- Board representation (how many and who)