Get In Shape:
Before You Go Chasing Investors,
Take the Investment Fitness Test
By Mark W. Sheffert
August 1999
Raising capital for a small business can make entrepreneurs feel like they need the
endurance and speed of Mohammed Ali, the motivation of Michael Jordan, and the
training and preparation of Michelle Kwan. Now, if your athletic talents are more
attuned to playing bingo, bridge and "Old Maid", then this article may help you with
the training / preparation, but … you’re on your own to find endurance, speed, and
motivation!
When seeking financing, you will be talking to basically two types of investors.
The first is an individual investor, known as an "angel". Angels provide 95 percent of
private equity financing under $500,000 and are typically the best sources of financing
for small private companies. They are usually wealthy individuals who are former
executives or business owners with capital to invest. They tend to invest in industries
that are familiar to them and that are in their hometown or home state. Their
investment criteria and expected investment returns vary as widely as their motivations
for making investments. Angels are not easy to identify, so the best way to find one
that’s right for you is to network in your business community.
The second common source of funding is venture capital / institutional investors
with funds that pool money from many sources to invest in high-risk companies poised
for growth. They typically invest between $500,000 and $10 million, purchase equity
securities in public companies, take higher risks with the expectation of higher rewards,
and have a longer-term orientation. Although venture capital / institutional investors are
easier to find than angels, competition for venture capital is fierce.
Whatever type of investor you pursue, the process of raising capital is not an easy
task that can be accomplished in a short time. Here’s where your endurance, speed, and
motivation will be put to the test.
Now let’s get to the training / preparation. Before you approach any potential
investors to begin telling your story, take this "investment fitness test":
1. Do you have a winning business plan?
The most significant factor for a small company in getting capital is having a
good business plan because it is the primary vehicle for communicating your story
about the future state of the organization and how you plan to get there.
First, investors look for business plans that meet the investor’s established investment
criteria. Most professional institutional investors publish their investment criteria
in their marketing literature and on their websites. They usually specialize in certain
industries (technology, health care, and internet-related businesses are popular right now)
and in established companies with a track record of success and profits.
For example, Norwest Venture Partners states on their website
(www.norwestvp.com) that they invest in "emerging growth information technology
companies including enterprise software, communications systems, and communications
services". They even have a section on their website for entrepreneurs that explains how
to write a proposal to them and for what their venture capitalists are looking.
The investment criteria for angels, on the other hand, are more difficult to find.
Very few advertise in the yellow pages or have their own websites, unless they are
famous angels like Paul Allen, cofounder of Microsoft and owner of the Portland Trail
Blazers. His website (www.paulallen.com) describes his vision of creating a "wired
world" of home-based personal computers with access to information and entertainment
via the internet. He looks for "established companies with proven management talent, a
solid business plan, demonstrated performance, and innovative products or services that
can be part of the Wired World". Unless you fit into this category, you will need to
network in your business circles to find angels who have invested into companies and
industries like yours.
Investors also want to see business plans showing that the company is capable
of being a market leader with competitive advantages. The plan should detail your
business strategy, marketing plan, and competition. They will want to know about how
your product / service fits into the industry, what the current market trends are, what
makes your business different, and why your business will succeed. Also, explain your
method of distribution and if the product requires significant service support.
Angels often say that they don’t invest in businesses --- they invest in people.
Your business plan must demonstrate you have a well-rounded management team with
experience in key areas of the business to execute the plan.
Remember that your business plan is the way you communicate your future and
how that vision is going to be achieved. Spend a lot of time and effort on it.
2. Can you achieve $20-$25 million in sales, a 40-50% gross profit margin,
and a 10% net income in five years?
Your business plan should also include a detailed financial section with five-year
pro forma financial projections. Most investors will look for businesses that will achieve
at least $20-$25 million in revenues, a healthy gross profit margin of approximately
40-50% (depending on whether the company is a manufacturing or service business),
and a 10% net income in five years.
You may be able to survive with a 20-30% gross profit margin, but you won’t be
able to provide required returns to investors at those levels. I realize that it’s difficult for
manufacturing companies to achieve these higher gross profit margins, but investors will
take their money to where they can get the greatest return.
Performance at these high levels would allow the company to conduct an initial
public offering (IPO) if they are not already a public company. If you are already public,
this level of performance would be reflected in a premium stock price, which would
allow the investors to sell into the market or the company to grow through acquisitions
by leveraging its premium value.
3. Do you require less than a $10 million investment?
Most funds have limits on the amount they can invest ranging from $5 million to
$10 million, and very few angels have more than $10 million to invest. As a general rule
of thumb for private companies and micro- and small-cap public companies, investments
are no more than $10 million and, for the large amounts of $5 million or more, the
funds will usually be paid in a phased approach over two to five years based on
performance.
4. Have you identified an exit strategy to liquefy the investor’s position?
Investors also look for businesses that have an exit strategy so they can get their
return in two to five years, or for some more mature companies, investors will go out in
four to seven years. I’ve seen many offering memorandums that tell a great story about
how to make money for the investor, but err by not considering how the investor will
harvest their investment in five years.
Exit strategy options include: to have the investor sell out to management and/or
the owner, to sell the company to new owners / investors, to take the company public
with an IPO, or, if your business is already public, to have a secondary public offering.
5. Can you show the investor that the potential investment returns are worth their risk?
Finally, investors will also want to know how to weigh the deal’s potential returns
against the potential risks. There is risk inherent in all investments: risk of the deal
falling through, risk in performance not meeting financial projections, risk in operating
problems such as quality or the loss of a key manager, and risk in changes in market
trends and competitive actions. Investors will want to see how prepared your business
is to overcome these risks and still provide them with a risk adjusted 3-7 times their
original investment in 2-5 years (sometimes measured as 30-40% internal rate of return
(IRR)).
If you answered "no" to all or some of the questions in the investment fitness
test, you now know where you need to do some more training before starting to pursue
investors. On the other hand, if you answered "yes", that means your investment fitness
level is in top shape and you’re poised at the starting line. On your marks, get set, …
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