Start Your Own Business, Seventh Edition

No matter what type of financing source you approach—a bank, a venture capitalist, or your cousin Lenny—there are two basic ways to finance a business: equity financing and debt financing. In equity financing, you receive capital in exchange for part ownership of the company. In debt financing, you receive capital in the form of a loan, which must be paid back. This chapter explains various types of equity financing; Chapter 14 explains debt financing.

Equity Basics

Equity financing can come from various sources, including venture capital firms and private investors. Whichever source you choose, there are some basics you should understand before you try to get equity capital. An investor’s “share in your company” comes in various forms. If your company is incorporated, the investor might bargain for shares of stock. Or an investor who wants to be involved in the management of the company could come in as a partner.

Keeping control of your company can be more difficult when you are working with outside investors who provide equity financing. Before seeking outside investment, make the most of your own resources to build the company. The more value you can add before you go to the well, the better. If all you bring to the table is a good idea and some talent, an investor may not be willing to provide a large chunk of capital without receiving a controlling share of the ownership in return. As a result, you could end up losing control of the business you started.

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One entrepreneur who wanted to open a restaurant got a list of potential investors by attending all the grand openings of restaurants in the area where he wanted to locate. By asking for the names of people who invested in those restaurants, he soon had enough contact names to finance his own business.

Don’t assume the first investor to express interest in your business is a godsend. Even someone who seems to share your vision for the company may be bad news. It pays to know your investor. An investor who doesn’t understand your business may pull the plug at the wrong time—and destroy the company.

How It Works

Because equity financing involves trading partial ownership interest for capital, the more capital a company takes in from equity investors, the more diluted the founder’s control. Expect it to be between 25 and 75 percent equity in your company. The real question is: How much management are you willing to give up?

Don’t overlook the importance of voting control in the company. Investors may be willing to accept a majority of the preferred (nonvoting) stock rather than common (voting) stock. Another possibility is to give the investor a majority of the profits by granting dividends to the preferred stockholders first. Or holders of nonvoting stock can get liquidation preference, meaning they’re first in line to recover their investment if the company goes under.

As Not Seen on TV

By now, nearly everyone who has dreamed of becoming an entrepreneur has seen at least one episode of Shark Tank. During it’s nine seasons, many hopeful small-business owners have pitched their products and ideas to a panel of “shark” investors, led by billionaire Mark Cuban. The sharks have invested in more than 225 businesses—and they’ve made many more offers that never closed. Just being on the show can boost a small business’ presence and sales.

But pitching investors in real life isn’t like the pre-screened and rehearsed process you see on TV. However, there are lessons you can take from the demands the sharks make of the entrepreneurs—ones that will be useful in securing investors the traditional way. Here are five big ones:

1. The 10-second rule. The first ten seconds of your pitch will set the tone and the impression investors have of you and your idea. Practice, practice, practice.

2. Be clear and concise. People who fail to get money or attention from the sharks typically lack clarity about their ideas and real conviction that they can succeed. Project clear goals, clear plans, and projections, and make sure your passion comes through.

3. Know the problem and the market. The sharks are notorious for honing in on the problem a business is trying to solve and how big that problem is. That helps determine the likelihood of success. You don’t need a product that’s going to solve a worldwide problem to have a good idea. If your business solves a problem locally and the problem is substantial where you’re located, that shows potential and your knowledge of the market. Be clear when you speak to investors about this.

4. Do the math—and do it well. Know the costs of making your product or running your business compared to the profits. Understand and be clear about your margins. Know the overall market size and a realistic share you can capture. Know what you plan to do with an investor’s money. Commit all this to memory—and be able to back it up.

5. Be willing to listen and learn from feedback. On Shark Tank, the sharks almost always offer smart lessons, although they’re often in the form of criticism or tearing apart (as sharks would) an idea they deem as unworthy of investment. If potential investors criticize or decide not to invest, listen for the advice in that criticism, and don’t be afraid to ask for feedback about what would have changed their minds. Use that to improve your pitch.

Even if they’re willing to accept a minority position, financiers generally insist on contract provisions that permit them to make management changes under certain conditions. These might include covenants permitting the investor to take control of the company if the corporation fails to meet a certain income level or makes changes without the investor’s permission.

Investors may ask that their preferred stock be redeemable either for common stock or for cash a specified number of years later. That gives the entrepreneur a chance to buy the company back if possible but also may allow the investor to convert to common stock and gain control of the company.

Some experts contend that retaining voting control is not important. In a typical high-growth company, the founder only owns 10 percent of the business by the time it goes public. That’s not necessarily bad because 10 percent of $100 million is better than 100 percent of nothing. The key is how valuable the founder is to the success of the company. If you can’t easily be replaced, then you have a lot of leverage even though you may not control the business. But keep in mind, although you might think you’re invaluable, you might not be in the eyes of your investors.

tip

When it comes to pitching to investors, it’s not what you say, but how you say it. Breathe. Enunciate. Pace yourself, speaking neither too quickly nor too slowly. Nervous? Fess up—admitting your insecurity puts the listeners on your side. Finally, remember—practice makes perfect.

If the entrepreneur is good enough, the investors may find their best alternative is to let the entrepreneur run the company. Try not to get hung up on the precise percentage of ownership: If it’s a successful business, most people will leave you alone even if they own 80 percent. To protect yourself, however, you should always seek financial and legal advice before involving outside investors in your business.

Venture Capital

When most people think of equity financing, they think of venture capital. Once seen as a plentiful source of financing for startup businesses, venture capital—like most kinds of funding—is not easy to come by. Venture capital is one of the more popular forms of equity financing used to finance high-risk, high-return businesses. The amount of equity a venture capitalist holds is a factor of the company’s stage of development when the investment occurs, the perceived risk, the amount invested, and the relationship between the entrepreneur and the venture capitalist.

Venture capitalists invest in businesses of every kind. Many individual venture capitalists, also known as angels, prefer to invest in industries that are familiar to them. The reason is that, while angels don’t participate in the daily management of the company, they want to have a say in strategic planning to reduce risks and maximize profits.

You may get lucky on websites, like Entrepreneur.com’s VC 100 (www.entrepreneur.com/vc100)—a directory of the top investors in early-stage startups. And luck is exactly what you need to persuade venture capitalists to invest in your business. If you think we’re trying to discourage you, we are. Money can be found for investing in your company, but the era of the venture capitalist happily handing out forklifts of money is over—especially for startups.

The Many Faces of Venture Capital

There are several types of venture capital. If you’re going to pitch for some, first understand the differences—and where you are most likely to find small successes.

Private venture capital partnerships are perhaps the largest source of risk capital. They generally look for businesses that have the capability to generate a 30 percent return on investment each year. They like to actively participate in the planning and management of the businesses they finance and have very large capital bases—up to $500 million—to invest at all stages.

Industrial venture capital pools usually focus on funding firms that have a high likelihood of success, such as high-tech enterprises or companies using state-of-the-art technology in a unique manner.

Investment banking firms traditionally provide expansion capital by selling a company’s stock to public and private equity investors. Some also have formed their own venture capital divisions to provide risk capital for expansion and early-stage financing.

Individual private investors, also known as angels, can be friends and family who have only a few thousand dollars to invest or well-heeled people who’ve built successful businesses in a similar industry and want to invest their money as well as their experience in a business. The Angel Capital Network (ACE-Net, www.angelcapitalnetwork.com) is a nationwide, internet-based listing service that allows angel investors to get information on small, growing businesses looking for $250,000 to $5 million in equity financing.

Small Business Investment Corporations (SBICs) are licensed and regulated by the SBA. SBICs are private investors that receive three to four dollars in SBA-guaranteed loans for every dollar they invest. Under the law, SBICs must invest exclusively in small firms with a net worth less than $18 million and average after-tax earnings (over the past two years) of less than $6 million. They’re also restricted in the amount of private equity capital for each funding. For a complete listing of active SBICs, contact the Small Business Investor Alliance, formerly the National Association of Small Business Investment Companies, at www.sbia.org

Specialized Small Business Investment Companies (SSBICs) are also privately capitalized investment agencies licensed and regulated by the SBA. They are designed to aid women- and minority-owned firms, as well as businesses in socially or economically disadvantaged areas, by providing equity funds from private and public capital. SSBICs are also restricted in the amount of their private funding. For information and a directory of active SSBICs, contact the National Association of Investment Companies www.naicpe.com.

Before approaching any investor or venture capital firm, do your homework and find out if your interests match their investment preferences. The best way to contact venture capitalists is through an introduction from another business owner, banker, attorney, or other professional who knows you and the venture capitalist well enough to approach them with the proposition.

Venture capital is most likely to be given to an established company with an already proven track record. If you are a startup, your product or service must be better than sliced bread—with an extremely convincing plan that will make the investor a lot of money. And even that might not be good enough.

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Keep this in mind when crafting your pitch to investor angels: When angels reject a potential investment, it’s typically because: 1) They don’t know the key people well enough or 2) they don’t believe the owner and management have the experience and talent to succeed. If you can correct for these before your pitch, your odds of getting an investment are better.

Earth Angels

The unpleasant reality is that getting financing from venture capital firms is an extreme long shot. The pleasant reality is there are plenty of other sources you can tap for equity financing—typically with far fewer strings attached than an institutional venture capital deal. One source of private capital is an investment angel.

Originally a term used to describe investors in Broadway shows, “angel” now refers to anyone who invests their money in an entrepreneurial company (unlike institutional venture capitalists who invest other people’s money). Angel investing has soared in recent years as a growing number of individuals seek better returns on their money than they can get from traditional investment vehicles. Contrary to popular belief, most angels are not millionaires. Typically, they earn anywhere from $60,000 to $200,000 a year—which means there are likely to be plenty of them right in your backyard.

Where Angels Fly

Angels can be classified into two groups: affiliated and nonaffiliated. An affiliated angel is someone who has some sort of contact with you or your business but is not necessarily related to or acquainted with you. A nonaffiliated angel has no connection with either you or your business.

“It is only as we develop others that we permanently succeed.”

—HARVEY SAMUEL FIRESTONE, FOUNDER OF THE FIRESTONE TIRE AND RUBBER CO.

It makes sense to start your investor search by seeking an affiliated angel since they are already familiar with you or your business and have a vested interest in the relationship. Begin by jotting down names of people who might fit the category of affiliated angel:

Professionals. These include professional providers of services you now use—doctors, dentists, lawyers, accountants, and so on. You know these people, so an appointment should be easy to arrange. Professionals usually have discretionary income available to invest in outside projects, and if they’re not interested, they may be able to recommend a colleague who is.

Business associates. These are people you encounter during the normal course of your business day. They can be divided into four subgroups:

1. Suppliers/vendors. The owners of companies who supply your inventory and other needs have a vital interest in your company’s success and make excellent angels. A supplier’s investment may not come in the form of cash but in the form of better payment terms or cheaper prices. Suppliers might even use their credit to help you get a loan.

2. Customers. These are especially good contacts if they use your product or service to make or sell their own goods. List all the customers with whom you have this sort of business relationship.

3. Employees. Some of your key employees might be sitting on unused equity in their homes that would make excellent collateral for a business loan to your business. There is no greater incentive to an employee than to share ownership in the company for which they work.

Competitors. These include owners of similar companies you don’t directly compete with. If a competitor is doing business in another part of the country and does not infringe on your territory, they may be an empathetic investor and may share not only capital but information as well.

The nonaffiliated angels category includes:

1. Professionals. This group can include lawyers, accountants, consultants, and brokers whom you don’t know personally or do business with.

2. Middle managers. Angels in middle management positions start investing in small businesses for two major reasons—either they’re bored with their jobs and are looking for outside interests, they are nearing retirement, or they fear they are being phased out.

3. Entrepreneurs. These angels are (or have been) successful in their own businesses and like investing in other entrepreneurial ventures. Entrepreneurs who are familiar with your industry make excellent investors.

“Quality, quality, quality: Never waver from it, even when you don’t see how you can afford to keep it up. When you compromise, you become a commodity and then you die.”

—GARY HIRSHBERG, FOUNDER OF STONYFIELD FARM YOGURT

Make the Connection

Approaching affiliated angels is simply a matter of calling to make an appointment. To look for nonaffiliated angels, try these proven methods:

Advertising. The business opportunity section of your local newspaper or The Wall Street Journal is an excellent place to advertise for investors. Classified advertising is inexpensive, simple, quick, and effective.

Business brokers. Business brokers know hundreds of people with money who are interested in buying businesses. Even though you don’t want to sell your business, you might be willing to sell part of it. Since many brokers are not open to the idea of their clients buying just part of a business, you might have to use some persuasion to get the broker to give you contact names. You’ll find a list of local business brokers in the Yellow Pages under “Business Brokers.”

Telemarketing. This approach has been called “dialing for dollars.” First you get a list of wealthy individuals in your area. Then you begin calling them. Obviously, you have to be highly motivated to try this approach, and a good list is your most important tool. Look up mailing-list brokers in the Yellow Pages. If you don’t feel comfortable making cold calls yourself, you can always hire someone to do it for you.

Networking. Attending local venture capital group meetings and other business associations to make contacts is a time-consuming approach but can be effective. Most newspapers contain an events calendar that lists when and where these types of meetings take place.

Intermediaries. These are firms that find angels for entrepreneurial companies. They are usually called “boutique investment bankers.” This means they are small firms that focus primarily on small financing deals. These firms typically charge a percentage of the amount of money they raise for you. Ask your lawyer or accountant for the name of a reputable firm in your area.

Matchmaking services. Matchmakers run the gamut from services that offer face time with investors to websites that post business plans for companies seeking investments. Fundraising success often hinges on the matchmaker’s screening process. In other words: Does the matchmaker have a rigorous selection process, or does it take money from anyone regardless of funding prospects? While rates vary, starting at a few thousand dollars, a matchmaking service may charge as much as $25,000 to locate investors in addition to a percentage of funds raised. Before using any matchmaker, obtain a list of clients to assess recent successes and failures. A good place to start is AngelList at https://angel.co or by googling “investor matchmaking.”

warning

Looking for an investor through classified ads? Be aware there are legal implications when you solicit money through the newspaper. Always get legal advice before placing an ad.

Angels tend to find most of their investment opportunities through friends and business associates, so whatever method you use to search for angels, it is also important to spread the word. Tell your professional advisors and people you meet at networking events, or anyone who could be a good source of referrals, that you are looking for investment capital. You never know what kind of people they know.

Getting the Money

Once you’ve found potential angels, how do you win them over? Angels look for many of the same things professional venture capitalists look for:

Strong management. Does your management team have a track record of success and experience?

Proprietary strength. Proprietary does not necessarily mean you must have patents, copyrights, or trademarks on all your products. It just means that your product or service should be unusual enough to grab consumers’ attention.

Window of opportunity. Investors look for a window of opportunity when your company can be the first in a market and grab the lion’s share of business before others.

Market potential. Investors prefer businesses with strong market potential. That means a restaurateur with plans to franchise stands a better chance than one who simply wants to open one local site.

Return on investment. Most angels will expect a return of 20 to 25 percent over five years. However, they may accept a lower rate of return if your business has a lower risk.

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Angels invest in companies for reasons that often go beyond dollars and cents. As a result, your appeal must not only be financial but also emotional. For example: “We need more than just dollars. We need you to bring your incredible wealth of experience to the table as well.” In the long run, that may be even more important than capital.

If angels consider the same factors as venture capital companies, what is the difference between them? You have an edge with angels because many are not motivated solely by profit.

Particularly if your angel is a current or former entrepreneur, they may be motivated as much by the enjoyment of helping a young business succeed as by the money they stand to gain. Angels are more likely than venture capitalists to be persuaded by an entrepreneur’s drive to succeed, persistence, and mental discipline.

That is why it is important that your business plan convey a good sense of your background, experience, and drive. Your business plan should also address the concerns above and spell out the financing you expect to need from startup to maturity.

What if your plan is rejected? Ask the angel if they know someone else your business might appeal to. If your plan is accepted, you have some negotiating to do. Be sure to spell out all the terms of the investment in a written agreement; get your lawyer’s assistance here. How long will the investment last? How will return be calculated? How will the investment be cashed out? Detail the amount of involvement each angel will have in the business and how the investment will be legalized.

Examine the deal carefully for the possibility of the investor parlaying current equity or future loans to your business into controlling interest. Such a deal is not made in heaven and could indicate you are working with a devil in angel’s garb.