Nothing Ventured, Nothing Gained
How to Find and Attract Investors
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.
aha!
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.
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.
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. The 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.
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, you might think you’re really valuable—but you might not be in the eyes of your investors.
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.
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.
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 capital—is no longer so easy to come by. Yes, there are venture capital firms out there. Quite a few, actually. There are websites you can go to, like Entrepreneur.com’s Top 100 Venture Capital Firms (entrepreneur.com/vc100)—a directory of venture capital firms—and you may find some luck. And luck is exactly what you need to convince 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.
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 the wheel, sliced bread, and the PC—with an extremely convincing plan that will make the investor a lot of money. And even that might not be good enough.
tip
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.
Earth Angels
The unpleasant reality is that getting financing from venture capital firms is an extreme long shot. The pleasant reality is that 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 his or her 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 between $60,000 and $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 he or she is already familiar with you or your business and has 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 come in contact with 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 he or she works.
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, he or she 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, or they are nearing retirement, or 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.
Netting Angels
Looking for angels? Now there’s a simple way to find them—online. Go4Funding, an angel investor directory, lists dozens of angels and investment networks on its site at go4funding.com. The site also has links to articles that run the gamut from the pros and cons of angel investing to tips for how the angel/investor relationship should work. You can also put your own requests for funding on the site, find experts to consult, and get business ideas.
Another user-friendly site for more in-depth information about angels is the Angel Capital Association (ACA). Although ACA is not a source of capital, this membership organization does provide plenty of information for entrepreneurs who are interested in raising angel capital. It also has an online directory of North American angel organizations sorted by region. It’s a great resource for leads, news, and information about angels who are willing and able to support your venture. Visit ACA at angelcapitalassociation.org. Other websites to check out include AngelList (https://angel.co/) and MicroVentures (https://microventures.com).
“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, 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 Angel List at Angel.com or Google “investor matchmaking.”
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.
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.
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.
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.
aha!
Angels invest in companies for reasons that often go beyond just 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.
Particularly if your angel is a current or former entrepreneur, he or she may be motivated as much by the enjoyment of helping a young business succeed as by the money he or she stands 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 he or she knows 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.