There comes a time for most entrepreneurs when the idea of using somebody else’s invested capital to grow their business seems like the way to go. Whether this thought process occurs in the initial formation stages or after the business has proven itself, raising funds can be a harrowing experience. One of my former clients (who had also completed U.S. Army basic training) once told me that the capital raising process was the most humbling and soul-crushing experience he had ever been through.
When we talk about raising capital, it usually means equity funding. With one exception (SBA loans), most early stage entrepreneurs either (a) have companies that are not qualified to obtain commercial (bank) financing or (b) have already tapped any sources of commercial financing. For the purposes of this post, we will focus on obtaining growth financing from equity investments – leaving aside all forms of loans, factoring or other debt instruments.
So, before we focus on the “How’s” of raising money, let’s first address the “Where’s” and “Who’s.” For our purposes, there are 5 categories of financing sources:
1. Competitions. If you are in the early stage of your venture, and don’t need a significant amount of growth financing, you may want to target various business competitions for your growth capital. Sponsors of these competitions range from businesses, to academic institutions, to economic development organizations. Winning or placing in these competitions can often provide the capital needed to advance the business to the next stage.
In many cases, competitions are the way to go for companies at opposite extremes of the spectrum: esoteric technology and “Main Street” businesses.
Companies with a focused technology plan that may not be able to raise funds elsewhere can sometimes find competitions directly in their niche. If you are in a particularly specialized technology niche, research may turn up some competitions in which you will have an advantage.
At the other end of the spectrum, many “Main Street” businesses are strong contenders in these competitions. The winner of last year’s Northeast Wisconsin Business Plan competition was a unique chiropractic clinic and Babson College’s 2009 business plan competition winner was a laundry pick-up/drop-off service. If you fall into this category, targeting competitions sponsored by economic development agencies is a good strategy.
2. Grants. Grants are similar to business plan competitions as a source for funding. To my knowledge, there are no direct grants at the Federal level for targeted simply for small businesses (though there are programs like Small Business Innovation Research and Small Business Technology Transfers). Nonetheless, many regional and state governments offer business grants, as do a number of universities and non-profit organizations.
3. Angels. An angel investor is simply any high net worth individual that provides investment capital to an entrepreneur. Angel investors really break down into two categories – (a) friends/families/colleagues/acquaintances who invest in your business and (b) “professional” angel investors and angel investing organizations who act very similar to venture capitalists or other institutional funders.
4. Venture Capitalists. Known colloquially as VC’s, Venture Capitalists are a specific type of private equity capital that generally seek above average returns by investing capital in early-stage high potential growth companies. Traditionally, VC’s invested in companies that were early in their life cycle, usually pre-profit and often pre-revenue. VC’s achieve returns on their investments when companies they have invested in list via an Initial Public Offering or are sold to another entity. Recent years have seen some changes in this approach, but most VC’s are focused on this type of investment strategy.
5. Other Institutional Financers. There are a host of other sources of capital that are not, strictly speaking, venture capitalists. Some pension funds allocate a small component of their funds for direct investments in venture style investments, as do certain hedge funds and other similar entities. For the most part, the difference between an institutional fund and a VC is of little relevance to an entrepreneur seeking capital.
Do You Qualify?
From this point forward, we’ll focus on seeking financing from Angels, Venture Capitalists and Other Institutional Financing Sources (though the elements needed for these sources are likely to be of assistance to those entering business plan competitions or seeking grants).
The first step in this process is determining if your business is “qualified” to receive funding from these sources. There are four primary components to examine in this regard:
- The Big Idea? Professional investors look for entrepreneurs with “world changing” ideas. Companies with Big Ideas create an environment of excitement and passion. The entrepreneur, the management team, employees, vendors and customers are inspired by the Big Idea. The Big Idea fosters a level of commitment and enthusiasm that many companies don’t have. Investors recognize that this atmosphere helps breed success.
You need to determine if you have a Big Idea. Is your business concept world changing? Will it be a source of passion and inspiration for others? Can you “infect” investors, employees and the rest of the world with your enthusiasm?
If you’re business isn’t founded upon a Big Idea, you don’t have to give up your quest to raise funds. However, you’ll need to recognize that you’ve got a harder road ahead of you when trying to secure capital.
- Serve. Related to the concept of the Big Idea is the idea of service. Who does your business help and how does it do so? How will your business change the status quo for the better? The Big Idea and Service may seem counter intuitive. After all, aren’t investor focused on an increase in shareholder value and return on capital? Many investors have learned that venture funding is as much an art as a science – it can’t simply be reduced to formulaic analyses. Ventures with Big Ideas that Serve are game changers – they have the potential to break the status quo in dramatic ways. Dramatic status quo breakers (Big Idea + Service) have the potential for home run returns – which is what investors look for.
By crafting the answer to the Big Idea and Service questions, you’ll be way ahead in the capital raising game. Of course, you’ve also got to demonstrate your ability to execute the business model that has a Big Idea and Service. One of the most important considerations in that regard? Your management team.
- Team. Successful entrepreneurial growth is a team sport. We’ll talk more about the management team in the Pitch section, but it’s important to review it when determining if you should be seeking funding. If you’ve demonstrated a status quo changing business model (Big Idea + Service), you’ll need to show that your team has the depth and breadth to execute on your plan.
First off, do you have a team? If you are a solo entrepreneur, forget the idea of raising significant growth capital – unless you have a history of founding and helming successful ventures in your past. I know it’s unpleasant to hear that, but you need to be prepared. For most investors, if you have a status quo changing business model, you should be able to demonstrate it’s legitimacy by assembling a core team.
Your team should have a mixture of two key components: domain expertise and start up experience. Domain expertise is simply knowledge of the technical and/or business aspects of a product, industry, market or technology. Most entrepreneurs begin with a level of domain expertise and add team members that bring specific skills needed in that area. Start up experience, as the phrase suggests, is simply a history of operating in an early stage venture. Many investors have been burned by funding companies where the team had significant domain expertise, but no experience with the vagaries that plague and early stage company. You want a mix of both on your team.
- Needs. Why are you raising capital? It’s a question that often entrepreneurs don’t spend enough time answering before seeking funds. What specifically will you do with any funds that you raise? Do you need to finish technology development? Commercialize a prototype? Build a sales team? Pay off loans coming due? Do you want the funds for “general working capital?” Be aware that investors like to fund growth. Repayments of loans (or earlier investors), working capital slush funds and the like are unlikely to receive funding. You’ll need to tie your capital needs directly to success of your business model in order to generate a positive response.
At this point, you’ve completed the necessary groundwork in your pursuit of equity capital. If you intend to pursue angel or institutional financing, you’ve now spent the time determining that your business fits for those financing sources. In future posts, we’ll examine the process of Researching and Targeting prospective investors, Building Your Financing Pitch Package, Making Contact with financing sources, Pitching Your Company and proper Follow Up.