Ideas need capital; even companies that bootstrap eventually need to raise capital in some form sooner or later. There are few things an entrepreneur should be prepared with before raising capital or facing an investor.
Knowledge Having deep knowledge of your industry, trends, and the nuts and bolts of your business is imperative. This is something an investor is definitely going to use to gauge your individual potential. Even if the business and industry are great, a heavy weightage is on the ability of the individual or team that is going to execute the plan.
It is very safe to assume that the investors will ask a lot of questions that are driven by numbers and data. Having a strong understanding of the financials of the business is important for an investor, and in general something an entrepreneur should possess. The revenue/ product mix, margins, working capital cycles, balance sheet ratios, returns on equity, are some of the questions that might be thrown at you.
No one is going to back knowledge and numbers if it is not coupled with a strong vision. Investors want to back entrepreneurs who have a vision, a realistic dream. This part is less quantifiable, but it maybe the decision-making factor in case the investor is looking at multiple companies in the same sectors.
When you have the above macro points covered, it's important to get into the brass tax of the deal you are offering the investor. Once these macro categories are covered, you will need to be able to talk about the details of the investment.
How much to raise
To understand the amount of capital required to start a business, it's important to clearly define the uses of capital, and ascertain the operating cash flows once this capital is infused. Often people raise money because it's available (2015-2016 in India) - this leads to complacency with costs, and also tends to have startups throwing money at solving problems which is not a sustainable strategy. A clearly defined source and uses of the capital is a starting point. Usually, it is a good idea to keep a 20 percent contingency for unforeseen situations; most people underestimate this contingency number and overestimate their revenue forecasts, leading to a painful cash crunch.
When you’re figuring out the amount to raise, it’s a good idea to raise money that will sustain the company for at least two years. Raising capital is very time consuming for the management team, and it always takes longer than expected for the money to hit your account.
Who to raise from
One of the most important decisions is picking your investors. Today, capital is available for good ideas and strong management teams. If you are unable to get in front of investors, that’s probably the first sign of a chink in your business. Few other points to keep in mind:
» Don’t only focus on financial valuation, figure out how the investor could add value besides the money they bring to the table
» Make sure the investors' investment time horizon and your business plan match. If you are raising institutional capital, try and gauge the life cycle of the fund that it is investing from. If the fund is in its fourth or fifth year of a seven-year tenure, the investor will likely put you under pressure to exit sooner than you anticipated
» Make sure the investor and you are on the same page with regards to their level of involvement in the company. Investor involvement can be productive for the business, but clear lines should be drawn so that the management team has freedom to build on their vision
» If you have a choice, fewer investors on the capital table is always better that having a large number of small investors
» If your business has strong visible cash flows, then using a measured amount of leverage, and going by the debt route is also something you should not disregard.
Closing the deal
Many entrepreneurs get lost with only negotiating the valuation, however, the boundary conditions are equally important to keep in mind when stitching the deal. Few critical points/clauses to keep in mind, and understanding the repercussions of:
» Voting Rights
» Board Control
» Liquidation Preference
» Tag and Drag Clauses
» Employee Stock Options: Investors will usually want fully diluted shares, which make it harder to institute an ESOP pool, clarify this upfront.
A good idea to prepare for this is to get a sample Share Holder Agreement and review the different clauses. It is also helpful to go through the due diligence checklist of a reputed law firm. These documents and checklists will not only help prepare the data you will need to provide the investors legal advisors, but also get you thinking about all the points you will need to negotiate and agree upon.
Lastly, once you have raised money from your investors, it is very important to have a transparent relationship and periodic reporting structure with them. Remember, they are a key stakeholder and have an important role to play in the success of your business. It is also useful to pick their brains casually once in a while, get access to their network or just bounce off ideas. If there is a good rapport and transparency in your relationship with your investors, you will find it easier to deliver the bad news when it does need to be delivered. Be rest assured, there will be bad news to be delivered at some point.
The author is a Founder and Managing Director of SILA.
The thoughts and opinions shared here are of the author.
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