Strategies for Raising Growth Capital in a Turbulent Market
Andrew J. Sherman, Partner, Dickstein Shapiro Morin and Oshinsky LLP
You would have to be doing your best Rip Van Winkle imitation to not realize that in the past 18 months have been very volatile from an economic, political and technological perspective, and we all face 2002 with some genuine fears and concerns -- Are we on the edge of a recession? What will the one-year old Bush administration truly do to foster the needs of small and growing companies? Which companies will survive the dot.com shakeout? Will global markets remain strong? We'll learn a lot more about the answers to these questions by this time next year, but between now and then, here are a few of my observations and predictions:
The Next 12 Months Will Be Very Darwinian. Unlike the past few years, only the smart and the strong companies will do well in 2002, as there is simply not enough fat in capital markets or the workforce to take the weak along for the ride. There will be more focus on protecting and building on what you have, rather than focusing on rapid growth. Entrepreneurs must be flexible and highly responsive to market changes and customer needs, and should be extra careful in the management and use of precious resources. The party is not over but the bouncer at the door just got a lot bigger and is being more selective about who gets in to the party (and who stays in!).
Growth Must Be Strategic and Creative. The capital markets for smaller and mid-sized companies will not be as accessible nor as affordable as they were in 1999 and 2000. Therefore, your plans to raise capital to grow your business in 2002 must be more strategic and more creative than ever before, with a greater focus on strategic investors partnering, licensing, alliances and even domestic and international franchising as strategies for expansion, as set forth in greater detail below.
Valuations Must Be Realistic. If you have been lucky enough to raise capital over the past few quarters, don't expect the sky-high valuations that entrepreneurial companies enjoyed over the past few years. Venture investors have returned to ground level and realize that many of their investments will not qualify for an initial public offering twelve months later! Therefore, be prepared to give up more ownership for smaller amounts of capital and possibly even more control if you need to raise equity capital. The capital markets are now focused on very specific opportunities, not large-scale sectors or trends. There is no forgiveness or room for mediocrity just because your company is in a "hot sector." You need to get more creative and aggressive in your search for capital and uncover new stones, such as strategic financing from customers, vendors or corporate venture capitalists, all three of these sources are expected to grow significantly in 2002.
You Will Need to Hire the Strong-Willed and the Patient. It has always been difficult for emerging business owners to compete with their larger competitors to recruit and retain qualified personnel. The early-state business owners' most recent "secret weapon" to attract human capital has been the promise and potential upside of stock options. But the qualified workers of the past few quarters have been sufficiently burned by worthless options, failed IPOs and dilutive mergers so that these plans may no longer serve as an effective carrot. To combat this trend, take the extra time to look for potential employees who are not as focused on the "rapid rise to riches" and may be willing to trade a friendly and flexible atmosphere for the higher salaries offered by your larger competitors.
Make Technology Your Friend. As executives of growing companies, you will need to use the Internet and available communications technologies more strategically than ever before in order to survive in the highly competitive business environment that 2002 will bring. The entrepreneurship boom of the last 10 years means that more companies of all sizes will be competing for the same customers and available market share. It is critical that you take advantage of internet-based resources to gather competitive data, generate new leads, enjoy opportunities for cost-savings, and learn new information that will help you manage your business and level the playing field in competing against larger companies.
Best to Market Beats First to Market. Ray Kroc did not invent the cheeseburger anymore than Steve Jobs invented the computer or Fred Smith invented the postage system. But all three were visionaries regarding the potential and opportunity of these products and services and built companies around these opportunities. They were aggressive, creative, persistent and had an ability to convince others to buy into their vision and share their dream, on a foundation of trust and integrity and substance. They brought new applications to existing industries and then trained customers to become comfortable with the new paradigms that they had created. Suddenly, almost overnight, having a meal in three minutes, a package in 24 hours and a personal computer at your desk became not the exception, but the rule. These developments set a new standard that everyone else has to emulate and improve upon. That's what great entrepreneurs do -- they get an entire industry to jump higher, run faster and move farther, by moving the bar each time that everyone starts to get comfortable or complacent.
So what does it take to survive and manage growth in this volatile environment? To continue to flourish, emerging growth companies need to put (and keep) in place for 2002 and beyond the following:
- A strategy and commitment to protecting and leveraging the company's intellectual property;
- An experienced and mature management team that knows how to actually make money, not just raise money;
- A business model that will produce sustainable and durable revenue streams (e.g., targeted customers who can actually pay your bills);
- A genuine understanding of the strengths, weaknesses (and likely next moves) of your competitors;
- A corporate culture which is more focused on financial performance and financial tables than pool tables and chill-out rooms; and
- A leadership vision which is more focused on keeping your eyes on the road rather than searching for the next exit strategy.
Virtually all capital formation strategies (or, put simply, ways of raising money) revolve around a balancing of four critical factors: Risk, Reward, Control and Capital. You and your source of funds will each have your own ideas as to how these factors should be weighted and balanced. Once a meeting of the minds takes place on these key elements, you'll be able to do the deal.
Risk. Venture investors want to take steps to mitigate their risk, which they can do with a strong management team, a well-written business plan and the leadership to execute the plan.
Reward. The rewards desired may vary depending on the type of venture investors. The entrepreneur's objective is to preserve the right to participate in a significant share of the growth in the value of the company as well as any subsequent proceeds from the sale or public offering of the business.
Control. It's often said that the art of venture investing is "structuring the deal to have 20% of the equity with 80% of the control." But control is an illusive concept that's often overplayed by entrepreneurs. Depending on the venture investor's philosophy and its lawyers' creativity, there are many different tools available to venture investors to exercise control and mitigate risk. Only the entrepreneur can dictate which levels and types of controls may be acceptable, but remember that the higher risk deals are likely to come with the higher degrees of control.
Capital. Negotiations with the venture investor will often focus on how much capital will be provided, when it will be provided, what types of securities will be purchased (preferred stock, convertible notes, debt with warrants, for example), at what valuation, what special rights will attach to the securities and what mandatory returns will be built into the securities. You need to really think about how much capital you really need, when do you really need it, and are there any alternative ways of obtaining these resources?
In the current environment, there is no capital available for bad deals, there will always be money for great/hot deals -- but what about the bulk of the companies in the soft fuzzy middle?
So where is the money? Where should you be looking? What options are still available in this turbulent market?
Option 1 - Wait it Out / Bootstrapping
- Too timely to look for capital yielding limited results
- Need to kiss too many frogs
- Valuations toomlow -- Terms are too tough
Option 2 - Reposition to be Among Today's Hot Sectors
- Retool business models to meet current fickle demands of investors, but don't try to fit a square peg into a round hole
- Get business plans to those ready to take their dollars off the sidelines
Option 3 - Spread the Love, Spread the Risk
- Private Placement offerings under Regulation D are a real option in this marketplace
- Spread the risk of the investment among 20-30 investors and lessen the possibility of control of the company by the investors
Option 4 - Let Yourself Be Wined and Dined
- Vendors/Strategic Partners -- have cash available to "buy" attractive financing terms, the loyalty of a new customer, etc.
- Need to show growth potential
Option 5 - Get Married
- M&A may not get the valuation you want in a buyer's market but relieves the burden of making payroll
- Alliances - formal joint ventures to get access to more resources
Option 6 - Find A Smaller Angel
- Angels still doing deals but in smaller amounts and tougher terms
- Must be a great fit
- Tap into more strategic/rolodex aspects of investment
Option 7 - Generate Cash Through More Creative and Expanded Revenue Streams
- IP leveraging strategies -- squeezing more juice out of existing assets
- High margin, low cost revenuestreams
- Major corporate trends are in this direction
- Position company better for "down the road" capital formation
Option 8 - More Dollars From Existing Investors
- Rights Offering
- Down Rounds / Tougher Terms
- Salvage what they have
- Keep existing investors well-informed
Option 9 - Commercial Debt Markets
- Borrowing costs are very low
- More banks are willing to lend against intangible assets
- Policy pressure on banks to provide loans to smaller and high growth companies
Option 10 - General Tips
- There will always be capital available for great deals even in the worst of times
- Raising capital for survival is always different than raising capital for growth -- sources of capital can smell desperation from 50 miles away
- Be sure to properly analyze the true costs of capital (e.g. transactional costs, borrowing costs, equity ownership dilution, etc.)
- In times of fear and uncertainty, smaller and emerging businesses will always have a higher cost of capital as being at the lower end of the food chain -- calm in the markets tend to reduce these costs
COMMON MISTAKES ENTREPRENEURS MAKE IN THE SEARCH FOR CAPITAL
- Lack of preparation - today's capital markets require you to take the time to really get inside the head of the typical investor and deliver a business plan and a business model which meets their key concerns. In the "go-go" netcentric economy, investors expect you to be able to Think Big and Move Fast. You must build an infrastructure that can be responsive to rapid growth (the scalabiltity of the business) in an under-served niche within the market. You will be judged on whether you can demonstrate a platform that can ramp up quickly with a team that really understands the target industry. You want to show that your company can generate a sustainable and durable revenue stream that will become profitable over a reasonable period of time.
- Letting the search be guided by a cannon instead of a rifle (the search must be focused on the most likely sources).
- Ownership does not equal control--an investor can have 10% of the ownership and 90% of the control (and vice-versa) depending on how the deal is negotiated and structured.
- Misjudging the time it will take to close a deal.
- Falling in love with your business plan (Creating stubbornness, inflexibility and defensiveness-a deal killer).
- Spending too much time raising the money and not enough time managing the business along the way.
- Failing to understand (and meet) the investor's real needs and objectives.
- Taking your projections too seriously.
- Confusing product development with the need for real sales and real customers.
- Failing to recognize that the strength of the management team is what really matters to investors.
- Providing business plans that are four inches thick (Size does matter and shorter is better) (You should be prepared to have multiple presentations in different lengths - the one pager, the two-pager and the full plan).
- Not understanding that most investors are very, very busy and hate to have their time wasted (Keep it simple and get to the point in your presentations).
- Providing business plans that are more exhibits than analysis.
- Timing is everything-don't raise money at the last minute-it will already be too late and the cost of desperation is very high. (The best time to raise money is when you can afford to be patient.)
- You can't sell if you don't tell-don't be so afraid of sharing your ideas that you don't tell anyone about it.
- Being price wise and investor foolish-it's not just about getting the best financial deal, it's also about finding what other strategic benefits the investor brings to the table.
- Valuation of small companies is an art, not a science (be ready to negotiate as best you can depending on your negotiating leverage).