Highlights- Avoid the Trap

Avoid the Trap

Raising capital is not easy. There are many factors affecting the chances of getting cash from lenders and investors. Some can be controlled but most cannot. The process in this sense demands a flawless execution in relation to those variables that can be managed - something that rarely happens. Based on our work with companies and investors in a wide array of situations, we have identified the 12 most common mistakes people make when raising capital. All 12 can be avoided.

Krogger Highlights | 2015

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Starting a new venture or project is definitely daunting. Successfully embarking on such a journey requires the right mix of ingredients – a winning idea, a great team, resilience, passion, lots of perseverance and, of course, capital.

The importance of raising capital is obvious. It is the lifeblood that nurtures a start-up from its fragile beginnings to self-sufficiency. And even when ventures have reached that point, self-generated resources are seldom enough to survive in the long term, much less to grow sustainably. Raising capital is a continuous process.

Not surprisingly, ventures and established businesses spend disproportionate amounts of time trying to find the capital they need in the initial stages of their operations or projects. Some succeed but many actually fail. With the demand for resources structurally outweighing the supply of investable ideas, it is a mathematical certainty that many businesses will simply not find the capital they expect or need. Raising capital is in this sense a zero sum game and hence fundamentally competitive.

This dynamic not only affects the chances of raising cash – it also has effects on the terms and conditions under which funded businesses receive capital injections, which are often onerous and in some cases regrettable.

Leaving aside all those factors businesses cannot control (e.g. investors or lenders current risk tolerance, market sentiment, etc.) many entrepreneurs and managers fail to raise money at reasonable terms over and over again due to mistakes and traps that can and should be avoided.

Based on our work with companies and investors in a wide array of situations, we have identified the 12 most common mistakes people make when raising capital – 3 for each of the four key stages of the capital raising process: Planning, Pitch, Negotiation and Closure.

Planning

Planning for the capital raising process ensures that the idea requiring financing is ready to be presented to the right potential investors and lenders. The most common mistakes during this phase include:

1. - Having a weak business plan

A business plan that fails to convey what is unique about a company in a succinct but comprehensive way, almost certainly will kill the prospects of raising capital. In our experience, at least half of the ventures looking for money are not ready to pitch to investors. Their plans fail to answer the most basic questions about their businesses, financials are not well thought out, and as shocking as it sounds, in many cases, investors don’t even understand what the business is about after reading the executive summary.

Sometimes the need for cash is so urgent that pitching with a half-baked plan seems justifiable. Entrepreneurs and small owners start calling lenders and investors without being prepared, hoping that they can articulate a good opportunity ‘on the fly’. They should avoid the temptation. The chances of getting funds this way are almost nonexistent and actually make matters worse, as that specific investor will never look at any other proposal from them. One thing is to reject an opportunity because the idea itself has shortcomings; another very different is to do it because the team raising the money is not well prepared.

2. - Focusing too much on one source of financing

As mentioned before, there are many factors companies cannot control in the search for financing. This is why successful capital raising starts with optionality – the simultaneous creation of financing alternatives in the context of what the business needs.

We have seen innumerable struggling entrepreneurs fixated with equity financing for no particular reason and small companies that would only talk to their banks, dismissing any other source as unattainable. This is myopic behavior. A true capital raising strategy considers all available sources of funds that are aligned with the company’s objectives; evaluates their merits and incorporates them as and when required.

Increasingly, new ventures find the money they need from many different sources: from traditional bank loans, equity investors, vendor financing and invoice factoring to alternative sources such as crowd-funding, government grants and corporate sponsorships. Every potential source counts.

3. - Approaching the wrong investors

A significant proportion of companies raising money does not have a targeted strategy when approaching investors. They would talk to anyone that can potentially give them the money and end up spending valuable time and resources talking to the wrong people.

A true investor should be more than the money. After all, they having cash does not mean that they will invest. Companies should prepare a comprehensive, targeted list of investors that are likely to be interested in the idea or project. Answering the following questions might help:

          • Has the investor invested in similar companies or in the same industry? What else does she bring to the table besides money?
          • Is the investor’s geographical focus in line with the company’s plans?
          • Does the investor have enough cash to participate in follow-on rounds?
          • Is the investor knowledgeable enough about your industry? What about her track record providing advice to other entrepreneurs? Is she an active or passive investor?
          • What is the investor’s track record in exiting investments?
          • Would other companies funded by that investor recommend her?

Pitch

Pitching is all about convincing the potential investor or lender that a venture has the best team to execute the idea. Significant time is spent on answering prospective investors’ questions as part of their due diligence and perfecting the business plan to incorporate their relevant feedback. The most common mistakes we have seen during this phase include:

4. – Poor presentation skills

Investors and lenders receive literally hundreds of proposals every year. As such, companies looking for money have usually one chance to impress them and stand-out.

Few things are more frustrating for investors than sitting through a bad presentation on an idea that sounded good on paper. After all, companies are not only selling the idea, but also the team behind it. Management teams that come across as lacking enthusiasm, presence and knowledge of their proposal during the presentation, almost always fail raising cash.

5. – Stretching the truth

In the heat of the moment, some managers and entrepreneurs tend to stretch the truth about their businesses. When questioned about things such as competition, achieved milestones or even other interested parties, many people just push it too far. Yes, a pitch is in essence a marketing exercise, but one thing is to present your best features in contrast with your weaknesses and another is to almost lie about it. This is bad tactics. Sooner or later an investor or lender is going to find out to what extent the pitch was close to reality, and more important, some are actually looking for ways to help and get involved – so being transparent and giving them a chance to add value, goes a long way.

The same applies to the questions investors raise after the initial presentation and as part of their formal due diligence. Investee companies should do all they can to answer those as professionally, truthfully and quickly as possible. Moreover, they should also make sure to incorporate what they learn – there is always room for improvement and soon they will find that the same questions keep on popping-up in every pitch.

6. – Agreeing to unreasonable exclusivity periods

Interested investors might ask for an exclusivity period if the pitch has been successful. In essence, this is a period of time for investors to perform their due diligence with the explicit agreement that the company will not talk to any other investor.

This request needs to be considered carefully. We have seen countless entrepreneurs departing from their original plan; spending time and money they don’t have to accommodate a promising investor just to end up chasing her for an answer that never comes or has been ‘no’ for a while without them knowing.

As a guide, we have found that 3 to 4 weeks is more than enough for a simple business in start-up phase seeking money from venture capitalists; 4-6 weeks if dealing with strategic investors and 6-8 weeks if the company is an established more complex business. Naturally there are exceptions to these rules and ultimately this depends on the specifics of the situation, but in general, companies should limit these agreements to promising, serious investors with a good track record.

Negotiation

The objective of this phase is to get the best deal possible for the company and frankly, for the investors as well. It is natural to think that by definition, both parties start from opposite and conflicted positions – the company wants the maximum amount of cash for the least possible equity stake (or cost if it is borrowing) and the investor/ lender wants the contrary. The world is much more complicated than that. In our experience, aggressive winner-takes-it-all investors don’t go too far (reputation works both ways) and on the other hand, unreasonable demands from companies raising money are obviously non-starters.

Thus, a good negotiation seeks to balance these positions to help both the company and the investor/lender reach their respective objectives. In this sense, we have identified the following mistakes as the most common during this phase:

7. – Asking for too much (or not enough) money

Figuring out how much money a company should raise is not an easy task. Still, it has structural implications for the future of the business. If the company doesn’t raise enough money, it will run out before it can get to the next stage and prove that is worth additional capital. If it tries to raise too much, investors might balk at the proposal or demand too much of the company.

The money question is intrinsically related to the implied valuation of the company. Without a full understanding of the value of the business, it is very difficult for companies to have a credible discussion about the amount of cash they want from investors in exchange for a fair share of the business. Still, many companies – especially start-ups – ask for amounts that simply don’t make sense and are disconnected from reality. If the valuation of the company is too low with respect of the cash received, the owners might end-up giving away control of the company too early in the game. If on the other hand, the valuation is too high, the cash might not be enough and by the time more is needed, a down-round (selling equity at a lower valuation than the one previous investors participated at), and consequent dilution might be the only option.

8. – Failing to explain what is the use of proceeds

Related the previous point, failing to explain exactly how the business intends to use the cash they are looking for is a recipe for disaster. Throughout the years we have come across a disproportionate number of companies trying to raise capital without even knowing how they are planning to use it. They label their needs as ‘working capital’, ‘certain corporate uses’ or ‘miscellaneous’ which mean nothing. The use of proceeds needs to be as specific as possible.

Another common mistake is to derive the needs for cash from the ‘management’s case’, which is inherently optimistic. Suffice it to say, we are yet to find a company that does not underestimate the amount of cash they need.

9. – Lack of appropriate legal and financial advice

Raising capital is not only about the cash. In fact, the amount is probably the least contentious point during the negotiations once the previous two points have been resolved. It is negotiating the terms of the deal what consumes most of people’s time and energy.

Deal terms are too numerous to list here. They include everything from the instruments to use for the investment (is the investor buying common equity, preferreds, etc.?) to legal rights (does the investor have preferential liquidity rights? or drag/tag along rights?) and governance mechanics (who controls the board?). In this sense, all legal agreements (letters of intent, term sheets, share purchase agreements, etc.) need to be considered in their totality as the permutations are almost limitless. Negotiating terms can indeed become a landmine.

It follows then, that just getting the money does not mean that the capital raise has been a success. The world is littered with companies and entrepreneurs that raised cash, but in order to do so, agreed to untenable terms that came back haunting them once the company was up and running. This can be avoided.

Companies seeking capital can always use the help of professional advisors – from a strong legal counsel that can negotiate deal terms to shrewd financial advisors that can ‘bridge’ different valuation positions – having an experienced advisor as part of the capital raising team, is certainly invaluable.

Closure

As we mentioned before, capital raising is a continuous process. The work does not end once the company gets the money. The time to spend it comes and with it, new responsibilities arise. The business now has contractual obligations governing some of its decisions and time needs to be spent on managing the relationship with both lenders and investors. The most common mistakes we have seen after closing include:

10. – Poor cash flow management

One of the consequences of not asking for enough money during the negotiation phase is that when reality bites, cash reserves dry up incredibly fast. Even if businesses get the funding right – absent a focused, disciplined management of the company’s cash will likely end up in bankruptcy sooner or later.

Companies will eventually burn through the capital they raised – that’s what investors expect. But those resources need to be carefully administered and channeled to build a sustainable business that can generate multiples of the initial cash invested. Way too many companies simply burn through all of their cash before the minimum foundations required are in place, pushing them to launch desperate capital calls no long after they close a financing round.

Management teams should be conspicuously fanatical about cash management. In the end, for investors and lenders alike, cash is the only metric that matters. Not taking care of it is a lethal mistake.

11. – Sitting on bad news for too long

If something goes very wrong, recently funded companies should inform their investors or lenders a soon as possible.

Over the years, we have seen start-ups and companies run into trouble and keeping it from investors for way too long. They hope that the market turns in their favor or something major helps them out of the problem. That rarely happens. Chances are that by the time a company gets in touch with their funders, it is probably too late.

Recently funded companies should be very transparent with their financing partners. They are very motivated to protect their own investment and therefore would do whatever is necessary to help the management team find a solution. The earlier this is done, the greater the likelihood of solving the problem.

12. – Not leveraging the experience of new investors

“We are really looking for smart money here” – we have heard this line over and over again from many entrepreneurs and managers raising capital and yet, strikingly, only a handful actually takes full advantage of what investors bring to the table besides their money. Issues of control, professional pride and even personal chemistry, often get in the middle and the relationship perversely evolves into ‘something that management has to deal with’ instead of becoming an additional resource to tap into when needed.

The relationship with investors and lenders, just as any other relationship, needs to be nurtured and protected. The fact that they have already agreed to fund the company makes this even more important. In the end, companies can always follow the letter of the agreements, limit the interactions to board meetings and nothing more, but it would be a shame not to leverage the experience, contacts and advice that most serious investors and lenders can offer. After all, companies get that as part of the deal.

Raising capital is not easy. There is a myriad of factors affecting the chances of getting cash from lenders and investors. Some can be controlled but most cannot. The process in this sense demands a flawless execution in relation to those variables that can be managed. All 12 mistakes mentioned above are avoidable – paying attention to their impact and preparing the capital raising team to tackle them, will dramatically increase the chances of finding the cash the company needs to achieve its objectives.

 

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