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When Not to Raise Capital

By Garrett Fisher
October 9, 2011

Businesses seeking to raise investor capital use the concept as a tool in business plans significantly more so than businesses actually raise investor capital. Like any financing tool, there are appropriate and useful occasions to use it and also situations where it does more harm than good.

The primary issue with the idea of raising capital is the sheer volume of times that the idea is kicked around as a fundamental cornerstone to a successful business plan. Given that it is so important in the mind of many entrepreneurs (and yet is successful in so few occasions) lends to a significant distraction factor. Namely, on occasions where it would be better suited to move on and find other sources to propel a business, entrepreneurs are instead building business plans on capital that they likely will not get. It translates into a significant waste of time and business resources. Furthermore, when compounded with painful opportunity cost, big problems are not solved and growth opportunities missed on a fruitless quest.

While some CEOs may label the approach as a limited accounting (cynically: “bean-counting”) perspective, remember the perspective of the investor: institutional capital sources employ analysts and individuals with a sometimes similar “bean counting” mind critically trying to find issues with business plans. It has been stated that venture capital is “extremely Darwinian” – often resulting in highly frustrated entrepreneurs dismayed that a capital source will not sign on to his vision for a business. While not getting capital is a setback, it is not necessarily a judgment on the entrepreneur’s vision, abilities or business plan. The purpose of this article is to identify situations where an entrepreneur will repeatedly face setbacks and waste valuable time and resources that could have been spent pushing the business forward incrementally (and ironically making it more attractive for an investment later on).

Very Early Stage

  • When Not to Pursue: Most institutional capital is interested in businesses with established operations, quantifiable revenue streams and trailing EBITDA. The vast majority of companies that receive institutional capital fall into the above criteria. If a company does not meet all or substantially all of these requirements, institutional capital more often than not will not be available. There are exceptions for disruptive technologies with very specific applications and synergistic acquisitions into like-kind portfolio holdings with significant back-end economies of scale. Aside from institutional capital, the angel investor world is often considered a next option. Angel investors are a long shot generally; contingent on the contact network of the business owner and amount of capital sought. Unless the business is profitable on a trailing basis with stable positive cash flow or unless there is attractive security in some assets for the investor should the business fail, expect a very uphill battle for angel capital. It is important to recognize that an individual’s contact network should be considered. If investors already trust a business owner, then it’s a different story from having a business plan and deciding to go and “find some investors.”
  • What Companies Should do Instead: Remember that many success stories started with an idea, a garage, a small amount of cash, endless determination and some element of a wing and prayer. Where businesses often go wrong is to ask someone else to bear the entire burden of bringing a business from a simple idea to a flourishing operation. Banks and investors want to see some reasonable investment on the part of the business owner. Break the business plan down into manageable pieces, prove some of it and continuously revisit capital needs as the business develops. Do not let the pursuit of capital defocus & impede sheer determination to make a business a success.

Burdensome Amounts of Capital

  • When Not to Pursue: Seeking a capital investment that is not commensurate with the size of the existing business, trailing earnings and ability to scale operations lowers successful capital placements. Additionally, when a business has multiple stages of growth over many years, seeking a massive capital round upfront (exacerbating disparities between existing operations and projected) creates more of a hassle.
  • What Companies Should do Instead: Break down capital infusions into quantifiable pieces. If $10MM for a $2MM company is sought (a bit of hyperbole here), is there a first step that will produce additional net income, solidify the business further or do some other significant good? If capital sources are skeptical, show what a small amount of capital can do. Each step of a long business plan that becomes proven further increases chances of additional capital going forward.

Unrealistic Expectations

  • When Not to Pursue: This type of situation arises when a business has see-sawing performance and has nailed the business model only in part of the operation. For example, a retail operation that has a few locations with stellar results and other locations losing money. Business plans that make the assumption that the stellar results can be repeated, every single time with significantly more units in a quick period of time will turn off capital sources as unrealistic. In another case, consider a business with inconsistent earnings year over year that produces projections assuming rapidly increasing earnings (a chart that looks like a hockey stick). It is surprisingly common that presentations to investors involve a non-existent or barely operational business with exponential year over year growth ending in 5 years with an IPO on the New York Stock Exchange. While it seems silly in this context, the concept is presented by very small businesses to investors more commonly than expected. While Groupon, LinkedIn and Facebook have been tremendous stories, they are the exception and not the rule. If a business is endowed with that much success, of course it should run with it; however, consider how realistic it is to make a presentation expecting to be the next Facebook.
  • What Companies Should do Instead: Be realistic. If a certain percentage of units or sales (or whatever other metric of generating revenue) historically flops, then it would be realistic to assume a similar percentage going forward. Since it is so rare that a small business can grow their size explosively in a short period of time, if the projection calls for it – then show an explosively compelling reason for the growth. Avoid unrealistically commoditizing the business (i.e., if 1 salesperson = $1MM in revenue, consider how appropriate it is to project scaling the business that fast based on how fast salesmen can be hired). Tie projections to realistic business cycles. For example, the “recovery” we are experience is anemic and unlikely to be followed by a boom for some time. Factor that reality, possibly even a minor double dip into the forecast. Perspectives grounded in reality build confidence in the business owner’s projections.

To Solve Cash Burn

  • When Not to Pursue: When a business is losing money, the temptation to plug the hole with a fresh round of investor cash while not making significant structural changes is extremely appealing. While there are a myriad of reasons that it may make sense to a business owner that the business is going to turn around (and they may be real as well), the business is in a significantly handicapped position to attract investors. Often times, emergency cash can be obtained from existing investors. It is extremely rare to assume that one can go to market hoping to find new investors to rescue a declining situation.
  • What Companies Should do Instead: Face the problem(s) squarely and make aggressive decisions to halt the slide (aggressiveness of changes should be commensurate to the danger the business is in). Finding an investor seems easier on paper than confessing to a bank, landlord or vendor that cash flow is a problem and help is needed. It is also easier than having to reduce workforces and abandon old growth objectives. When a business is on the edge, remember that “time is money” and pursuing a possibly fruitless capital quest at the expense of business-saving changes could be foolhardy. In a truly serious case, turnaround capital is a viable option – though expectations should be in line with the marketplace. Turnaround capital is highly expensive (“expensive” being defined as how much of the company is sold for the capital) and often results in a management changeover. This situation is generally a wise idea when either it is one of the only options the business has to salvage any investor value or it is a means to avoid a business bankruptcy that will trigger personal guaranties and possible bankruptcy of owners.

To Pay a Salary

  • When Not to Pursue: A pitfall of some entrepreneurs to develop a business plan that fundamentally consists of the entrepreneur conveniently receiving a full salary from day one while operations are spun up, customers sought, and a business made. Unless investors are already known, masking what is ostensibly paying a wage as an investment is not a value proposition.
  • What To do Instead: Recognize who is risking their capital and build the business plan accordingly. It makes no sense to ask an investor to risk all capital while an entrepreneur is given a decent income stream. Build business plans where realistic equity and sweat equity is contributed commensurate with ownership stakes.

Capital markets function much like bank financing: a cruel duality where capital is available when a business needs it least. Instead of approaching the situation and directing resources toward frustrating and agitating denials and setbacks, consider the appropriateness of investor capital as a specific tool to be used in specific situations. Above all else, deploy limited management resources toward driving a business forward in the most expedient way possible.