Raising Equity

5 Common Mistakes to Avoid When Raising Equity

Raising capital for a business, whether it is a start-up or a mature company, can be an extraordinarily frustrating and time consuming experience. Entrepreneurs want to operate and grow their business, not raise capital. But the fact is that for most businesses, the entrepreneur or CEO is responsible for raising capital.

When attempting to raise capital, CEO’s very often make some crucial mistakes. These mistakes not only can dictate whether or not the business will be able to raise capital, but also how long it will take and the ultimate cost of the capital. Using the wrong assumptions, raising capital can be impossible.

We believe there are 5 common mistakes that CEO’s make when raising capital:

1. Unrealistic Expectations of Value

Most of us has watched Shark Tank at least once. Just watch one episode and you will likely see this mistake. The entrepreneur goes to professional investors with a company that did $100,000 in sales last year and confidently tells the Sharks he will sell 10% of his business for $1 million. What’s the chance of this CEO getting funding? Zero.

With few exceptions, investors will pay for what you have already done – not what you believe you will do in the future. Transactions are generally priced as a multiple of last twelve months revenue or earnings.   Sometimes a fast growing company can be given credit for the last quarter results annualized, but that’s the exception rather than the rule.

Investors are particularly unimpressed with a great idea and an entrepreneur who models earnings five or ten years out. Discounting cash flow back to today may be worth $10 million on paper, but generally an idea – even a fully baked idea that only needs capital to start – isn’t worth anywhere close to that amount.

Recently a CEO of a company that has been operating for six months called us. He had a $10 million acquisition ready to be funded. Between his small platform and the acquisition, he told me that the business would be worth $100 million. He was willing to give up 20% of the company for $20 million, using $10 million to complete the deal and another $10 million for growth capital.

Regardless of how good the idea is – or how good the acquisition is, a deal isn’t happening at anything close to that valuation. Why should an investor pay $20 million for 20% when he could theoretically pay $10 million for 100%? It makes no sense – but the CEO was absolutely convinced that someone would find this highly attractive.

When raising equity capital, use a FINRA licensed investment banking professional. You should expect them to provide you with an expected range of values prior to a formal engagement. They should have the resources to show the valuations of companies similar to yours, and to detail any private market M&A transactions that have occurred.

2. Expecting to Raise Capital Quickly

We also get calls from CEOs who want to raise capital and the CEO confidently tells us that his business is so compelling that we should be able to close a deal in 30-60 days. Or worse, he has a payroll to cover and hopes we can be in talks with someone next week.

The reality is that raising equity capital generally takes at least 4 months, and any CEO should expect and plan for 6-12 months.

Why?

Private equity firms are working on dozens of deals at the same time. On the first contact, they want to see an Executive Summary of the proposed transaction. That Executive Summary is normally a 2-5 page document outlining the company, its prospects and why it needs capital. If the firm is interested, this is followed up by a Confidential Information Memorandum.

The investment banking firm preparing the Executive Summary and Confidential Information Memorandum will normally require four weeks to gather the information from the company, perform its due diligence, write the materials and generate a list of potential investors who may be interested in the opportunity.

In week 5 the private equity firm is contacted. It normally takes a week or two to get a Non-Disclosure Agreement signed, the Executive Summary sent and feedback received from the private equity firm.

In week 7, the Confidential Informational Memorandum is delivered. Normally firms are given four weeks to process this information internally, to ask questions of the bankers and if interested, to provide the bankers with an initial proposal, or term sheet.

By the time the Term Sheet is delivered, 10 weeks have already gone by.   Even if the Term Sheet were instantly accepted, due diligence (legal, financial & operational), negotiating stock purchase contracts, Board governance and a variety of other issues will easily take 6 weeks.

Four months have elapsed, if everything goes smoothly – and frankly, that rarely happens.

Be realistic about the time involved.

3. Expecting to Raise Capital Without Investing Time & Money

A corollary to Expecting to Raise Money Quickly, is the expectation raising money doesn’t cost money.

Entrepreneurs often forget that raising capital normally entails significant legal, accounting, travel and for those that hire a banker, investment banking expense. It’s not as easy as setting up a couple of phone calls resulting in someone falling in love with the business and writing a check.

The process generally entails a significant amount of expense to get to a Letter of Intent for the investment, and then the due diligence starts. A data room may need to be set up, normally at a cost of $5,000 or more. Much of the entire history of the company is loaded into the data room, including all significant contracts, incorporation documents, financial documents and detailed information on all aspects of the business.

Due diligence teams will converge on your office, talking to your employees, getting into your financial systems, and outside accountants will scrutinize every aspect of your financial statements. At the end of the process, any “dirty laundry” will most likely have been found, and the quality of your financial statements and systems will be tested.

It’s all good when the investment is made, but most investors don’t just write a check. They review every aspect of your business is great detail, and that costs you money, time & effort.

4. Fishing in the Wrong Pond – Know Your Target Investor

Entrepreneurs looking for capital typically don’t know where to look, or who their target investor is. The CEO of a company with $10 million in sales might have heard that KKR is a great partner – but KKR won’t touch a $10 million business.

Who do you target? Venture capital? Private equity? Family offices? Wealthy friends? Customers? Suppliers? New joint venture partners?

In many cases, the best capital is capital coming from a strategic partner – someone whose investment will help you succeed.

CEO’s need to “fish in the right pond”.   Sending a packet to 100 venture capital investors is a waste of time, energy & money. Having a single conversation with the right party may result in capital. A quality investment banker who knows your business, your industry and the market will be worth far more than the fee they charge if they can make the right introduction.

5. CEO Plays Lawyer

Entrepreneurs often want to save money by being their own lawyer. What’s the old saying? “A lawyer representing himself has a fool for a client!” Well, a non-lawyer representing himself is arguably worse.

In today’s world, it is easy to find a document on the internet & edit. But transaction lawyers know how to protect their clients, and what deal terms are customary, or mandatory in a private placement. They make sure that the regulatory filings are done – many CEOs have no idea that the SEC needs to be notified of most private placements through Regulation D.

Entrepreneurs often are willing to pay a broker or finder a fee on a successful raise. After all, if Joe can introduce me to an investor who writes a check for $10,000,000, why not pay him a fee?

Most CEOs don’t know that unless Joe is part of a FINRA licensed firm and it is the firm, not the individual, who formally does the private placement, then Joe, the CEO and the company have taken on a huge risk.

Securities law says that if a non-FINRA licensed person is paid a success fee, then the investor can, at any time, ask for all their money back. So five years after the investment, the company has a financial downturn and is nearly bankrupt. The investor can demand that the investment be rescinded and ask for all their money back. Of course a company in this situation can’t pay back the money, so the investor sues the CEO, and will most likely win.

Raising capital has always been difficult, but since 2008 it has become even more difficult. The good news is that the private equity firms have a lot of capital to invest today, and everyone is very busy putting money to work. This is the best environment since 2006.

Realize that raising capital requires a significant amount of your time, energy and will cost money. Budget out the time required and the financial, accounting and legal resources required to complete the process.

Raising capital is stressful enough without having unrealistic expectations. Hopefully this article is helpful in framing your expectations and increasing the probability of your success.

Published on Axial Forum, October 28, 2014