What Information Do I Need to Share for a Capital Raise?

You may hear stories about businesses that raise capital after one meeting, with terms agreed to on the back of a napkin.  Those situations are the exception, not the norm.  Most capital raises require entrepreneurs to share a lot of intimate information about their business with investors.

Trying to assemble information mid-process can be chaotic.  We always recommend folks get their information organized in advance of formally launching a process.

What information will you need?

Investors need information on your business in order to determine if you fit with their criteria.  Here’s what you’ll typically need to provide before you get any indication of valuation from an investor.

  • A business overview
  • Sales and marketing materials that further describe your product/service offering
  • Historical financials for the last few years, including income statement, balance sheet, statement of cash flow (if available)
  • Projected financials
  • The current sales pipeline
  • Revenue by customer
  • Management operational reports or KPI dashboard
  • Employee census with title, salary, and start date
  • Capitalization table and funding history

While, investors may ask for additional information in order to better understand certain aspects of your business, the information outlined above is most of what an investor needs to discuss your deal with their investment committee.

Once you’ve negotiated the terms of a deal with an investor, they then move into confirmatory diligence.  During confirmatory diligence, an investor will validate everything you’ve told them up until this point.   It’s at this point in a capital raise process that you’ll be sharing a lot more information.  Investors will send you a diligence request list, which outlines all the information they expect to see.

Who Else do I Include in a Capital Raise Process?

Here are some of the other folks who should be involved in your capital raise.  Ideally, you want to let these people know about the capital raise prior to marketing in order to incorporate feedback and make sure they are prepared to field questions as they arise.

Accounting resources

Whether this is an in-house person or external position, whoever does your accounting will need to be involved in the diligence process.  They will need to walk investors through how the accounting is done and explain specific accounts and transactions.

Information Gatherers

You or someone at your company will need to compile all the information an investor will want to see during diligence.  This is a heavy lift, and it’s helpful to divide and conquer the load when chasing after this information.

Tax Advisors

There is an infinite number of tax implications when it comes to raising capital or selling a business. Find a good tax advisor and consult them early in the process to avoid surprises.

Your Senior-level Team

During a diligence process, you need to be prepared to discuss every component of your business.  Where appropriate, the senior members of your team need to be ready to participate in the process

Also, it’s hard to hide the fact that you’re raising capital and it’s usually not productive to do so when you’re a small company.  Your team is going to know something is going on.  We recommend letting at least the critical team members know about the capital raise in advance. This helps you set the internal narrative vs. allowing your teams’ imaginations and rumors run wild.

Should I Hire an Investment Banker?

There is an entire universe of advisors who specialize in helping entrepreneurs sell their businesses and raise capital. These advisors typically fall into three categories: Investment Bankers, Business Brokers, and Consultants.

411 on Investment Bankers

A good investment banker will help you manage the entire sell-side or capital raise process. They take over a lot of the heavy lifting and help ensure you get the best valuation for your business. Here are a few of the specific tasks investment banks help with.

  • They help you craft your strategy
  • They create marketing materials for you
  • They introduce you to the right investors
  • They field initial investor questions
  • They organize and assist you during investor meetings
  • They manage the diligence process
  • They help negotiate your deal

With all that support, why wouldn’t you hire an investment bank to help you through a capital raise?

First, to offer the high-touch service, quality investment bankers are expensive. You can pay anywhere from 1-8% of your deal in deal fees to the investment banker in addition to a monthly retainer in the tens of thousands.

Second, a good investment banker might not be willing to take you on as a client. Here are a few reasons why:

You’re too small, or your transaction interests won’t generate enough fees.

Like any service-based business, investment banks are limited by the number of resources they have. Each investment bank seeks to optimize the return on their staff’s time while ensuring they provide quality service to their clients.

Given the level of support investment banks provide, it takes just as much time to do a small deal as it does to do a larger deal (if not more). Therefore, these firms often have minimum fee requirements and deal sizes.

Your deal is too risky.

Investment banks live off of successfully completed deals. Investment banks make the bulk of their income when a successful capital raise takes place. If they take on a company that isn’t as attractive to buyers, there is a higher likelihood the deal will fail, and they will waste resources that could have been spent on another project. Further, each failed deal will reflect negatively on their abilities as investment bankers when seeking to gain new clients.

If your business is under $10M in revenue or $1-2M in EBITDA, you are usually too small for most investment banks to take on as a client. Also, if you’re raising a small amount of capital, (<$20M) your transaction interests are typically too small for an investment bank.  There are a few exceptions, like if you’re growing incredibly fast and have visibility into being a much bigger business.

The 411 on business brokers and consultants

Business brokers tend to play under the investment banker minimum. They typically focus exclusively on selling businesses vs. capital raises and tend to spend less time with each client. The quality of advice and service you get from a business broker varies greatly broker to broker. Many brokers will do nothing more than create a bullet point summary of your business and send it to every person in their network. Others do a better job supporting you throughout the process. Business brokers make most of their income by charging a percentage of the completed transaction.

Consultants are usually paid on a flat fee or retainer basis to help with particular aspects of a capital raise. Like brokers, the level of service you get varies greatly.  Our Capital Studio functions as a consultant and you can learn more about our offering here.

Do I need an Advisor?

Given the complexity of the capital raise process, everyone should have at least one outside advisor that they trust to help them navigate a capital raise process. Whether this is a professional advisor or an unpaid advisor, you should enlist the help of someone who understands your business and the capital raising process.

Here’s Our Typical Recommendation to Business Owners

Go with an investment banker if:

  • You want to sell your business and fall within the sweet spot for an investment bank (>$10M in revenue or $2M in EBITDA)
  • You want to sell a piece of your business and raise a meaningful amount (>$20M) of growth capital

Go with a quality business broker who will run a targeted process if:

  • You’re ready to sell now, you’re under the sweet spot for investment banks, you don’t have access to the logical buyers, and don’t have the time to do the research

Find a consultant who specializes in the type of transaction you want to pursue if:

  • You need help with your capital raise strategy, you aren’t sure if your business is optimally positioned, or you don’t know who the right investors are.

Go at it alone if:

  • You have a solid capital strategy, already know all the logical buyers or investors for your business, don’t need any help pitching your business

Should I Hire a Lawyer for a Capital Raise?

Yes.  You should always hire a lawyer to help you with a capital raise.

You don’t just need a lawyer, you need a lawyer who specializes in capital raising and has represented many similar types of deals.  Transaction-focused lawyers know the ins and outs of raising capital and can make sure you are protected and get a fair deal.

If your current legal representation doesn’t specialize in these types of transactions, you need to seek new representation.

What Should a Good Lawyer Help You do?

A good lawyer will provide legal assistance throughout the capital raise process. Here’s a general overview of what they will help you do:

  • Make sure your corporate legal documents are in good shape to share
  • Draft a template non-disclosure agreement to send to investors
  • Help you evaluate and negotiate term sheets
  • Help you prepare and negotiate transaction documents and amendments to the corporate documents
  • Provide advice on what terms are “market”
  • Ensure regulatory compliance
  • Potentially connect you with investors who could be interested in the deal

Is Now The Right Time to Raise Capital?

Entrepreneurs tend to agonize over timing for a capital raise, but there is never an optimal time to raise capital.

There will always be theoretical value left on the table. You need to decide if raising capital now will yield more value for you in the long-run than not raising capital now.

There are two scenarios where a business owner has an immediate need to raise capital and the answer to “is now the right time” is almost always “yes”:

  • You need capital to fund your business. This applies to both companies with negative cash burn and businesses with a working capital crunch.  A capital raise process can take 4-6 months.  If you’re going to run out of cash in that period, you needed to be out in market yesterday.
  • Your circumstances require you to access liquidity from your business.  Whether you want to retire or need cash for personal reasons, you have a higher need to raise capital now.

For other entrepreneurs, it’s less about “need” and more about “want.”  They want capital to help achieve their goals.  To answer “is now the right time” you need to decide whether the benefits of raising capital now outweigh lost future profits.

Here are two ways of thinking about this:

  1. For entrepreneurs seeking growth capital, you must determine whether the capital you raise today will help you make more money in the long run.
  2. For owners seeking liquidity, you have to evaluate whether reducing risk and diversifying assets today, makes up for lost profits in the future.

In either of these situations, you need to understand the ownership dilution you’ll be taking by raising capital and the corresponding opportunity cost/benefit of raising capital today.

What is ownership dilution?

Ownership dilution is the ownership percentage you give up in exchange for raising equity capital. Dilution is a function of valuation and the amount of capital you raise.  The higher the valuation, the less dilution you take.  The less capital you raise, the less dilution you take.

What is cash dilution?

Cash dilution happens when you raise debt.  The cash required to pay back debt could have been used towards business growth or owner compensation.  Further, debt is senior to equity holders, which means in the event of a sale, debt gets paid back first.  If the cash from debt wasn’t deployed smartly, then an entrepreneur could lose out substantially.

Opportunity Cost

If you can’t see a path to creating more value for yourself by raising capital, then you shouldn’t raise capital.

How Much Capital Should I Raise?

This is the wrong question.  The right question is: How much capital do I need to achieve my goals for the next 18-24 months?

If you raise more capital than that, you will give up too much ownership in your company.  If you raise less than that, you’ll be in continuous capital raise mode and waste valuable time that could be spent running the business.

If you can’t answer this question, you should not be raising capital yet.  Every investor will ask you how much capital you’re looking for and what the capital is for. It will be seen as a big red flag to investors if you can’t answer these questions.

The best way to determine how much capital you need is by creating a bottoms-up analysis of your anticipated expenses.  This analysis is called a use of proceeds.

Here are the primary uses of proceeds:

Financial:

  • Liquidity for existing shareholders
  • Pay down existing company debt
  • Fund working capital

New Hires

  • Sales & Marketing
  • Operations
  • Executives
  • Back Office

Growth Opportunities

  • Building new products/services
  • Purchasing acquisitions
  • Taking on large customers

Cap-Ex

  • Equipment
  • Facilities
  • Technology

Other Expenditures

  • Sales & Marketing
  • Technology
  • Consultants

What Type of Capital Should I Raise?

You have a unique business and risk tolerance.  You need to identify the least dilutive types of capital that fit with your company, goals, and personal preferences.  Here are a few rules of thumb for deciding which type of capital to choose:

When does debt make sense?

  • If you have a profitable business that only needs a small amount of capital or short-term financing and you have little other debt.
  • If you have ample cash flow, a long track record of success and strong visibility into continued future profitability.
  • If you need capital to purchase assets that a lender can use as collateral.
  • If you are a startup company with limited traction, angel investors are often willing to participate in convertible notes.

When to raise equity?

  • If your business has very few fixed assets for a bank to use as collateral.
  • If your company has negative or limited cash flow to pay back debt.
  • If your business or growth initiative has a high-risk profile (startups and new products).
  • If you’re seeking a strategic partner to help with the growth of the business.

When do hybrid models make sense?

A combination of debt and equity is often the right path for businesses of all stages.  In these situations, equity is viewed as the lead investment, and debt comes in alongside to provide incremental capital, without further dilution to existing owners.  Leveraged buyouts are a common form of this situation.

Seek advice from trusted advisors who understand your business and the capital markets to help you determine the right type of capital to pursue.

How Will An Investor View My Business?

All of the discussion about valuation in the last section has probably left you wondering how investors will view your business.  This is an important question to answer when you’re developing your capital raise strategy.  If you know what the perceived risks and opportunities are for your business, it will help you better prepare for the rest of the process.  You’ll be able to better highlight the positive attributes of your company and you may even have time to mitigate some of the risks before you launch a process.

To understand your business through an investor’s lens, you need to look at each attribute of your business and assess the risks and opportunities.  We encourage you to reference this post on what makes an attractive investment opportunity as it’s a good starting point for viewing the different components of your business through an investor’s lens.

It’s incredibly challenging to look at your business with unbiased eyes.  Your business is your baby, and you’ve been living in the day to day for too long to approach an analysis with an unbiased perspective. We recommend you seek a trusted advisor or third party to help you do this.

What is My Business Worth?

“What is My Business Worth” is usually the first question an entrepreneur asks when they decide to pursue a capital raise. Here’s the answer:

Your business is worth what someone is willing to pay for it.  Nothing more, nothing less.

That statement is wholly unhelpful for anyone who is trying to understand what their company is worth but it’s important to highlight since many entrepreneurs tend to fall into a valuation trap.  They get a specific valuation in their head and are then disappointed when no investors put in offers at that valuation.

If you get multiple offers from investors, they will probably fall within a fairly narrow valuation range.  That’s because most investors will view your business through a similar lens and conduct a similar analysis to arrive at a valuation.

Instead of focusing on a specific valuation number that you think your business is worth, it’s more productive to determine a likely range you think investors will pay for your business today.  This post will help you do that.

The Price of a Business

In the capital markets, the price of a business is called a “valuation.”  There are two types of valuations you should be aware of: Equity value and Enterprise value.

  1. Equity Value is the price an investor puts on the equity portion of your business. This is often referred to as “Pre-Money valuation” by investors.  The Equity Value = the Price Per Share x Number of Share Outstanding.  This is most commonly used when raising growth or venture capital.
  2. Enterprise Value (“EV”) is the total market value of your business. Many businesses are financed with both equity and debt.  The enterprise value accounts for these multiple stakeholders.  Enterprise Value = Equity Value + Net Debt.  (FYI: Net Debt = Debt – Excess Cash.)  Enterprise Value is most commonly used when selling all or a portion of your business.

Determining Valuation

In a perfect world, an investor performs a Discounted Cash Flow Analysis (“DCF”) to determine the appropriate valuation. A DCF projects out expected cash returns for the investor and then applies the level of return an investor expects to receive to arrive at the present value of those cash payments.  The present value represents the price an investor is willing to pay for a business today.  This is a highly simplified explanation of a DCF, for more information on DCF’s check out this link: Discounted Cash Flows Analysis.

But, we don’t live in a perfect world.

The practice of using a DCF to value private businesses requires many assumptions.  You have to make assumptions about the business’s industry, how efficient the company is at deploying capital, how fast the company can grow, etc.  A DCF also ignores supply and demand dynamics in a market.  Further, for anyone without a finance background, DCFs are complicated and confusing to explain.

So, to simplify valuations for private businesses, the capital industry created two ways to value private companies:

Market Multiple Method

For established businesses with revenue and profitability, the market multiple method is the most popular valuation method.  To value a business, investors apply a valuation multiple to either Cash Flow, EBITDA, Revenue or some other industry appropriate metric.

For example:  If your EBITDA is $1M and the market multiple is 6x, then $1M x 6 = a $6M Enterprise Value.

How do you find the right valuation multiple for your business?

The multiple an investor will pay for your business is the simplified version of all the assumptions that go into creating a DCF analysis.  Here are the primary factors driving valuation multiples:

  1. Your industry:  Some industries are more attractive to investors than others given their growth potential or risk profile, thereby commanding higher valuation multiples.
  2. Your market position:  Companies with market leadership or differentiated offerings command higher valuation multiple.  Investors have likely seen several other businesses in your space. They will be able to benchmark you compared to competitors.
  3. The stage/size of your business:  The larger your business, the higher the multiple usually is, assuming other factors about your business are favorable.
  4. Your historical and future growth: The faster you’ve been able to grow, the higher your multiple usually is.
  5. Your visibility into future earnings:  The more visibility you have into future earnings, the less risky you are and the higher multiple you’ll have.  Companies with recurring revenue and high margins have higher multiples.
  6. Your scarcity value:  There is a lot of capital chasing a small number of ideal investment opportunities.  If your business falls into this “ideal” zone for investors, investors will pay up to get the deal.
  7. You:  Experienced entrepreneurs with excellent teams command higher multiples than one-person shops or first-time entrepreneurs.

In summary, the lower the risk of losing money and/or the higher your visibility into growing the business, the higher your valuation multiple will be.

You can get a pretty good idea of the multiple range an investor will use for your business by taking a few data points and then applying those data points to your business.

Public Comparables

For most businesses, there are companies in their industry or with similar business models that trade on public stock exchanges.  By going on free websites like Yahoo Finance, you can find the EV / EBITDA and EV / Revenue multiples for these businesses.  Note that small businesses almost always have lower multiples than large public companies (Smaller companies are riskier).  Use public multiples as the absolute top end of the range for most industries.

Comparable Transactions

There are usually recent deals in your industry where a company has sold or raised capital.  Sometimes valuations are publicly disclosed and available. They serve as a useful benchmark, particularly if you can find information on similar size companies as your business.  Comparable transactions are usually why entrepreneurs get fixated on an unrealistic valuation.  If a company you perceive as similar to you trades at a very high valuation, then you may expect the same valuation. What you don’t know is how that company differs from your business and the motivations of the investor driving the premium valuation.  Don’t go into a capital raise process expecting outlier valuations.  Go into a process with a realistic view of where all deals in your space are trading.

For many industries, the comparable public comps and transaction multiples are publicly available through research reports by Investment Banks.  Try googling “your industry, valuation multiple,” and you may get lucky and find some good data points.

Investment bankers and advisors who specialize in your industry are often helpful in giving you a rough sense of where valuations will shake out.  They’ll usually give you some range or guidance on what you can expect for free, and if you hire one, they’ll do a lot of work to narrow down where you can expect your valuation to shake out.

Speculative Valuation Method

Speculation: assumption of unusual business risk in hopes of obtaining commensurate gain.

Sometimes it seems as if early-stage valuations are pulled out of thin air with no correlation to the actual performance of the business.  In some cases, this is true.  In most cases, there is a fair amount of analysis that goes into valuing a startup.

All investors seek to generate a certain level of return for the risk they take investing in private business.  Startups are very risky.  To compensate for this likelihood of losing capital, investors hope their well-performing investments will generate outsized returns.

To generate outsized returns, a startup must grow very quickly into a big business.  Growing this fast is hard work.  Teams need to stay incentivized to do this hard work.

When assigning a valuation to a business, a few factors come into play:

  • The attractiveness of the company and its team.  Some companies check every box for investors and have experienced and capable teams. These companies command higher valuations.
  • What the growth plan is.  Businesses that want to and can become multi-billion dollar businesses command higher valuations than those who will likely only grow to $10M of revenue before exit.
  • The amount of capital being raised to achieve the growth plan.  The more capital you raise, the bigger the valuation needs to be to avoid the management team who is running the business from taking too much dilution where they are no longer incentivized to grow the company.
  • How likely the investor is to lose money.  To put money in at high valuations, investors often require preferred equity and liquidation preferences.  This prevents the investor from losing money and shifts risk on to the management team to execute.

The investor will consider all these factors and then back into a valuation today that they speculate will allow them to achieve a certain return in the future when the company exits.

Valuing early-stage and high-growth companies is an imperfect art, not a science.  Seek help and trusted advisors to help you determine an appropriate valuation range for your business.

The 411 on Investors

Raising capital is a dual-sided sales process.  Investors are selling their capital to you, and you’re selling your business to investors.  Like any good salesperson, if you understand how investors make decisions and what their goals are, you are more likely to win the deal.  This post is focused mostly on professional investors.

What Are Professional Investors?

Professional investors use private investor capital to buy equity ownership in companies directly.  “Private investors” can be individuals or institutions who pool capital for individual investors (think pension funds, insurance companies, or endowments.)  Professional investment firms invest in companies, hold the investment for several years, and then sell the companies for a profit (hopefully).

Professional investment firms make it easier for investors to access private companies and make it easier for entrepreneurs to access capital.  They do this by pooling the capital from many different private investors into a “fund” and then make investments out of that fund.

“Professional Investor” is a broad category that covers everything from venture capital through huge leverage buyouts.   We’ll get more into the different types of firms later in this post.

Main Priorities of Professional Investors:

While there are outliers, investors are usually fairly predictable creatures.  They are looking to put money to work and generate a certain level of return in exchange for their investment.

Investors generate returns in one of two ways:

  1. They sell their shares for more than what they paid for them
  2. They receive payments out of the cash flows of the business over what they paid.

The returns investors expect are directly correlated to the amount of risk an investor takes.  Equity investors are taking on a lot of risk.  They usually expect minimum 20% annual return.  On the other hand, debt providers who have assets for collateral in case something goes wrong, are taking less risk and may only expect a 6-8% return.

What Do Professional Investors Do?

Contrary to what you see on Shark Tank, investors don’t get to sit in tufted leather chairs all day while raining judgment down on entrepreneurs.  Below is the high-level detail of where we spend most of our time.

  • Fundraising: Professional Investors can’t make investments unless they have the capital to invest. Investors spend a lot of time and resources getting in front of high net worth individuals and institutional investors to convince them to invest in our funds.
  • Sourcing investments: Once investors have the capital lined up, they need to find companies to invest in. Professional investors look at hundreds of deals a year and make only a few investments each year.  To find the perfect “needle in the haystack” investment, they have to network.  Some firms have teams who do nothing but call companies all day long.
  • Forming relationships with management teams: This is one of the most critical elements of being successful at professional investing. Developing strong working relationships with management teams helps investors win deals and better manage investments.
  • Evaluating investment opportunities: The pitch you see on Shark Tank is the beginning stage of evaluating a business. An investor’s job is to become a quasi-expert on a company in a very short period. They spend a lot of time getting to know management. Investors sift through hundreds of Excel files, legal documents and conduct countless hours of research to make sure they fully understand the business before investing.
  • Negotiating deals: Valuation and ownership percentages are the tips of the iceberg when negotiating agreements. Negotiating a deal requires countless pages of legal documentation with every sentence being a potential point of negotiation.  If this sounds more boring than Shark Tank, that’s because it is.
  • Managing investments: Some professional investors are fairly hands off. Other firms are operationally intensive and will drop in their team members to work day-to-day with the management teams.  The best firms offer strategic advice, support and connections to help improve the business.
  • Selling investments: Investors make most of their money by selling investments, so they spend a lot of time making sure the businesses are best positioned to get the highest price.

What are the Different Types of Professional Investors?

 

Angel Investors

Angel investors are high net worth individuals who invest their personal capital in pre-revenue or seed-stage companies.  Not everyone qualifies as an angel investor.  To comply with SEC regulations, only “accredited investors” or people with $1M in assets or who make over $200,000 a year, qualify as angel investors.  Angel investing has dramatically increased over the last ten years, and websites like AngelList help match angel investors with startups raising capital.  Angel investors typically write smaller check sizes ($10k – $500k), so startups need to sign up multiple angel investors to complete a capital raise.

Accelerators

Accelerators typically take 5-10% equity stake in a startup in exchange for strategic support, market exposure and sometimes a small amount of funding.  Accelerators can be an excellent resource for first-time entrepreneurs who have limited proof points in their business.  Like angel investing, the number of accelerators has substantially increased over the last ten years.  Some of these new entrants offer very little strategic value in exchange for equity.  If you go the accelerator route, do your diligence on the track record of the accelerator.

Venture Capital

Venture capital firms invest equity in early-stage, unprofitable businesses.  Capital is exchanged for equity and is used to fund the operations of the business.  Venture capital often follows an angel investment or accelerator program. Venture capital firms invest in the entire spectrum of early-stage companies, from pre-product businesses through larger billion dollar “unicorns.”  Venture capital is a high-risk form of investment where the majority of investments lose money or break even at best.  To cover these odds, venture capital firms look for high-return opportunities in every investment.  If your business doesn’t have the chance to grow 100%+ a year and be a minimum $100M business, it will be tough to get a venture capital firm interested.

Growth Capital

Growth capital firms invest equity in a relatively mature business to fund expansion opportunities.  Growth capital firms focus on breakeven or profitable businesses with strong growth trajectories.  ROND Capital provides growth equity to small growing businesses, which you can learn more about here.

Middle-Market Private Equity

Middle-market private equity firms invest in established and profitable businesses between $15M-$500M in revenue (the financial thresholds differs from firm to firm). Investments are usually leveraged buyouts, where a combination of debt and equity are used to buy the business.

Mega Buyout Private Equity

Mega buyout firms invest in large companies with revenue worth $500M and above.  Investments are typically structured as leveraged buyout transactions.  Mega buyouts are the majority of big-name transactions you hear about in the news.

Mezzanine Debt

Mezzanine debt is not technically equity, however, it is commonly used in addition to private equity capital. It replaces a portion of the equity in a private equity transaction.   Mezzanine debt is typically utilized for a business with steady cash flow.

Distressed Investors

Distressed investors invest in mismanaged businesses or companies on the verge of bankruptcy. They seek to revitalize struggling businesses by replacing management, rebranding, developing new products, divesting business units and other initiatives.