Which Business Characteristics Are Attractive to Investors?

The following characteristics are attractive to investors.  Businesses that have these characteristics are more likely to secure investment capital than those that don’t.  Very few companies check every single box.

A+ management team

A strong management team is the most important element of an attractive investment opportunity.  Investors spend a lot of time getting to know management and evaluating their strengths and weaknesses.  Strong management teams have proven executives, strong leaders, and industry experts.

Strong market position

Investors prefer to invest in businesses which are best positioned to lead the market and win new business.  Great investment opportunities have differentiated products with meaningful value propositions that compete effectively with other industry players.

Track record of growth

Most investors (turnaround firms excluded) want to see a history of growth.  As a general guideline, established companies (non-startups) with revenue growing north of 25% are good growers.  For startups, investors look for over 100% growth per year.

Multi-pronged growth strategy

If you want to get an investor excited about your business, discuss your multi-pronged growth strategy.  Companies that have the opportunity to become much larger get investors excited.  The prongs of a growth strategy are: 1) More sales of existing products to target customers, 2) Selling existing products into new customer segments or geographical regions, 3) Launching new products to the market and 4) Acquiring other businesses that achieve either one of the above or open up a new transformative opportunity.

Attractive customer dynamics

Investors want to invest in companies with a diversified base of happy customers.  Investors want to see low customer concentration among your top customers (limits the risk associated with losing a customer), increased same-customer revenue, and low customer attrition.  Well-known customer names is a bonus and point of credibility, because it’s not easy to win big accounts.

Predictable revenue

The ability to forecast and predict future revenue gives investors more confidence in ongoing growth.  Companies with multi-year contracts, repeatable sales cycles, and recurring subscription revenue tend to be most attractive to investors.

Ample free cash flow

For leveraged buyout investors, debt is often essential to the deal and paid down with cash flows from the company.  Since debt is senior to an investor’s equity, leveraged buyout firms avoid companies with limited cash flow as they won’t be able to pay down debt, interest payments or cover operational costs.

Limited operational risk

Investors evaluate the operational risk of each process and department within a company.  Companies with high concentrations in suppliers or channel partners, with no available substitutions, are riskier.  Companies without internal processes to manage sales, marketing, customer service, IT, etc., are also riskier.

Favorable industry trends

Investors want to see a large, growing industry with favorable regulations and trends.  Investors prefer to invest in sectors that will exist for years to come, rather than industries that could become obsolete with new technological innovation.

Reasonable valuation expectations

Professional investors invest other individuals’ capital, who expect a certain return. If investors pay a high valuation for a company, they will have to get an even higher exit price to meet return goals. Regardless of how great a business may be, if investors don’t have a path to achieving their return thresholds, they won’t be able to do the deal.

Multiple exit/return opportunities

Investors make most of their money when they exit companies.  To sell a company, there has to be a buyer. We will evaluate the logical buyer universe before investing.  An ideal scenario is a broad landscape of potential strategic acquirers as well as other private equity firms.

Nearly Always Unattractive Businesses

There are a few types of businesses where very few of the above characteristics apply, and it’s incredibly difficult to raise capital.  Not impossible, but very difficult.  Here are a few examples:

  • Single-Person Service Providers – If you’re an independent service provider, it’s much more difficult to raise capital. The success or failure of the business is dependent on you not getting hit by a truck, which presents a significant risk factor for all capital partners.
  • Small Turnaround Businesses – Small businesses that are going through a downturn or on the brink of bankruptcy have a tough time raising capital.  If you do find a capital partner, the terms are going to be unfavorable.
  • Products with no sales – If you invented a product and had zero or minimal sales after a long period, it’s difficult to find someone to invest in the business.

What Are The Pros and Cons of Raising Capital?

Raising capital is risky.  There is no question about that.  Before you raise capital, you need to decide whether you’re comfortable with the risks.  Here are the main ones:

  • Except for grants or gifts, all capital comes with strings attached. You will have to give up some form of control.
  • You will own less of your company in an equity capital raise and to get the same value for your business after raising equity, you need to create a more valuable business
  • Capital may come with restrictions as to how the business can operate going forward
  • You risk competitive sensitivity by opening up your business to other parties for diligence
  • A capital raise can be a distraction to you and your employees
  • Raising capital can be a long process
  • The wrong capital partner can harm your business

Here are the reasons many entrepreneurs, despite these risks, choose to raise capital each year:

  • Breathing room. When you’ve been operating on a shoestring budget at maximum capacity, it can be a huge stress reliever to have a cushion to execute your business plan
  • Capital helps accelerate your growth plan to create a larger business, faster
  • Capital enables you to access liquidity from your business
  • Capital can help you increase the value of your business and the dollars in your pocket when you ultimately exit
  • Capital will enable you to bring on more resources
  • The right investment partner can add immense strategic value to your business
  • A good investor can provide invaluable unbiased perspective
  • Capital can help you buy out existing shareholders
  • Distributions from the sale of a business are taxed at capital gains rate vs. ordinary income

What are the Different Types of Capital?

The materials in this guide mostly focus on raising equity capital; however, you should understand all capital options available to business owners before deciding on a capital strategy.  The last thing you want to do is raise the wrong type of capital, only to regret it down the road.

There are two primary types of capital: Debt and Equity.  Let’s dive in to each of these in more detail.

Primer on Debt

Debt is considered a cheaper form of capital than equity because it’s non-dilutive capital.  Non-dilutive means you aren’t required to give up ownership in your company in exchange for the cash.  Debt can be a fantastic option for business owners.

Debt lenders are risk-averse.  They don’t expect huge returns, but they don’t want to lose money either.  To prevent loss of capital, they require insurance in the form of collateral, liquidation preferences, and repayments.  This insurance can make debt riskier than equity for small, growing businesses.

Here are the primary types of debt available to entrepreneurs:

An SBA loan:

The Small Business Association (“SBA”) offers a variety of loan programs to small business owners.  You typically access this capital through local banks who administer these programs.  The SBA website (link here) has a great deal of information on these types of programs.  SBA loans tend to have more favorable terms and fewer restrictions than traditional bank debt, but the process for applying for these loans is not quick and not every business qualifies.

A CDFI loan:

Community Development Financial Institutions (“CDFIs”) are non-profit organizations that provide loans to help generate economic growth in disadvantaged populations.  These loans generally have favorable terms, but not all businesses qualify for CDFI loans, and eligibility differs between organizations.  For more information on CDFI’s check out the CDFI website here.  For a searchable database of CDFI programs near you, check out this link.  You can find even more info on CDFI loans here.

A line of credit:

A line of credit functions as a credit card for businesses.  For companies who only need a small amount of cushion to cover a short-term gap in profitability or fluctuations in working capital, this could be a viable option.

A term loan:

A term loan is a lump sum provided to a business which comes with annual interest and principal payments.  This is similar to a mortgage on a house, and the assets of the company are typically used as collateral to secure the term loan.  If you don’t have enough business assets, lenders often require personal guarantees on the loan.

Venture debt

Venture debt is either a term loan or line of credit offered to startup business alongside equity from another investor.  The key provision for venture debt financing is that the company has ample cash on hand and an investor who is capable and willing to contribute additional equity to the business.

Mezzanine debt

Mezzanine debt has a higher interest rate but generally does not require annual principal payments.  The debt is typically paid off in a lump sum at the end of a set term.

Convertible Notes

Convertible Notes are debt instruments that convert into equity based on specific provisions and timelines.  These are common with startup companies who have limited traction and don’t want to place a valuation on the business.

SAFES

SAFES are a relatively new invention by the folks at Y Combinator and are similar to Convertible Notes.  SAFES allow startups to raise capital from investors for the promise of future equity in the company.  This isn’t debt or equity, but it’s an IOU, and in our opinion, any IOU is a form of debt.

Primer on Equity

Equity is more expensive than debt because you give up ownership in your business in exchange for cash.  However, equity doesn’t have cash interest payments or rights to liquidate the company (usually).  You also get more support and advice from equity providers than you do debt partners.

The most important thing you need to understand about equity is that it has three different structures:

Common equity:

Common equity is what employees and founders of the business own.  An all common deal structure means all investors are in the same asset class as founders. Upon the sale of a business, all owners would split the proceeds from the sale pro rata based on their ownership percentage.

Participating Preferred

Participating preferred is the most dilutive and expensive form of capital for entrepreneurs.  The participating preferred structure means that an investor gets paid back a multiple of their original investment, then participates pro rata with all common investors in the remaining proceeds.  Investors use this structure to guarantee returns for risky or underperforming businesses.

Convertible (or Non-Participating) Preferred

A convertible preferred structure is a middle ground between common and participating.  Investors have the option to receive either a pre-negotiated preferred return or to convert into common and participate pro rata with common investors.

What Does a Typical Capital Raise Process Look Like?

On average, it takes 4-6 months to complete a capital raise process.  While each process is unique, they all follow the same steps, as outlined below:

1. Planning

Planning is the most critical step in a capital raise process.  This is where you create your game plan.  Don’t start talking to any investors until you know the basics of what it is you’re trying to accomplish with a capital raise.  For more information on planning for a capital raise, check out Part 2 of our Capital Raise Prep Guide.

2. Preparation

Preparing for a capital raise is essential for three reasons: 1) Being more organized on the front end saves you time running around hunting down information while you’re in the thick of diligence; 2) It helps you to control the initial narrative of how your business is perceived in the market, and 3) You waste less time with the wrong investors.  For more information on preparing to launch a capital raise, check out Part 3 of our Capital Raise Prep Guide.

3. Marketing

The marketing stage of a capital raise process is where you contact prospective capital partners and manage the initial meetings and information requests.  The culmination of marketing is a signed term sheet or letter of intent, which outline terms of the deal.

4. Diligence

Diligence is where you choose a capital partner and move towards negotiating and finalizing the deal documents. At this stage, you will be providing a lot of information about your business to a prospective capital partner for them to get comfortable writing a check.  The culmination of diligence is a closed transaction and money in your account.

5. Post-Close

Immediately after closing a deal, there is a lot of work to be done. You need to communicate with your team and other stakeholders in your business, put in new processes and start deploying the capital you just raised.

The Missing Step in Most Capital Raise Processes

Experienced entrepreneurs usually add an extra step between steps 1 and 2, which can help accelerate a capital raise process.

Savvy capital raisers let certain investors know about their upcoming plans to raise capital in advance of launching a full process.  The ideal outcome of this strategy is a good, quality investor steps up to invest in your company; thereby eliminating the need to launch a full process.

Nearly all entrepreneurs can incorporate this tactic into their capital raise.  Your pool of potential investors may be professional investors, or it could be high-net-worth individuals, customers, vendors, etc.  Keep these preliminary conversations very high-level.  Tell them that you’re planning to launch a capital raise, explain why, and ask if they are interested in participating when the time comes.  If someone steps up and wants to move quick, great. If not, you at least have these contacts warm for when you do launch your process.

How can I shorten a capital raise process?

  • You already know the right capital partner(s).  They already trust you, love your business, and it should take them less time to get up to speed and close a deal.
  • You quickly identify the right capital partner(s) and they are excited about your business and willing to move fast to prevent someone else from getting it.

What could cause my process to take longer?

  • Wasting time with the wrong investors who will never put money in your business
  • If you do a poor job of communicating the merits of your business to investors
  • If your business is struggling or not in the best shape
  • If you can’t get information to capital partners in a reasonable time period
  • If a meaningful change happens to your business while you’re talking with capital partners (major lost customer, etc.).
  • If you get far down the path with an investor and they back out and you have to go back out to market.

Why Are You Raising Capital?

 “You know what sounds like fun, let’s call a bunch of investors and let them poke around the business for the next several months.”

–    Said no entrepreneur, ever.

Entrepreneurs who are satisfied with the current state of their businesses and financial positions, do not need to raise capital and shouldn’t.  Their time is better spent running their businesses.

Before you spend more than thirty seconds exploring a capital raise, you need to have a good reason to do it.  There are only three reasons:

  1. To Accelerate Growth
  2. To Get Liquidity
  3. To Fund Negative Cash Flow

Let’s dive into each of those motivations in a bit more detail:

Raising Capital For Growth

Take the next few minutes to think about the following question:  “If you had unlimited access to capital, how would you grow your business and where would you spend that capital?”

If you can’t answer this question, growth capital isn’t right for you.  Capital is a tool that can help you meet your goals and accelerate your business’s growth trajectory. Capital alone doesn’t grow a business.

Before you set out to raise growth capital, you should have a plan for how to deploy that capital.

Raising Capital For Liquidity

There is no marketplace to quickly and easily take money out of your company.  If you want to buyout another shareholder or sell a portion of your ownership, you will likely need to raise outside capital to turn illiquid value into cash.

FYI – If you sell a piece of your business but retain a meaningful amount of ownership, this is called a “recapitalization.”  As you explore investor websites, you’ll see this term used often.

Growth capital and liquidity aren’t mutually exclusive.  Entrepreneurs can raise capital to fund growth initiatives and cash out a piece of their ownership stake for liquidity at the same time.

Raising Capital To Fund Negative Cash Flow

There are three types of businesses that need to raise capital to fund negative cash flow:

  1. Startups that need to fund the build-out of their companies
  2. Business owners who need to fund working capital
  3. Business owners who are going through a downturn and need capital to fund operations

If none of the above scenarios describe you, do not raise capital.  If one of these does, then keep reading through our capital raise prep guide.

Capital Raise Checklist

If you can answer yes to all these questions, then you are ready to raise capital now.  If you can’t, each question in this checklist is also a link which will provide you with more information.

Capital Raising 101:

  1. Do you know why you are raising capital?
  2. Do you know what a typical capital raise process looks like?
  3. Do you know what the different types of capital are?
  4. Do you know the pros and cons of raising capital?
  5. Do you know which business characteristics are attractive to investors?
  6. Are you knowledgeable about professional investors?

Create the Right Strategy For Your Business

  1. Do you know what your company’s valuation range will be?
  2. Do you know how investors will view your business?
  3. Do you know what type of capital makes sense for your business?
  4. Do you know how much capital you want to raise?
  5. Does it make sense to raise capital now?

Prepare the Smart Way For an Equity Capital Raise

  1. Do you have a good transaction lawyer signed up?
  2. If you are hiring an Advisor, have you signed one up?
  3. Have you looped in all the appropriate people, including employees, investors, board members, vendors, etc. to help you?
  4. Do you have all the information you’ll be sharing with investors organized?
  5. Do you have good marketing materials put together to share with investors?
  6. Do you have the right information in your investor deck?
  7. Do you have a defensible projection model put together?
  8. Do you know what legal documents you need?
  9. Do you know how to stage your capital raise process?
  10. Do you have a target list of investors put together?

Managing Your Marketing and Diligence Process

  1. Do you know how to get in front of investors?
  2. Do you know how to handle initial investor meetings?
  3. Do you know how to evaluate investors?
  4. Do you know what questions investors will ask you?

Introduction

Imagine this situation:

You are a professional football player.  Your career is on the upward swing, and you’re talking to your coach about advancing to the next level.  Your coach tells you the following:  “To advance your career, you need to win a ballet competition.”

This is what it’s like for an entrepreneur who raises outside capital for the first time.  To raise capital, entrepreneurs must learn an entirely new set of rules and strategies they may never use again.

Some entrepreneurs forgo the “learning” part and jump right into a capital raise with little to no prep work.  This tactic works successfully for only a small percentage of entrepreneurs, and it’s usually because they already know the right investors.

For the majority who try this approach, they end up looking like an NFL lineman in a tutu. If they do manage to raise capital, they waste valuable resources and usually leave meaningful value on the table.

Savvy entrepreneurs do their research and seek out advice and input from trusted advisors before raising capital.  They are thoughtful in preparing for a capital raise and in approaching investors.

This Capital Raise Prep Guide is designed to empower you with the general information and tools every entrepreneur should have at their disposal before raising capital.  It will make you better prepared to raise capital and ultimately rock that tutu.