Sustainable Business/Raising investment funds

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This chapter is designed to give you a brief introduction to the types of funding available and in particular whether your business might be able to attract outside investment. It also explains how you will have to modify or expand your Business Plan to attract such funding.

The chapter covers these topics:

• What sources of funds are available?
• Are you ready to share control of your business?
• Do you have the right kind of business?
• How committed are you and your team?
• Funding by agreed goals or outcomes
• The need for an exit strategy
• Preparing your presentation

If after reading this broad overview you want to pursue any of these topics in more detail, we recommend that you:

• Visit the website www.escalator.co.nz or phone 0800 822 748 and ask for the New Zealand Trade and Enterprise Escalator Service Introductory Pack. This pack includes the Investment Ready Guide booklet which covers in more detail all the subjects mentioned in this chapter.
• Seek professional advice as early as you can, specifically from your lawyer and accountant. At the very least inform them of your plans, as they may have contacts that could help you.
• Apply directly for the Escalator deal-preparation service online at www.escalator.co.nz or call 0800 822 748.

What sources of funds are available?

The most common types of funding available for business development and growth can be summarised as follows:

Personal equity, friends and family

Most businesses are funded by the owner’s own equity (capital). The most common sources of small business equity are the owner’s savings and/or a loan or mortgage raised against the owner’s home. Further financing is often raised from friends and family. Personal equity can also include the cashflow or savings you have built up in your business.

Bank and private institution finance

The second most common source of funding for business development is the private banks and financial institutions. These funds, whether in the form of short or long-term financing are typically for specific purposes, such as an overdraft to provide short-term working capital or a term loan to purchase buildings, machinery or other assets. Leasing and hire purchase arrangements also fall into this category. Note that such funding involves little risk for the lender (the funding is characteristically secured against collateral, personal guarantees or a good trading record), and the funding is for specific purposes. The banks or other lending institutions are not interested in taking up any ownership stake in your business.

Government assistance

Some businesses qualify for government funding or assistance. This is more likely to be forthcoming if your business concept involves a new or advanced technology concept with the potential to provide significant employment and/or generate significant foreign exchange (export dollars) for the New Zealand economy. You can browse www.nzte.govt.nz to find out if your business qualifies for any kind of government aid. If you have an advanced technology business or business concept, visit the Technology New Zealand site at www.frst.govt.nz or contact their nearest regional office for details of possible support or funding programmes.

Angel investors

Simply put, an angel investor is the name given to a person who is prepared to invest in a promising business venture, often at a relatively early stage.

For example, a typical angel investor might be an experienced business person with spare investment funds who is looking around for a more exciting investment opportunity than parking spare funds in a bank account or term investment. Investing in high-growth companies allows angel investors to trade off the risk against the excitement and the opportunity to back a potential winner. They are interested in good returns, but are also attracted to the energy of a young company—sometimes backing people they like as much as the idea itself.

Angel investors will rarely go into an industry they know little about since this poses a danger for them. Most prefer to enter an industry they know and have contacts in, so that they can reduce their risk and add value to the business by offering expertise, capability and advice.

The value of angel investors is that they will often back and finance promising small businesses at an earlier, developmental stage where venture capitalists refuse to tread. This is often the stage before the business has any sales or marketing track record, but needs funds to build prototypes or research feasibility. They also fill an important gap by operating in smaller investments (in New Zealand typically up to $1,000,000, but normally less than this), where venture capitalists would not get enough of a return to be interested.

Angel investors do expect a decent return on their money (a minimum is usually 30 percent), and often want some equity (ownership) position in your business to compensate them for the risk.

Venture capitalists

Venture capitalists are investment companies or fund managers that provide cash in return for part-ownership of your business.

Venture capitalists are a different class of investors to angel investors. Their core business is investing in other businesses (unlike angel investors, who may still be in business) so they are typically far tougher in their requirements. Because of the time and cost of due diligence (checking out your business), venture capitalists are not interested in looking at small investments. In return for risking their funds, they tend to favour only high-growth companies that are likely to provide them with at least a 30 percent to 50 percent return on their money.

Venture capitalists will typically want to play an active role in your business. This may range from actually placing a manager inside your company (if they feel the business lacks certain skills), to helping you with strategic alliances and contacts with other companies. At the very least they will require representation on your board of directors to oversee the running of the company.

Venture capitalists also add value through their experience of taking products or services to commercialisation, and through their international networks.

Corporate investors

If your company does very well, then one option at a later stage is that a corporate (a larger company which is usually a multinational) will start to take an interest.

These corporate investors are not primarily interested in high rates of return on any funds invested in your business, nor on taking a percentage of the company. Instead, they will want to buy you out. The most common exit for most venture capital funded companies is a buy-out by another company (known as a ‘trade sale’).

The venture capitalists are happy as they are able to exit at this stage. They can take their profits and invest in another business. As owner you will be happy as you will also get lots of money (for your percentage of the company). Typically you will secure a contract to continue working in the company on a salary plus stock options to keep you keen (as the corporate will usually still want your input).

Why does the corporate buy you out? Their key reason is for strategic synergies. They want your business as you do something they don’t (or do it better than they do). For example you may have a superior technology, a unique product or service, exceptional staff, or a long-term contract guaranteeing sales, etc.

Another difference between venture capitalists and corporate investors is that corporate buyers don’t want to exit. They will buy your business for the long haul, as part of their overall corporate development strategy.

Are you ready to share control of your business?

Both angel investors and venture capitalists may require a share of control in your business. Venture capitalists will typically require more control and closer scrutiny of your operations.

If you are not prepared to surrender some control of your business there is no point in approaching them. You will be wasting your time and theirs. This is the major stumbling block for many New Zealand business owners, but the reality is that owning 40 percent of a business worth $5,000,000 is clearly preferable to 100 percent control of a business worth $250,000.

Bear in mind that business wealth is most commonly achieved by sharing control of your business. In other words, using outside funding as leverage to accelerate the growth and development of the business.

Do you have the right kind of business?

It’s a mistake to believe that only advanced technology businesses attract investment funds or the attention of investment capitalists. But your business must have some special distinguishing features before you can hope to attract investment funds. Here are some questions to think about:

Does your business have the ‘WOW !’ factor?

Does your concept break new ground? Are people really impressed by what you’ve developed? Is this feeling shared by a wide range of business people, not just close friends? How much market research have you undertaken? What is the level of interest?

Barriers to competition

Most important, does your business have a sustainable competitive advantage? What would make your business even more attractive to investors is a high barrier to competition.

For example, if your idea would be very hard to copy because you possess ground-breaking advanced technology that others could not easily copy, this is a strong competitive advantage. Do you own patents or protected intellectual property? How long will you be able to sustain your market lead? Have you thought ahead in your strategy plan to second-generation products and services to keep ahead of the field?

Is your potential market big enough?

Venture capitalists will only invest in businesses that have a high growth potential. You might attract some angel investment for a product or service likely to prove a hit on the local market, but venture capitalists are unlikely to be interested unless you can demonstrate a global demand for your product or service. The New Zealand market is just too small to be of interest to them.

At what stage is your business?

All businesses go through a life cycle from development to decline. Is your business in the development stage, the start-up or introductory stage, the growth stage or maturity stage?

As mentioned, during the development or start-up stage you’re unlikely to attract funding from venture capitalists. They will want more concrete evidence that the business idea is viable than just enthusiasm and your conviction that it will change the world. Your likeliest sources of funding for these earlier stages are your own equity, plus what you can raise from friends and family and perhaps funding from angel investors.

The growth stage offers you the best opportunities for attracting investment funds from venture capitalists. This is the stage where you have got the product or service off the ground and the business is generating cashflow. Note that if they invest at this stage, they will want to exit your business before the maturity stage, and certainly well before the decline stage.

How committed are you and your team?

You are very unlikely to attract investment funds unless you can demonstrate total commitment to your business. It’s a mistake to assume that you can tap into other people’s money without risking any of your own equity or assets.

Investors will want to be convinced that you are passionate about your business, that you are risking most of what you have on the business, and that you have exhausted all sources of funding first. After all, why should they risk their money unless you’re prepared to commit yours?

Of course there’s also what’s known as ‘sweat equity’. A person may have spent years of their life developing a certain product or service, and this certainly counts in the investor’s mind. Years of commitment and labour can sometimes mean even more than money.

An excellent team

One of the features that venture capitalists will scrutinise very closely is your business experience and skills. Do you have the skills and experience necessary to build your business? What about your energy, dedication and commitment? What is your leadership track record?

They will also be interested in your business track record, that is, have you been involved with previous business successes?

They will apply the same scrutiny to your key staff team members, so your Business Plan should explain in some detail their skills and experience and how you intend to keep them motivated and dedicated to the task of building a great business.

Excellent business ideas are far more common than excellent business teams that are capable of developing the potential of these ideas. For this reason venture capitalists will take a keen interest in your team and may propose additional people to fill skills gaps. For example, if you lack a marketing specialist, they might suggest a suitable person for this role.

An advisory board

In your Business Plan you should also provide details of your advisory board and how often this meets. Every business looking for investment funding should have such a board, which might typically consist of your lawyer, accountant, industry experts and others that you might co-opt, such as experienced business people. More experienced business people might also be assisting you in a mentor role.

Funding by agreed goals or outcomes

It is worth emphasising that you are unlikely to get all your funds at once. For example, if you secure venture capital funding of $1,000,000 dollars to develop your business, you are highly unlikely to receive a cheque for that amount. Instead the funding is likely to be fed into the business in negotiated amounts as you achieve agreed goals or outcomes or meet agreed timelines.

The good news is that when venture capitalists commit to your business they will usually agree to continue to invest in you as the years go by and introduce new investors if the need arises since they have a vested interest in the success of your enterprise.

Venture capitalists can also help your business in many other ways. Because they have had experience of many business management teams they will be able to help you develop your team, provide ideas for increasing staff commitment and provide or suggest managers to oversee critical areas in which your present team may lack skills.

In addition, they are well placed to help you with strategic alliances, networking and contacts with other companies, both here and overseas. These advantages can significantly improve your chances of success and speed up the growth of your business.

The need for an exit strategy

It may sound strange, but venture capitalists will need you to spell out your vision of their exit strategy as part of your strategic plan before they consider investing in your business. This is because venture capitalists are typically not long-term investors. Their aim instead is to invest funds in a business, help build the business up to its maximum strength, and then exit the business to repeat the process. Their investment timeframe is typically three to five years or less.

Your business plan should therefore spell out when this is likely to occur. The exit strategy can take several forms, such as the venture capitalists selling their shares back to you and/or your management team, or selling their shares to another investor, or facilitating the sale of the company to a larger company, or helping to list your company on the stock exchange.

Obviously the more successful your business becomes, the easier it will be to facilitate one or more of these options. What is important is that the venture capitalists can see a clear and convincing exit path for themselves.

Intellectual property you own

The intellectual property of your business may be the most valuable asset you have. Make sure it is yours and that your employees don’t think they own it. Many companies have been shocked to find that when a key employee leaves, so do all the files. And if the employee completed work at home (for you) they may argue that work is theirs. Regardless of who is right or wrong, an investor does not want to see employees running off with the goods.

At best it can cause huge delays as the issue is resolved, even if finally it is in your favour. Insert clear instructions in your terms of employment that all intellectual property developed by the employee is owned by the company. If this is too late, then get declarations from your employees that all the intellectual property is yours. See your lawyer immediately to make sure this is watertight.

Any investors will also need evidence that any brands, patents, trademarks or existing copyrights are actually owned by the company with no claims or liability issues likely to emerge.

Try to separate out the intellectual property issues from trading activities.

Confidentiality agreement

In the course of seeking investment funds you will have to tell many people about your idea to arouse interest in backing you. But there comes a time, particularly when you need to reveal intellectual property, trading or financial details when you have to start asking people to sign a confidentiality agreement.

This agreement has two purposes:

1. It lets potential investors know that you have thought about confidentiality issues.
2. It helps prevent people telling the wrong people.

Anything discussed therefore has to be kept confidential by the person you talk to.

Structuring the deal

Before you approach an investor, you’ll need to think carefully about how you will structure the ‘deal’. Make sure you get plenty of advice from experienced advisers as you don’t want to gain an interview with an investor before you fully understand what you’re doing.

For example, you need to know what type of funding you’re after. Is it all equity, where you exchange part ownership of your company for the cash? Or is it going to be all debt, as you think you’ll be able to repay the money without giving up ownership?

Possibly you may require a mix of some equity and some debt. Are you going to lease or buy essential equipment? The critical aspects of any deal are: what type of deal (equity, debt, etc.) does it involve? What will the capital be used for? What is the exit strategy?

Attend the free Escalator Service workshops

You should not approach an investor before you understand how the investment industry works. Your next step is to attend a free Escalator workshop: this will give you an opportunity to increase your understanding of possible deal structures and enhance your chances of receiving investment capital. You can also apply directly for Escalator deal-preparation assistance. For more information visit www.escalator.co.nz or phone the Escalator help desk on freephone 0800 822 748.

Preparing your presentation

If you’re seeking outside capital, you will more than likely have to present your idea at some stage to a group of investors. Your presentation should be as professional as possible because there is unlikely to be a second chance. A suitable consultant can advise on how to shape an effective presentation, but it is important that you do not delegate the whole task out, since the presentation must reflect your own commitment and hard work.

At the core of your presentation will be your Business Plan, which should include these key elements:

• A clear strategic plan and your vision for the business.
• The history of your business and its achievements to date.
• The competitive advantages of your business concept and its ‘wow’ factor.
• The potential market size (local and international) and your marketing plan.
• The barriers to entry for potential competitors, such as advanced technology,
• patents, intellectual property protection, etc.
• The growth potential, supported by evidence of market research.
• Your management team: their leadership skills and experience.
• An impressive advisory board.
• Any environmental, legal, regulatory or development constraints that need to be overcome.
• Realistic financials including documentation of existing loans and liabilities and plans for their reduction.
• Your funding requirements and how funding will be applied to grow the business.
• An exit strategy.

Four final pieces of advice

1. Market research

One of the key missing ingredients in any business plan written to attract investment capital is thorough and robust market research. You need to demonstrate that you have a clear understanding of your market, your competitors and your industry.

Plus, make sure you conduct research internationally! Never make the mistake of researching just New Zealand companies who might assist or compete. Market research needs to be global. Find out about potential international competitors, especially what they do, how much they charge, their distribution strategy and if they have expansion plans. The last thing you want is to develop your business and then have the ‘18 tonne gorilla’ in the form of a large overseas business squash you.

2. Channel partners

Think carefully about how you will distribute your product or service. You do not always have to go direct to the end user. For example, if you had developed some unique software for small business owners, then you could:

• Package the software in a box and sell direct to small businesses.
• Package the software in a box and sell the product to computer stores (who would then resell to the small businesses).
• Look for a channel partner (such as Mind Your Own Business, or Microsoft), who might add your software to theirs (in effect you lose your branding, but then you do not need any boxes).

Many successful smaller businesses seek an alliance with larger companies so that they can use the distribution and channel power of the larger companies to sell their products or services.

3. Good systems add value

Good systems are often what create value in a business. For example, successful franchises rely on clearly written operating system to train new staff and franchisees. Show investors that you have excellent business systems. The more you have systemised the better. What do you do that makes the business a success? Document the processes step by step.

Effective systems help to deliver consistency in:

• Revenue streams and profits
• Quality and service
• Customer satisfaction, retention and referral business
• Growth

Investors may be reluctant to invest if the business relies too much on you, so show them you have systems in place that allow the business to function without you.

4. Five-year forecasts

If you are serious about attracting investment into your business, then you need forecasts that project further than three years. The reasons are:

• Software and computer technologies typically have a useful lifespan of three years, but certainly need updating at five years. A five-year forecast will build in these looming potential costs.
• A five-year forecast forces you to go beyond your comfort zone (most people can guess what might happen in three years, but not in five years).
• It makes you think ‘what would happen if this business does really well’? Are you prepared for the cost (such as time spent at work and away from family, traveling overseas, etc.)?
• Many investment people and companies want to exit after five to seven years, and therefore will want to see your projection of what the business will look like after this time.

Make sure you extend your forecasts.