Friday, May 23, 2008

How to Find Investors - Part 1

The first step is to determine what type of investment you are offering, which will help you determine the most appropriate target investment group.

Type of Investment
Broadly speaking, this entails answering the following questions:
1. At what stage is the company currently operating?
Typical answers would be concept (i.e. on paper only), organizational (some people and facilities in place), initial operations (also know as "pre-revenue"), revenue generating (but typically not yet profitable), cash-flow-positive (a very important milestone to investors), or later-stage (also known as growth or expansion capital)

2. What is the range of investment amounts that you need from this round?
See previous post on business planning.

3. If you raise what you seek and you successfully do what you said you would do, what is the result?
This answers the "where does my money get you" question. A clear and definitive answer is necessary here, even though it involves some crystal ball usage.

4. What are you offering in return for the money?
Specifically how much and what type of stock (common or preferred) and what rights and privileges are you willing to offer. The answer to this question also pegs your perceived value of the company before the investment, or the "pre-money" value. This is often the most contentious negotiation point, especially for a company that has not achieved profitability. For example if you give up 20% of your company for $200,000, your implicit pre-money valuation is $800,000. The post-money valuation is $1,000,000.

5. How long will it take to achieve success?
The subtext here is that you must also have a cogent answer for "what happens if things don't go the way you planned." If that question comes up and you have a well-thought-out answer you can deliver without missing a beat, you will have increased your odds of a successful funding by double.

6. What are the risks?
Some of this answer falls naturally out of the answer to all of the previous questions. Concept companies are naturally more risky than profitable enterprises, but you should evaluate additional risks too. For instance, does you success depend on a drastic change to established consumer patterns, or is there a crying need in a niche about which you have special knowledge?

These six characteristics define the type of investment you are offering. Each of the investor groups below, are attracted by a different combination of characteristics.

Broad categories of Investors:

1. Friends & Family - this is the group that will accept more risk and a longer reward cycle. The investment is often motivated by more than detached financial gain and therefore typically the first source of funding for an idea-stage company.

  • stage- concept and higher
  • $$$- smaller ($100k typical)
  • size- any market opportunity size is ok
  • reward- reasonable
  • timing - patient
  • risk - higher tolerance

2. Angel Investors - these investors, typically individuals investing personal funds, bridge the gap between the Friends & Family and more professional venture investors. They too will accept a higher risk profile, especially where they can personally relate to a large potential reward. The best Angel investors will be ones who have some historical experience with your industry, because they will have a quicker and deeper "buy-in" to your concept. The down-side is that Angel investors do not invest as a single entity, but rather must be rounded up one by one - often a daunting and time consuming task for the entrepreneur.

  • stage- concept and higher
  • $$$- small to medium (to $750k typical)
  • size- meaningful market opportunity
  • reward- reasonable, but more expensive
  • timing - patient (5 yrs typical)
  • risk - higher risk tolerance

3 Venture Investors - these are professional financial investors who care nothing for you or your company. They are solely concerned with the financial results of their investment. These statements are not intended to criticize the venture firms, but it is important for the entrepreneur to understand how venture firms are motivated. Venture firms are typically more risk-adverse and are not "patient money" despite their protestations to the contrary. Do not, under any circumstances, negotiate a Venture term sheet without engaging your own counsel. The sophistication level jumps substantially with the transition from Angel to Venture investment and the potential for a mistake that costs you dearly is too high to go it alone.

  • stage- revenue and higher
  • $$$- medium to large ($1M to $5M typical)
  • size- substantial to large opportunity
  • reward- expensive (unless company is already very profitable)
  • timing - shorter term (2 to 4 yrs typical)
  • risk - medium or lower

4 Non-Equity funding - Often overlooked by entrepreneurs, this includes many sources, but two are most predominant.
-Borrowed Money from banks or other institutions is the cheapest form of financing you can obtain in the end because you give up no equity. If your company is ultimately very successful, the 20% to 50% you might give up to venture firms is vastly more costly than even a fairly steep interest rate on a loan. How to borrow money without profits or asset? - Keep tuned. Subject for another post.

-Customer financing. In certain industries, principally manufacturing or service, you may be able to convince one or more major customers to pre-pay for their order in exchange for a negotiated discount or exclusivity or some other benefit. This is perhaps the most overlooked and cheapest form of funding for an early stage business. Pre-payment of 12-24 months production or service can often be enough to get a company to profitability and thus skip one or two of the funding stages outlined above.

5. While beyond the scope of this article, for post-entrepreneurial companies, those that have achieved most of their early success goals, there are Private Equity investors, Merchant Banks and Investment Banks who provide liquidity or access to the public capital markets.

  • stage- profitable, preferably with double digit compound annual growth
  • $$$- large ($15M minimum typical)
  • size- large opportunity - multi billion market size
  • reward- can be very inexpensive if the company is very profitable with high growth
  • timing - N/A
  • risk - medium or lower

Thus for an early stage venture, step one is to match the stage of the company with the risk-reward appetite of the investment groups described above.

Step 2 - Next article: How much to ask for

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