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Positioning Your Company for Investor Funding

Friday, June 1st

By H. Randall Goldsmith, Ph.D.

A small minority of companies qualify for funding in any given year. Over the past few years the number of companies receiving private equity investment capital from unrelated investors (angels or angel groups) is about 50,000 per year. The average amount of initial investment in a new venture opportunity by angels is about $500,000 with investment contributions from 3 to 5 investors. Surveys indicate that the odds of funding are one in seventy-two or less than 2%. Another source of initial startup funding is from venture capital firms that raise a pool of investment capital from pension funds, insurance companies, corporations, and other sources of capital. These firms invest in about 3,000 deals per year of which only 2% of their funds are invested in 6% of the deals in their portfolio. Thus, the odds of getting startup funding from venture capitalists is even much smaller than funding from angels (180 deals per year compared to 50,000 per year).

That being said, it has been my experience that deals meeting investor qualifications, usually get funded. Many potentially fundable deals do not get funded because they are not aware of investor criteria. After assisting several hundred companies to realize investor funding, I share with you below my observations on how to position a startup company for investor funding.

First, be able to answer five fundamental investor PRE-SCREEN questions:
How much money do you need? The answer to this question quickly identifies whether your need for capital falls within the investors range of capability and interest. If the venture needs $10,000,000, it is typically beyond the range and capability of an angel investor. This answer also should generally correlate with the stage of development of the company. Angel investments are typically targeted for pre-product and pre-revenue investments with the intent of helping the company get to the point of initial sales and revenue. The typical range for this investment stage is $50,000 to $2,000,000. Stages and funding levels beyond this range fall in the venture capital market.

What do you intend to do with the funds? The answer to this question quickly identifies whether the use of funds falls within the angel investor's expectation. Angel investors are not keen on seeing their funding used for physical assets such as land, buildings, and equipment. All of those "things" can be rented. The investors realize that startup success depends on achieving a balance of technical, marketing and business milestones that VALIDATE the product can be efficiently and effectively delivered to a large and growing market at a price acceptable to the market. Funds should be budgeted on anything and everything necessary to achieve the first sale.

How much return will the investor realize on the investment (ROI)? The answer to this question determines if the ROI meets the investor's minimum requirement. The source of this answer resides within the venture's financial forecast model. ROI is determined by considering the amount of the original investment, the length of time before the investment generates a pay back, and the amount of pay back.

When will the investor realize a return? The answer to this question resides within the commercialization plan that reflects a time line when business venture milestones will be accomplished (see chart). The range of a potential payback will usually occur when the business venture has reached profitability. Investors realize their expected rates of return depend on achieving a return within an expected length of time. Angel investors expect a return of 10 to 20 times their original investment typically within 7 years. Venture capitalists expect a return of 5 to 10 times their investment within 5 years. Ventures that go beyond the time line of the projected return reduce the ROI.

How will the investor realize a return? The answer to this question resides within the business venture's exit strategy. The exit strategy is based upon a projection of current market behavior. The first and most prevalent exit strategy is to position the business for a merger or acquisition (M&A). An analysis of M&A market behavior identifies which companies in the same market sector are acquiring companies similar to the proposed business venture, at what stage of revenue performance and at what acquisition prices. Another exit strategy is an initial public offering (IPO). The success of this approach is about 50% less common than a merger or acquisition. A final approach and the least attractive to investors is a scheduled buy-out which is typically a default strategy in the investment agreement when one of the other exit strategies fails to materialize.

If the answers to these questions satisfy the investor's expectations, it will lead to another set of more detailed questions related to venture risk. Investors eventually base their final decision on an in-depth analysis of the risk associated with the venture opportunity. If the risk exceeds the investors risk threshold, they will not invest. The investor's assessment of acceptable risk will determine their expected rate of return. The greater the risk the greater the expected return. The old saying, "the greater the risk, the greater the return" applies.

The answers to these questions will be found in the business plan. Investors consider five primary risk areas: 1) execution, 2) product, 3) market, 4) financial, and 5) management. In the final analysis, each of these risk factors must be acceptable to the investor. If any one of the five fails to meet the investor's satisfaction, it will "kill the deal." The challenge for the entrepreneur is to know the "risk appetite" of investors for investment in deals consistent with the venture's stage of development.

It is also important for entrepreneurs to identify "smart money" investors who can realistically assess the risk levels based upon the investor's knowledge, background, and experience with the venture's industry sector (space). Presenting an investment opportunity to an angel with no previous experience in the space is not as promising as presenting to one who does.

Investment opportunities that can address the key risk elements in their business plan will better position themselves for funding. There are some key considerations that investors will look for within each of these areas:

  • Product Risk: The primary product consideration is how close is the product or service to the market? If it is still in the conceptual or research stage, it is more risky than one in the pre-production stage. Investors prefer "proprietary products" over commodity products. Proprietary products are priced and sold on the value proposition that they directly or indirectly enhance the overall productivity or life experience of the buyer. Commodity products typically compete with a large number of providers on the basis of being faster, better, and/or cheaper. The market protection offered by intellectual property protection in the form of a patent or copyright is attractive to investors. Also, a venture that offers multiple products to the same target market reduces investment risk.
  • Market Risk: The primary consideration for market risk is how close is the venture (not just the product) to sales? Sales are the ultimate indication of market validation. Beyond sales, the need for a large and growing market is fundamental to an investor deal. Capturing a target market that demonstrates a commitment and loyalty to the product and/or brand versus a market that historically shifts between providers based upon the most recent innovations reduces risk. Identifying the strengths and weaknesses of the competition and specifically demonstrateing how the venture's marketing strategy will capture market share from the competition.
  • Financial Risk: The primary financial consideration is how close is the venture to cash flow? Beyond financial sustainability cash flow insinuates that business systems are in place for basic operations. The need for one round of investment infusion is less risky than ventures requiring multiple rounds. A clearly defined and achievable financial plan, strategies, and time line that result in predicable profits reduces risk. Investors prefer venture opportunities with business models that generate recurring revenues for the financial model.
  • Management Risk: The primary management risk consideration relates to the experience and skills of the entrepreneur followed closely by the strength of the Board of Directors. Savvy entrepreneurs with experience in launching a new venture (whether the previous venture was successful or not) reduces risk. Serial entrepreneurship carries more weight than having been in large corporate management. Investors prefer to see all of the executive positions held by experienced and qualified talent. Likewise, a well-connected Bboard of Ddirectors with a variety of skills and backgrounds is highly valued by investors.
  • Execution Risk: Some execution risk factors are inherent to the deal. For example, ventures in major markets with significant support resources and infrastructure are less risky than ventures in rural markets. Funding and venture sustainability is more likely when the economy or the industry is healthy versus one in a recession. Ventures with "new economy" emerging technologies that are attractive to pubic markets are more likely to be successful than ventures with core or "old economy" products or services. Some of the manageable execution risk factors are the overall innovative product, marketing, and production strategies for delivering a solution that solves a large and "painful" market problem. The ultimate question the investor will ask is "Does this venture have the resources, talent, plan, and opportunity to be the dominant venture in the market with unfair advantages over the competition?"

Entrepreneurs who can answer the five fundamental questions and devise a business model and plan that meets the investor criteria above will be positioned for private equity investment. But equally important, addressing the points above sends a signal to the investor that you understand what is required for a high-performance venture to be successful; you understand investor needs and criteria; and you have and will continue to expend the energy and resources necessary to bring your venture to a successful conclusion.