FUNDING A RAPIDLY GROWING VENTURE (PART ONE)
The natural by-product of a successful start-up is growth. But growth is costly and often puts on enormous strain on the already sparse resources of a young venture. Typically, to meet significant demand, the new company will need additional capital beyond any internal cash flows. Growth capital, or second-round financing, consists of those funds needed to take the venture out of the start-up phase and move it toward becoming a market presence. To the extent that the entrepreneur has met the sales and earnings targets estimated in the start-up business plan, available financing choices increase substantially when growth finances or second-round financing is sought.
The fact that more choices are available is important because, normally, the amount of money needed to grow the business is significantly greater than that required to start the business. One exception is high-tech companies that incur considerable research and development costs prior to start-up. This type of company may spend millions of dollars and accrue several years of losses before its first sale. It may also go through several rounds of financing and grants before it has something to sell to customers.
Most venture capital today is still going to biotechnology, software, and other high-technology ventures, but in general, the best companies in any industry have the easiest time finding capital from any source. Being one of the “best’ companies requires having an excellent track record (however short), a sound management team, a potential for high growth, and a plan for investor exit with an excellent rate of return on money invested. Investors in growth companies typically will not go into a situation where their new money is paying off old debt, or where cash flow is poor. They want to know that the infrastructure is in place, sales are increasing, and the growing venture needs capital only to take it to the next stage.
The Cost and Process of Raising capital
Make no mistake about it; raising growth capital is a time-consuming and costly process. For this reason, many entrepreneurs choose to grow slowly instead, depending exclusively on internal cash flows to fund growth. They have a basic fear of debt and giving up, to investor, any control of or equity in the company. Unfortunately, they may act so conservatively that they actually stifle growth.
Raising Money Takes Time
It is important that entrepreneurs understand that nature of raising money so that their expectations will not be unreasonable. The first thing to understand about raising growth capital (or any capital, for that matter) is that it will invariably take at least twice as long as expected before the money is actually in the company’s bank account. Consider the task of raising a substantial amount of money – several millions of dollars, for instance. It will take up to several months to find the financing, several more months for the potential investor or lender to do “due diligence” and say yes, and then up to six more months to receive the money. In other words, if an entrepreneur doesn’t look for funding until it’s needed, it will be too late.
Moreover, because this search for capital takes the entrepreneur away from the business just when he or she is needed most, it is helpful to use financial advisers who have experience in raising money, and it is vital to have a good management in place.
The second thing to understand about raising growth capital is that the chosen financial source may not complete the deal, even after months of courting and negotiations. It is essential, therefore, to continue to look for backup investors in case the original investor backs out.
Another point about second-round investors is that they often request to buy-out the first-round funding sources, who could be friends or family, because they feel the first-round investors have nothing more to contribute to the business and they no longer want to deal with them. This can be a very awkward situation, because the second-round funder has nothing to lose by demanding the buy-out and can easily walk away from the deal; there are thousands more out there.
It Takes Money to Make Money
It truly does take money to make money. The costs incurred before investor or bank money is received must be paid by the entrepreneur, whereas the costs of maintaining the capital (accounting and legal expenses) can often be paid from proceeds of the loan or (in the case of investment capital) from the proceeds of a sale or internally generated cash flow.
If the business plan or financial statements have been kept up-to-date since the start of the business, a lot of money can be saved during the search for growth capital. When large amounts of capital are sought, however, growth capital funding sources prefer that financials have the approval of a financial consultant or investment banker, someone who regularly works with investors. This person is an expert in preparing loan and investment packages that are attractive to potential funding sources. A CPA will prepare the business’s financial statements and work closely with the financial consultant.
All these activities result in costs to the entrepreneur. In addition, when equity capital is sought, prospectus of offering documents will be required, and preparing it calls for legal expertise and often has significant printing costs. Then there are the expenses of marketing the offering. Such things as advertising, travels, and brochures can become quite costly.
In addition to the upfront costs of seeking growth capital, there are “back-end” costs when the entrepreneur seeks capital by selling securities (shares of stocks in the corporation). These costs can include investment banking fees, legal fees, marketing costs, brokerage fee, and various other fees charged by state and federal authorities. The cost of raising equity capital can go as high as 25 percent of the total amount of money sought. Add to that the interest or return on investment paid to the funding source(s), and it’s easy to see why it costs money to raise money.
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