In last month’s Recruiting Outside Investors Part I, we discussed some of the initial questions you as a business owner should be asking yourself when considering raising external capital. Specifically, we touched upon the need to understand 1) where the money would be used, 2) how much capital would be necessary, and 3) who your potential investors could be.
Here we’ll build upon that and evaluate the methods of debt and equity financing to help you see which might make more sense to you and your business.
1) Debt vs. Equity
|PROS||The lender does not have a claim to the company’s equity, so getting a loan will not dilute the owner’s stake in the company.||The business owner doesn’t have to worry about interest and covenants.
|You are in control of how the loan gets used. The lender could present some restrictions but typically has no say in the way you run your business.||Investors typically take a long-term view, and as such, don't expect a return on investment immediately.|
|Principal and interests are known amounts that you can forecast and prepare for. An exception would be if you chose to take out variable-rate loans.||You won't need to channel any profits into debt payments, meaning there will be more cash available to use on expanding your business.|
|Interest on the debt can be deducted on the company's tax returns.||You can forget strong and beneficial relationships with equity investors who can give business owners exposure to their own networks of industry connections. Investors can also be a great source of experience, counsel, and insight.|
|CONS||A big factor in raising debt is capital requirements. You'll typically be required to pay out interest along the way, which can be a significant determinant of whether you'll be able to afford acquiring debt.||There is a relinquishing of a portion of the company. This is a big call to make.|
|If you ended up with too much debt on your balance sheet, it's possible you'll be seen as "high risk" by potential investors, which in turn, can hinder your ability to raise capital by equity financing in the future.||Along with sharing control, you'll also be sharing profits.|
|The company's assets could be held in collateral to the lender||You will likely have to consult with investors before making certain decisions; that could slow down the process and there is the potential for disagreements.|
What can serve as a happy middle ground between debt and equity financing is the hybrid method. Common avenues of hybrids taken by smaller or younger companies include SAFEs and convertible notes.
The SAFE—Simple Agreement for Future Equity—is exactly that. It’s an agreement made now for an investor to buy a company’s equity at a later date. It sets a valuation cap and/or a discount rate at which the investor can purchase the company’s equity. A convertible note, on the other hand, is a form of short-term debt that can later be converted into equity, usually in conjunction with a financing round. These notes offer an affordable method for funding compared with traditional priced equity rounds.
3) Investor Fit
Another consideration, when recruiting outsider investors, is investor fit. It can be the crux of a lot of issues that arise. When you think about fit, essentially it is an alignment of goals. Your goal is to obtain capital to further your vision via your business; the investor’s goal is to identify an opportunity to benefit from what you’re doing with your company. In both cases, the motive is—maybe not solely, but certainly includes—profit.
Equity investors can be categorized as either financial or strategic investors.
Financial investors include private equity firms, venture capital firms, and family offices. They look for a return on their investment within a set amount of time, typically four to six years. Their goal is to identify businesses with attractive growth prospects and competitive advantages, to invest capital, and to realize a return via a sale or an initial public offering.
Strategic investors, on the other hand, are operating companies. They could be related to your business, as competitors, customers or suppliers. It’s possible they may be neither but are looking to enter your market for growth. Either way, their goal is to identify companies whose products or services can be synergistically effective when integrated with their existing operations for long-term value creation. They can provide complementary services to your business, such as an extended runway, validation of ideas, and larger marketing platforms.
When evaluating a strategic investor, keep these points in mind:
- Have the potential investors made investments in similar types of businesses? Are they experts in your space?
- How much operational and/or strategic control do they want?
- Talk to other firms that have worked with the prospective investor. Find out what it’s like to work with the point person on the investment, should you decide to move ahead.
Raising capital can be a lot of work. It’s crucial that you are prepared for the amount of time involved. Just as important is to have a team in place. Internet entrepreneur and venture capitalist Reid Hoffman says, “No matter how brilliant your mind or strategy, if you’re playing a solo game, you’ll always lose out to a team.” Build and add to your alliances as you work to grow business; relationships will always matter.
Summarizing parts I and II of Recruiting Outside Investors, a few bullet points for you to remember:
- Understand how much capital you really need.
- Forecast how long will it take you to create positive return on the investment.
- For debt, make sure you can make the payments comfortably.
- For equity, pick an investor with the right “fit” for your goals.
- Know your comfort level with risk.
- Seek professional advice.