Recommendations on Capital Formation: Right Type. Right Amount.

Lenard Marcus . April 21, 2015

Whether your business is a newly launched operation or a full-on small business that's humming right along, you'll rarely experience real growth without a substantial load of cash. When founders think about raising capital, it’s important to match the amount and types of capital with the company’s long-term strategy. The following are investor perspectives that will help guide small businesses through their growth stage.

Taking the Right Amount

Before you determine what the right amount is, you need to be sure you are truly ready. Read this earlier post on determining readiness.

Too often, I meet founders who have decided to take ‘some’ outside capital -- enough to provide a brief increase in working capital, but not enough to really attack the market opportunity.  Founders are in a unique position as they have built something tangible and are now opening the door to ‘outsiders’ with extremely favorable rights in some cases. 

That said, not taking enough money to deliver a strong uptick in enterprise value is simply a mistake. Prior to taking capital, we suggest you identify 3-5 operational goals that you want to achieve with the funding. For example, revenue growth, EBITDA performance, hiring needs, etc.

If you are a small tech company with less than $5M in revenue, reach out to the angel community or early-stage investors. The key is to take enough capital to demonstrate an increase in value. Communicate goals to prospective investors regarding how their dollars will help the organization grow.

 Lenard_CapitalFormation

Taking the Right Type

Switching gears, once you have decided to take on outside capital, it’s crucial to take the right type of capital. 

Entrepreneurs must think about changes in competitive dynamics and the challenges of expediting growth when they take capital. And, small tech companies may want to consider equity instead of debt unless you have demonstrated cash flow positive achievement over an extended period. If your business does not project to become cash-flow positive in the near future, equity is likely preferred to debt.

When making these decisions, run multiple projections with multiple scenarios considering the type of captal with the future in mind.  Once you determine the ideal dollar amount, add another 20% since founders tend to be very optimistic regarding the performance of their companies.  Yes, that extra money means more dilution, but ensuring that the company reaches its post-funding goals is critical to gaining credibility from existing and future shareholders.

Small tech companies should strongly consider equity instead of debt until they have demonstrated cash flow positive achievement over an extended period. Taking a growth equity investment needs to be considered in terms of growing the pie.  If you can maintain 100% ownership and sell a company for $25M in three years, that is not a bad outcome at all.  But if you take 25% dilution and believe that the equity will enable you to sell the company in 5 years for $100M, then maybe it's worth the risk.

Recommendation

Recommendations

  • Try not to let sensitivity to dilution prevent you from taking enough capital. 
  • Taking an insufficient amount of capital and expediting growth only to run out of money puts the company and all shareholders in a troubling position. 
  • If you need $4M, take $5M to give a little cushion. 
  • Stress-test your financial plan.  Every quarter will not be a growth quarter.  Some of the best companies had flat revenue years during their growth period.  Be cognizant of this and incorporate these points in your decision regarding financing.

Once a founder makes the decision that they are ready to take an investment, the key is to finalize a finance-able, well thought out, business plan that enables the company to show an increase in enterprise value if funded. 

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