Do You Deserve Investment Capital?
In my last column, we covered the questions you should ask to help determine whether a venture capital or private equity firm is a structural fit for you. The goal is to not waste your time with no-chance meetings.
Now we’re going to back up. Before you approach any potential investor, you need to take a hard look at your own situation.
This sounds basic and self-evident, but it’s not. Often, entrepreneurs have unrealistic expectations about what capital can or should do, or they haven’t accurately assessed the reality of their personality or their business.
Here’s what you need to be asking before you start talking to the money.
Will capital really fix my problems, or just hide them?
As a CEO, one phrase always made me suspicious: “We need more people.” I heard this in every department, from software development to customer support to sales. When I dove into the details, the problems generally weren’t about staffing. The majority of the time there was a process issue, or our strategy was faulty, or our go to market, revenue or business models needed modification.
This catch-all of “we need more [insert resource here]” is most common in rapid growth businesses where great entry-level workers are rapidly promoted to managers. These folks get their early successes by working harder. Rapidly growing companies, however, cannot solve problems by merely applying more effort in the same ways. As my home economics teacher said about baking, “You can’t just triple the recipe ingredients.”
For example, my company had great success with our first software product. With so many enterprise customers signing up, our customer satisfaction was going down. Our team continued to push on the front-end software they had worked on for years. The real problem, however, was our backend system integration--it was stretching from eight to 12 to 16 weeks.
We could easily have raised money at that point to just add more developers, but it wouldn’t have solved our problem. We needed to change our technology and processes to get the implementation time down. I moved people around and made the front-end enhancements a low priority. Within a year we were down to two-week installation times, and our customer satisfaction was through the roof. We re-deployed our people and didn’t have to raise money after all.
Figuring out whether capital is really the solution--or merely a stopgap--is a challenge for growth company CEOs. It’s hard to look at the product of your blood sweat and tears and say “Hey, money’s not the issue. We were wrong, or need to get better, in these areas, and we need to take the pain to fix this underlying problem.”
Do I need capital, or do I just want it really badly?
I used to see press releases blaring “Company Snags Millions from Investors,” and think two contradictory things. I would cheer “That’s awesome, someone believes in that idea so much that they’re investing millions!” But I would also cringe, because I felt like management was announcing “Hey, look at us, we can’t run this business profitably! Yay!”
The issue of need versus want is a complicated business issue (and yes, I find it a challenging topic with my kids as well). My definition for “need” is, “Without external capital my company will shut its doors within a quarter.” Every other justification is a “want.” Competition catching up, not enough sales or marketing muscle, a product in need of upgrade--these are all really good reasons for totally rational wants, but they are not needs.
In my first business I gave up majority control in my very first round. We had four newly contracted enterprise corporate customers but were five days from being out of money. I was a 28 year-old doctor $200,000 in debt with no business experience. These investors were the only ones out of more than 300 who I’d pitched over 18 months who would give me $5 million. This was the only way “right now” for me to keep the dream alive. That was a need, so I gave up a lot.
Typically, the need versus want questions are more nuanced.
● Is the opportunity as big as I believe? Do I believe in it enough to sell a piece of my company so my part will be worth very little unless the company becomes huge?
● Will the customers really come if I spend on sales people? Do I believe it enough to take on debt payments that will crush my company if those sales don’t materialize right away?
● Do I think my team and I can execute on the opportunity? Do I believe this enough to post a personal guarantee on a bank loan that will bankrupt me if we don’t?
Most critically, do I want capital badly enough to answer to people not in the foxhole with me? Whether it’s equity or debt or friends and family, everyone will want something and think they know better, but won’t really understand. This is not a small issue. Being a CEO is risky and high-pressured enough without the burden of managing people outside the business.
Need versus want, how bad you want it, and how much you believe it, determines what you’re willing to give up. What you’re willing to give up, more than anything, will determine if and what type of capital is right for you.
Do I deserve capital?
As an entrepreneur involved in fundraising--from the garage all the way to a $50 million recapitalization--I’ve believed that my company deserved capital. Great ideas, smart people, hard work, real product for a real problem. What else is there?
Later on, having been on the other side of even more such transactions, I have become more, shall we say, balanced, in how I assess what deserves capital.
I have a pretty simple threshold for deserving capital: If I were on the side deciding whether to put capital into my business, would I take a meaningful amount of my parents’ money and put it into this deal?
The reason I have this threshold is because it forces me to think really hard from the perspective of the person providing the capital. When I think of my parents in that role, I am much more realistic about the risk, opportunity, deal structure, timing, and every other assumption. I frankly end up holding the deal to a higher standard than I would if I were looking at investing my own money.
For example, I deserved some capital with that first business. I had a product, I had paying customers, I had one really out-of-the-park-homerun installation. But did I deserve $5 million? Probably not. I often tell people that if 28-year-old me pitched 41-year-old me” with that same deal, I probably wouldn’t have funded it.
For example, right now I’m looking at a business that has been self-funded to $9 million in revenue and will probably do $17 million next year. It’s all recurring revenue, with 10% EBITDA. They’ve exhausted the hodge-podge of angel equity vehicles and personally guaranteed debt, their operations are way more mature and sophisticated than is typical at that size, and they have an expanding market with the wind at their backs. They’ve borne the huge risk in the early stages and proven they can run the business. It’s a real opportunity. They want (but don’t need) $5 million, and they really deserve it.
Look at your business honestly. If you deserve capital, find the right type of capital and don’t stop until you get it. If you don’t deserve capital, make a Plan B to get to a point where you do deserve it. Reduce the risk for the other side. Show that you’re pursuing the opportunity because it’s desirable and the time is right, not just because you’re in too deep on a bad bet.
These are the questions you have to ask yourself before you seek capital. In my next column, I’ll talk about the types of capital that might be appropriate and realistic for your business.
ALAN YING | Managing Director, Polus Capital
Alan is the non-executive chairman of KLAS Enterprises, a leading provider of healthcare information services. He is also the President of Polus Capital, a provider of entrepreneur-friendly capital to growing and profitable businesses based out of Houston. He was formerly the founder and CEO of MercuryMD.