Street Smarts

By all accounts, there's more money available for small businesses than ever before. So why do some people have such a hard time raising start-up capital?

For people who want to start their own business, there's nothing more mysterious than figuring out how to raise money. I hear from them all the time. A lot of these first-time entrepreneurs have good, solid business ideas that they've researched and tested, but, try as they might, they can't find an investor. "What am I doing wrong?" they ask. "How can I find someone like you?"

They don't need someone like me. What they need is a better understanding of investors.

Let me tell you about Jordan, who E-mailed me a few months ago after reading some of my articles. He and his business partner, Seth, had a start-up that they thought could become a national provider of Internet-development services to small and midsize businesses. The two of them had invested $200,000 of their own money to get the business up and running, taking sales from $42,000 in the first year to $246,000 in the second. Along the way they'd learned a lot about the market and come up with a strategy for tapping into it.

They figured they needed $2 million to ramp up the new business over the next five years, and they were getting ready to approach potential investors. Jordan asked if I'd be willing to look over their business plan and offer them some advice. I said I would.

The business plan arrived the day before our meeting. It was very nicely done--about 35 pages long, with a hard cover bearing the company's name and logo. The text provided the right amount of background information about the business, the market, and the strategy for going forward. The numbers appeared to make sense. But a couple of things jumped out at me.

When I got together with Jordan and Seth, I asked them whom they were planning to go to for money. They said they had a meeting scheduled with some venture capitalists. I said, "No venture capitalist is going to buy this plan."

There were at least three problems with it from a venture capitalist's perspective. For openers, the plan said almost nothing about how much investors could expect to make on the money they put in, or how they would eventually cash out. That's a major omission if you're going to people who invest only in businesses that promise to deliver the particular rate of return they're looking for.

Second, the plan called for using a substantial portion of the investment to buy furniture, equipment, and other fixed assets. A venture capitalist was sure to ask, "Why buy? Why not lease?" Venture capitalists like to take advantage of leverage--within reason. The more debt you use to finance a start-up, the greater the potential increase in its equity value will be. It's like buying a house with a small down payment. There's a bigger risk of failing, but a bigger reward if you succeed. Jordan and Seth clearly didn't understand the investment philosophy of the people whose money they were asking for. Strike two.

But the biggest problem had to do with a small note saying that more than $200,000 of the $2-million investment would go toward "repayment of loans to officers and affiliates." I don't know anyone who'd make a substantial investment in a start-up knowing that the founders were planning to take 10% of the money and put it in their pockets. Venture capitalists certainly wouldn't allow it. They'd probably see it as a good reason to reject the deal.

On the other hand, they'd be impressed if Jordan and Seth said, "Look. We've financed this business ourselves for the past two years, using our own hard-earned money. Now we need your money, but ours is going to stay there at least until you get your investment out." That would have been a significant factor in their favor. So they'd taken a big positive and turned it into a big negative.

I asked them if they had any other prospects besides the venture capitalists. They told me they had a lead on a group of doctors.

I don't know what it is about doctors, but people who want to raise money always seem to have access to a group of them. You'd think doctors were ready to invest any amount of money in anything that came down the pike.

"How much are you looking for from each of these doctors?" I asked. They said the minimum investment amount was $250,000. I said, "You don't know these people, do you?" They admitted they didn't.

There are very few doctors willing to invest $250,000 in a start-up business. Wealthy professionals tend to approach these matters the same way that relatives, friends, or other amateur investors do. The first question they ask is, "How much do I have to put in?"

Listen, everybody has an investment plateau. It could be $10,000 or $20,000 or $100,000. Whatever it is, you won't have a chance if you come in too far above it.

So it's important to find out in advance the investment plateau of the people you're going to, especially if they're not professional money managers. If you can't ask them directly, you can talk to the contact person, or to accountants and financial advisers who know the investment habits of people like those you're planning to approach. Once you know their investment threshold, you can tailor the offering to make it possible for them to put in an amount they're comfortable with--or you can decide it's not worth asking them at all.

But you have to do your homework. Why? Because you have one shot with most investors. If you blow it, you're out of luck. People don't say, "Come back when you get it right." If you go in and don't know what you're doing, it's unlikely you'll ever get another chance.

To make the most of your opportunities, you need to plan your investment strategy just as you plan your business. You need to research the market. You need to find out as much as you can about potential investors--what they want, how they evaluate a deal--before you ever ask them for money.

Some research is easy. Most bankers, for example, are happy to tell you the exact criteria they use in making loans. Venture capitalists will also explain their philosophy if you approach them the right way. Alternatively, you can go to businesspeople who've received venture backing and ask them for advice.

But the best research is done while you're out looking for the money. That's why I tell people to build a certain amount of failure into the process.

I'm talking about including four or five long shots on your list of potential investors--and then making a point of approaching them first, knowing that you're probably going to be turned down. You're bound to learn something from each rejection. You should plan to learn as much as you can.

For example, you can draw up a questionnaire and go back to people who've rejected you. Make it clear that you aren't looking for money this time, that you respect their decision and aren't asking them to reconsider. Say that you just want to learn from the experience, and you'd be grateful if they'd explain why they said no. Was it you? Was it something about the business plan? Was it the amount of money you were looking for? (You can find a sample questionnaire on the Brodsky page at Inc. Online.)

The information you gather will allow you to strengthen your business plan and improve your presentation before you go to see the people most likely to give you their support. You'll get a better sense of what they're looking for, and you can make sure you're offering them what they want. Not that you should be dishonest, but there's no point in approaching them if their criteria don't mesh with your needs.

That's more or less what I told Jordan and Seth, but they had other ideas. They went ahead and met with the venture capitalists, who turned them down. A couple of weeks later, I got a call from Jordan, saying that he and Seth were splitting up. Seth wanted to keep looking for investors who'd let them take their own $200,000 out of the business. Jordan thought such efforts were a waste of time. In the end, all they could agree on was to go their separate ways.

Which goes to show, I suppose, that some business lessons are more expensive than others.

Norm Brodsky is a veteran entrepreneur whose six businesses include a former Inc. 100 company and a three-time Inc. 500 company. This column was coauthored by Bo Burlingham.