Even well-put-together presentations can founder, however, because of a failure to appreciate a crucial difference between entrepreneurs and investors: Entrepreneurs focus on the potential of an idea; investors focus on its risks. "The key to raising capital is lowering risk, not hyping the upside," says Douglass Tatum, CEO of Tatum CFO Partners and an authority on small-business financing. "The entrepreneurs who say how they'll reduce risk are the ones who get the capital." Of course, investors in growing companies understand that risk is part of the equation, but they want to see evidence that an entrepreneur recognizes the risk factors facing the business and has taken steps to control them. That means devoting a considerable amount of presentation time to addressing questions about market risk, financial risk, and technological risk. Remember, suggests Frank Gwynn, president of Freedom Medical, private capitalists "aren't entrepreneurs, they're numbers people -- they look at risk versus return." And that is how entrepreneurs should frame their business propositions when they make their presentations -- stressing not the dazzling upside but the return investors can reasonably expect, weighed against a limited and carefully defined set of risks.
"The key to raising capital is lowering risk, not hyping the upside. The entrepreneurs who say how they'll reduce risk are the ones who get the capital."
The most effective way to confront investors' concerns about risk, says Tatum, is to spell out exactly how the business will use the capital and how the capital will enable the business to increase profits, or at least become profitable. It's not enough, he says, to claim that the additional capital is needed for growth, since growth itself is a risk factor. He tells the story of a sandwich-shop franchisee with three stores who was seeking financing to expand to seven stores. Expansion to seven stores required the entrepreneur to add a layer of overhead -- a formal human-resources department, line management -- that absorbed more working capital than the additional stores could generate in revenue. So the sandwich-shop owner instead expanded to 13 stores, Tatum says, giving the business sufficient scale to offset the additional overhead. Had the entrepreneur expanded only to seven stores, he would have merely grown into unprofitability -- perverse as that may sound. "When you bust out of being small," Tatum says, "that's when the problems start."
Capital Connections: How Business Problems Get Solved
of course, even promising business ideas have their share of flaws and worry points. Presentations can be helpful to experienced private investors precisely because they reveal weaknesses and blind spots -- in either the business plan or the entrepreneur -- that can be addressed through the investors' network of contacts. Consider one of Rick Inatome's recent deals. The onetime beneficiary of angel capital is now something of an angel himself, and he recently traveled in Europe in search of promising opportunities. One entrepreneur presented an energy-saving technology that he wanted to market to operators of indoor ski parks, which are a popular recreation option in Europe and Japan. Energy costs are, no surprise, the biggest item in a park operator's budget, and the entrepreneur's innovation promises to reduce those costs up to 40%. After hearing the entrepreneur's presentation, Inatome decided to invest, even though the presentation made it plain that the entrepreneur "had no idea how to look at international partnerships." Drawing on relationships developed over the course of his career, Inatome was able to connect the entrepreneur with experts in master licensing agreements -- a necessity, since ski-park operators would license the energy-saving technology from the entrepreneur's firm -- and other specialists who could, in Inatome's words, "add value to the business plan."
That value can take many forms. When he's recruiting managers for SRC's investment partnerships, Stack looks for "someone who knows how to use resources." By that, he means someone who is familiar with the business's problems as well as with people who can solve those problems -- a retired manufacturing executive who can help clear a production bottleneck, say, or an adoption lawyer who can help a valuable employee with foreign-government paperwork. Here again, banks constitute an underutilized resource. "You should expect business expertise from commercial lenders," Stack says. "A lot of people don't ask bankers to do enough -- it's the intimidation factor." Banks constantly monitor the local economy, running projections and constructing best- and worst-case scenarios. Most banks will share that information with their business customers -- even those that just maintain a small payroll or operation account. The data can sharpen forecasts and improve risk analysis.
When the Financial Dating Game Begins Again
As a business matures and expands, its financing needs change, as does the value that the right financial partner can add. Freedom Medical, based in Exton, Pa., rents and repairs medical equipment such as ventilators, monitors, and infusion pumps -- an attractive financing option for hospitals facing capital-budget constraints because lease costs are charged to operating budgets. The company recently tapped the private-capital market to raise $30 million to fund its national expansion. Freedom is well past the start-up phase and is already professionally managed, says founder and president Frank Gwynn, so it no longer looks for management advice from its financiers. Instead, when Freedom hired an investment bank to place its equity with institutional investors, it looked for a firm that had experience with midsize companies, had a network of potential investors, and was interested in an ongoing relationship. "We were looking," says Gwynn, "not just for cash but for a strategic partner."
After what Gywnn calls a "dating game," Freedom decided Minneapolis-based RBC Dain Rauscher most closely fit its search criteria, and the investment bank then huddled with Freedom's finance and accounting staff to produce the all-important "book," the compendium of financial data and projections that is distributed to potential investors. Dain Rauscher then pitched the deal to 30 private-capital partnerships, selecting them from its network of investors based on their appetite for health-care investments and their long-term orientation. The investment bank further cemented the relationship by taking a piece of the deal for itself. Gwynn attributes the success to "a lot of forethought. Selecting who's going to do the capital raising -- it's quite a process to do it right." Freedom took eight months to settle on an investment banker, structure the offering, and close the deal, and the process could easily have taken longer.
