Timing Is Everything
You have decided that you need to raise money for your business. We have already discussed the difference between debt and equity money (see my September 2006 column). But how much money should you raise? And when is the best time to raise it?
The amount of money that you seek to raise is affected by a number of factors:
- The sources you'll approach for financing. The amount may be beyond the resources of traditional sources--your family and friends. On the other hand, it may not be large enough to interest various professional investors, i.e., venture capitalists. (From the VCs perspective, they have to put as much effort into a "small deal" as a large deal, and therefore tend to stick to larger deals.)
- Which form(s) of Other People's Money (OPM) you seek. Is it feasible to raise the entire amount as debt, or will you have to seek "equity money?" Can you qualify for that large of a loan? Will that much additional debt be in violation of the covenants of any previous loan? Will additional debt make it difficult to bring in additional investors in the future?
- The manner in which you seek it. Can you get the money from a single source or do you need to go to multiple sources? Can you raise the amount through sources with whom you are already acquainted or do you have to offer the investment in your company to the general "public” in order to raise that amount?
- Your obligations under the securities law. If you are selling securities, unless you qualify for specific exemptions, you are required to register with the federal SEC and, typically, with one or more analogous state agencies. There are limits on the amount of money that you can seek and still qualify for certain of those exemptions.
Perhaps most significantly, the amount of "equity money" that you raise can affect your ownership and control of the business.
In determining how much money to raise, there are competing concerns: adequacy of the amount raised to meet your needs and the cost of the money raised. There should be a reason for raising money -- an immediate goal. For a start-up business, the goal may to bring the business to “self- sufficiency," or to a point where it is feasible to raise additional funds at a lower cost. The amount must be adequate to accomplish your goal, and, preferably, to deal with unforeseen contingencies and take advantage of opportunities that might arise. But you don't want to pay too steep a price for something that you don't need. The cost factor is particularly important if the price for OPM is paid with equity interests in your business. You need to plan in order to avoid a cash shortage, but if you raise too much “equity money” too early, you may unnecessarily dilute the ownership of your business.
The cost (in terms of percentage ownership per dollar) is primarily a function of the valuation of your business at the time you seek "equity money." For that reason, you should correlate your fundraising with critical growth stages and milestones in the development of your business. Try to identify specific milestones or events that would cause a significant increase (appreciation) in the valuation of your business. (Typically, you raise only enough money to get you to the next milestone that significantly increases the value of your business.)
In other words, you build up the value of your business as much as you can before each successive round of financing and do not raise money until you actually need it. With a "parsing" strategy -- identifying a series of specific milestones or events that significantly increase business valuation, and raising only the amount necessary to reach the next milestone (taking into account the lead time necessary to raise funds) -- you can bring in equity investors without giving away the store.
Here's a quick scenario that helps put into perspective the decision to take on equity investors for particular milestones versus a heftier, less directed investment that serves the general growth of your business.
First, let's assume that the present value of your company is $100,000, and you need $400,000 to bring the company to the point where it is cash flow positive. If you bring in $400,000 of equity investment at this point, you would be left with only a 20% equity interest in the company (Your contribution to the venture would be $100,000 -- the pre-investment value of the company -- against the investors $400,000). In other words, the cost of the equity money would be 80% of your company.
Now let's assume that you identify a specific milestone that would cause significant appreciation in the valuation of your business -- e.g., completing a prototype. At a cost of $20,000, this prototype has the potential to increase the value of your company from $100,000 to $300,000. If you "parse" your financing, and raise only the $20,000 necessary to complete the prototype, you can significantly reduce the cost of raising the remainder with equity money after the prototype is completed.
With respect to the $20,000 funding, your contribution to the "co-venture" is $100,000, against the investor's $20,000, leaving you with an 80% equity interest. When you raise the remainder of the $400,000 after completing the prototype, the value of the company is $300,000 (80% of which is attributable to you), against the new investor's $380,000 (leaving you with approximately 35% of the equity).
If you could self-fund or obtain a loan for the $20,000 necessary to get to the point of obtaining the contract, so much the better. (You would retain approximately 44% of the company). Of course, if you identify other milestones or events that would cause a significant appreciation in the valuation of your business, and correlate your financing activities to those events, you will do better still.