I am concerned. No, I am worried.
I am worried about how unprepared entrepreneurs of startups and early-stage
companies are when attempting to raise capital – particularly over the next 12 to 18 months. After meeting with many entrepreneurs, I have found that most make four major mistakes in their attempts to raise funds.
It’s no secret that capital markets (debt and equity) are rapidly withdrawing from funding high-risk investments. For example, there were no IPOs in January 2016 – zero. According to Dow Jones VentureSource, 58 percent of IPOs issued last year traded below their issue price for all of 2015.
Why? Investors doubt the future performance of U.S. and global economies. Adding to these doubts are political uncertainty, tensions between businesses and government, and anxious investors. This is evidenced by the largest investment banks struggling to raise both equity and debt. Last month, Goldman Sachs tried to sell $2 billion in corporate bonds quickly. A few days into the sale, they had sold only half of the bonds and were paying an 11 percent premium – up from the expected 10 percent premium. The bond sale comes at a time when U.S. junk-bond issuances have dropped more than 70 percent from a year ago.
Recently, the Wall Street Journal reported that mutual funds are cutting the valuations of their startup investments at an accelerated pace and are making fewer new investments. This has shocked many venture capital firms and executives at startups.
The mutual-fund pullback threatens to deepen a wider downturn that has already led to falling valuations, shrinking ambitions and layoffs as the receding tide of capital forces startup companies, of all kinds, to focus on the bottom line rather than growth at any cost.
There is a lesson here. Lower deal volume, lower deal multiples and lower valuations are ominous signs for any young company and spell trouble for entrepreneurs seeking capital. So what can you do to increase your chances of a successful capital raise? Avoid these four major mistakes:
Mistake #1. Not thinking like investors. Understanding investors’ sentiments, their fears and concerns regarding investment risks is critical to raising funds successfully. Entrepreneurs are often too enamored with their concepts/products/services and believe that the market is just waiting for their “better mousetraps.” Therefore, they believe that all they need is money to overcome any market obstacles. While passion is important, it must be tempered with realities of the marketplace.
Mistake #2. Not having a well-thought-out, detailed business plan. Serious investors expect to see a business plan with the following: realistic pro formas; financial models; detailed use of funds; addressable target markets; audience segments; competitive threats; potential disruptive technologies; market research; first mover advantage; buyer resistance/acceptance; and exit strategies for the investors – to name a few. Without addressing these issues clearly, investors can become confused and come away without any compelling reasons to invest.
Mistake #3. Not raising enough capital during each round of capital formation. Most entrepreneurs have not developed a detailed “capital formation strategy.” Therefore, they do not know how much capital they really need and they do not know whether to raise debt or equity during the capital formation process.
Since they have never raised capital nor have a capital formation strategy, they tend to ask for too little from each investor, fearing they won’t get any capital at all. Also, they often seek investors who may only have $20 to $30 thousand to invest and haven’t the financial depth to invest more in subsequent capital formation rounds. As a result, entrepreneurs raise capital from “hand to mouth,” feeding the “burn rate” (the monthly rate the company spends money) just to stay alive.
I call this “the capital raise treadmill.” This treadmill is perpetual and pushes entrepreneurs to take any amount of money from anyone who will invest. Eventually, they run out of investors and their companies die on the vine.
Mistake #4. Not generating revenue streams and profits quickly enough. Investors want revenue-building early in the growth stage of commercialization and profits soon thereafter. In today’s financial environment, investors examine how fast revenues are being generated, how steep the revenue growth curve is and how soon profits can be generated. Most investors look closely at operating and net profit margins.
More often than not, entrepreneurs are on the capital raise treadmill, not minding the store. Unless they can prove their revenue models and scalability early in their growth stage – generating what all investors want, namely revenues and profits – they will fail to secure the capital they need.
Gary Miller is managing director of the Denver-based investing banking firm, SDR Ventures’ consulting division. Miller helps middle-market business owners prepare to: raise capital, sell their businesses, buy companies and develop strategic business plans. He can be reached at 720-221-9220 or firstname.lastname@example.org.