It’s fair to say that cash is the most important pillar of success. It’s certainly the most necessary to stay in business. Before sales generate the cash you need, outside financing is your lifeline. Obtaining financing may require giving away only a small percentage of the company or more than you would like, depending on your approach and your ability to get to the right investors at the right time.
Financing can come in the form of debt, equity or other strategic maneuvers like extended payables and reduced receivables that allow you to conserve cash. As we discussed in the 2nd Pillar of Success post, the keys to understanding how to capitalize your business are having a well-supported and accurate financial model and capital (cap) table, both of which differ from your business plan.
The business plan is your written story and the financial model is a realistic view in spreadsheet form of how you’ll get there, by the numbers. A good financial model provides support for the current and future valuation of your business. It ensures that you have a solid understanding of your costs, future revenues, when you’re going to need cash and how much. A cap table is essentially a budget of how your equity will be shared over time. It should guide the types of financing vehicles you’ll accept at a given juncture.
For example, instead of making an educated guess that you’ll need around $5 million of capital over the next two years, a finely-tuned financial model can help pinpoint that what you actually need is $1.5 million in the first 15 months and $3.5 million in the next 12 months. It may be tempting to raise all $5 million now, but if your financial model suggests your company will be worth much more in 15 months, then the amount of stock you’d have to give away to get all $5 million at today’s valuation would bust your cap table. With that level of specificity nailed down, you can decide exactly how you want to fund your cash needs to ensure that a) you’re giving away the minimum amount of equity possible and b) you’re selling your equity at the proper value.
Let’s explore both financing options:
Debt: If your business is capable of borrowing from a bank, vendor or customer, or changing payment terms with customers or vendors, that’s great because paying 8% interest is typically a lot cheaper than giving away equity. Using your financial modeling, you can set a disciplined course with the assumption that in one year, for example, you will have established solid business metrics that allow you to borrow to meet some or all of your cash needs.
Equity: Of course not all businesses are in a position to obtain a loan or take on debt, which is where offering equity comes in. Equity, however, is a very expensive form of capital. It can seem cheap because you aren’t paying interest, but if your company increases in value, your equity partner’s share will likely cost significantly more than debt.
If you go this route, the most important thing to determine at the outset is the price of the equity. As in our example above, this is a function of valuation, cash needs and timing. While preparing your cap table, founders will establish how much equity they need to retain for themselves, their co-founders and their current/future employees (where applicable). Then, your carefully constructed, conservative-leaning financial model will provide a fair, well-researched and supportable valuation of the company that will give you the confidence to stand up for your valuation during the due diligence of investors. Ideally, this allows you to give away the minimum amount of equity and control.
How to Determine Your Company’s Valuation
Trying to determine your company’s valuation prior to seeking equity investors is an area where hiring a fractional CFO can pay for itself tens, if not hundreds, of times over. Many companies are too early in their lifecycle to have an experienced (and expensive CFO) on the payroll, full-time. The Catch-22 is that startups and early-stage ventures usually have the greatest need for help and expertise in important exercises like creating understandable and believable forecasts, formulating investor pitch decks and crafting a compelling narrative that will lead to maximum valuation.
For instance, a client once showed me their financial model and said they’d like to sell equity to potential investors on the assumption that the value of their company was $2 million. After reviewing their financial model and projecting out, I told them they could do that, but they shouldn’t. Working together, we were able to demonstrate to an investor that the actual value of the company was $4 million. As a result, the entrepreneur raised $1 million based on a $4 million valuation and only had to give away 20% of the business—vs. the 33% his initial valuation would have required.
In addition, most legitimate investors expect a CFO to be in place in order to even consider investing. This is not really a “nice to do” anymore, but a “need to do.” It demonstrates that your company is serious about taking care of the financial side of the entity, and therefore a safer investment. If hiring a full-time CFO feels like an untenable financial burden, a fractional CFO can be a mutually beneficial solution for you and your investors.
How to Match Investors and Investment Opportunities
Investors that take big risks expect huge returns. However, there are ways to carve out portions of what might be considered a risky investment and make them less precarious.
Take, for example, a marijuana grow. This type of startup typically requires investors who are willing to go out on a proverbial limb and are therefore banking on sizable, and relatively fast, returns. The marijuana grow company founder does their financial modeling and determines that they need $4.5 million dollars of total investment to get started, and that the best mix would be to raise half in debt and half in equity.
However, of the $4.5 million dollars needed, $2 million of it is for a building. Now, the founder can tap into a whole new world of potential investors, because people who invest in buildings don’t have as high of a return expectation as those who invest in marijuana grows.
The founder then folds the real estate portion of the business into a separate entity, and is therefore able to raise $2 million dollars from real estate investors who simply want their investment secured by physical assets and an annual dividend of 8-12%—not the 10x return on within five years that investors in the marijuana portion of the business might be looking for. The moral of the story? Always consider if there are ways to divvy up investment opportunities to attract different types of investors who expect different rates of return.
In conclusion, the three pillars of success that every company should have in place are:
- A predictable legal outline
- A strong team that is properly incentivized
- Financing based on solid modeling and maximum valuation
Companies that have established all three of these pillars will be built on a solid foundation, the founders will have less sellers remorse and the business will have a much better chance of success.