Proceed With Caution!

The Dirty Half Dozen

It's important to keep in mind that many times a company becomes unfundable not because of a real flaw but because of a perceived flaw investors sense during the pitch and are unable to shake. Though such a situation amounts to a status of guilty until proven innocent, Cassel says this is simply the hard justice capital markets deal to entrepreneurs seeking investors. Following are six (more concrete) examples of situations that can hurt your chances of funding:

  • Lack of focus. To an entrepreneur, a product, service or technology that's applicable to everyone is Nirvana. Imagine the glee you'd have if you owned, say, the rights to sell oxygen. But to an investor, this sounds like trouble. The fact is, there may be many markets for a product or service, but even well-capitalized giants have trouble selling in multiple markets. Thus, for fledgling upstarts or companies expanding into new areas, the critical questions on a prospective investor's mind are these: Which market will you pursue with my money? How will you do it? And what does it mean if you succeed? "When a company lacks focus, it's simply an invitation for investors to walk away from the deal," says Cassel. "Investors fear that, without a specific focus, the company will in fact be focusing on so many different things that it won't be able to carry out the most fundamental purpose of the business, which is to create value and wealth for its shareholders."
  • Absence of an exit strategy. This is another fatal flaw. "Everybody wants an investor's money," says Cassel. But, he notes, they're often far less vocal about how the investor actually gets his or her money back and earns a return commensurate with the risk.

There are really only two exit strategies. A company is acquired, or it goes public. (Another option is for the company to buy back the investor's shares, but this rarely happens.) If an entrepreneur refuses to commit to one of these options, says Cassel, the company becomes unfundable.

  • Unwillingness to surrender control. Having a control freak at the top of the organization is a problem. It's expected that entrepreneurial genius brings with it some unique character traits, but this one can lead to disaster. If the person running the company cannot or will not surrender control, says Cassel, there is little likelihood they'll be able to successfully orchestrate an exit strategy for the investor. Why? "Because ultimately," says Cassel, "an exit strategy in the form of selling the company or going public is about a change of control."
  • Unrealistic valuation. This refers to the overall worth or dollar value an entrepreneur places on his or her business. Valuation is vital because it determines ownership positions for the entrepreneur and the investor. That is, if a business is valued at $10 million and the entrepreneur wants to raise $4 million in equity financing, it's likely going to cost 40 percent of the company.

All companies seeking equity financing, says Cassel, will be valued in comparison to similar publicly traded companies. "When an entrepreneur sticks to a valuation that is totally out of sync with the valuation yardsticks of their peer companies, that deal becomes unfundable," Cassel says.

Here's an example. Suppose publicly traded restaurants, on average, are valued at 17 times their earnings. Suppose further that you have a fledgling restaurant chain that you've valued at $5 million. If your company earns $100,000, that's a multiple of 50 times earnings--way off the mark. If you stick with that figure, what you'll get from investors is zilch.

  • Too small of a market. "You've got to be careful of the `so what' factor," warns Cassel. Especially if your market isn't very big, it's hard to get outside investors fired up about chasing it with you. It's one thing if you own a storefront business or operate an enterprise within a single community, but if you're competing nationally, Cassel estimates you'll need a minimum market size of $100 million.

Consider the case of one anonymous company that had developed computed tomography systems capable of scanning opaque industrial objects. Unfortunately, the machines were so expensive, they were restricted to the government and Fortune 50 laboratory markets. Annual sales for the entire market were just $10 million. One way the company was able to overcome this challenge--not just for would-be investors but for its very survival--was to develop products which cost considerably less, thus increasing their market potential.

  • Poorly written business plan. A weak business plan may not render your deal absolutely unfundable. After all, someone might see the genius behind the clutter. But Cassel says that's highly unlikely. "If you're going to a professional investor or an active angel investor," he says, "chances are, they get inundated with business plans. If that's the case, they won't take the time to labor through your muddled presentation." He adds that there's really no excuse for poorly written business plans because there are many places to get help preparing them.

One area of a business plan that can definitely make your deal unfundable is the financial projections. There are several ways this can happen. For established companies, a sales and earnings curve that deviates too much from historical standards isn't good. That is, the top and bottom lines have been growing at about 5 percent per year, but you're predicting they're suddenly going to accelerate to a growth rate of 50 percent per year once the company is funded.

The area of the business plan where most entrepreneurs err in a way that makes their companies unfundable is in the assumptions to the financial projections. Sometimes there are no assumptions. Other times they're just plain naive, especially regarding sales growth and selling costs. As one venture capitalist put it, "Assuming sales start at some base level and increase by 20 percent per year is just garbage. The fact is, there's nothing formulaic whatsoever about projecting future sales. It means thinking about what will happen each week, month or quarter, and it's damn hard work."

With a revised capital-raising strategy, Joanne Iverson is gearing up for her second assault. "We've changed the name of the company to Iverson Technologies Inc. because there seemed to be a bias against companies focused on gaming. We've also sharpened our focus and plan to concentrate on niche markets that we can realistically penetrate." Iverson suspects her earlier efforts may have suffered because she focused exclusively on the gaming industry.

Undaunted, she says, "Raising money is like running a business. You've got to make mistakes in order to learn. Once you learn how the game is played, however, success is within your reach."

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This article was originally published in the February 1999 print edition of Entrepreneur with the headline: Proceed With Caution!.

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