Money is the lifeblood of any business, and at some point, every company is likely to need an outside infusion to help it grow. Whether you're seeking a $1 million in venture capital or $1,000 from friends or relatives, you'll need to nail down a few basics before trying to make your case. Here are five things to you must do before approaching investors for any amount of money.
1. Clean up your credit.
If your business doesn’t yet have its own credit history, many backers will want proof that you can responsibly manage money and pay your debts. That proof is your personal financial track record.
"You should know your own credit history, because lenders and investors are going to take a close look at it," says Yuri Schmidt, an account manager with NYC Business Solutions, a city agency that provides free services to small businesses.
Get credit reports from the three major credit-reporting agencies, Equifax, Trans Union and Experian. You can get a free credit report from each of them on annualcreditreport.com.
If you find any mistakes, contact the creditor involved, requesting a letter acknowledging the mistake and stating they plan to inform the credit-reporting agencies about it. Then send a copy of that letter to all three agencies yourself to make sure the error is corrected promptly.
Next, consider your credit score. A 710 or higher is ideal if you are just starting a business. If your business is already generating cash flow, you might be able to get away with a 680. If your credit score is lower than 680, you may want to start looking into microloan providers or credit unions, whose lending requirements can be less strict than traditional banks.
Late payments to major creditors, like mortgage or auto loan companies, are also red flags. "They’ll look at how many times you were late and how long ago," Schmidt says. Be ready to explain any tardiness in the past several months and to offer proof that your cash flow is healthy.
Investors might be less concerned with your credit score than lenders, but they’ll be wary of entrepreneurs with major blemishes such as a bankruptcy or loan default on their record.
2. Line up your team.
The big question for nearly every financial backer is: Can you do this? They'll want to know that you and your co-founders or management team can execute the ambitious business plan you’ve presented and pay back your loan or generate a return for investors.
"Investors want to have a gut feeling they can trust you and your team," says Larry Kaplan, a New York area consultant who advises new ventures. Be ready to make the case for why you and your team have the skills and experience the business requires. "The question is: Have they done this before and where have they done it?" says Kaplan.
Make sure you and your key people can talk about what may be ahead for the business, what the later phases of growth might be, what can go wrong, and how you might handle those things.
3. Write a detailed business plan.
Writing a business plan is easy. Writing one in sufficient detail for investors can be tricky. Entrepreneurs often leave out key numbers and are overly optimistic with those they provide, Kaplan cautions.
For starters, know your burn rate, which measures how much money a not-yet-profitable business is spending each month, and break-even point, Kaplan says. Have a good estimate on your first-year cash requirements, your gross margin, and how it compares to the average for your industry. Also calculate a realistic growth rate and how your costs will scale up as your sales do.
New entrepreneurs are almost always too optimistic about how quickly sales will happen. A good plan will also cover who your customers are, how you will get them to buy your product, and your cost of customer acquisition.
Once you’ve worked out these details, "you have to know them cold," says Kaplan. "You have to convince the other person that you know more about this business than anyone else."
4. Do your homework on your backers.
Entrepreneurs should do a lot of research and soul searching before deciding what kind of outside money they need and who to approach for it.
Match your business strategy and financial needs to the right backers, says James Geshwiler, the managing director for Common Angels, a Boston-based angel group. For example, if you won’t have strong cash flow -- necessary for debt payments -- for quite a while, then a bank loan is out. And, venture capital investors rely entirely on capital gains to make their money, so if you absolutely don’t want to sell your business, then VC shouldn't be an option.
Next, pre-qualify backers the same way you do potential clients, by learning how they do business and what their criteria are. "If a bank’s minimum loan is $500,000 and you need a $50,000 line of credit, don’t be surprised when they don’t return your calls," Geshwiler says. What's more, angel investors typically invest relatively small amounts and always worry that their stake in a company could wind up diluted if big investors come in later. As a result, they may avoid companies that are likely to need much bigger follow-on investments than he can provide.
A big question that founders often don’t ask: Do you have funds available? "It’s a serious question. VCs can be fully committed. Some banks weren’t able to lend for a while because of TARP," Geshwiler says, referring to the Troubled Asset Relief Program, the federal government's program for bailing out banks hit hard in the financial crisis.
5. Create an investor wish list.
Draw up a list of ideal investors, but choose them carefully. Accepting financing means taking on a new relationship, one you’re likely to have for a long time, be it with a bank or investor or a different relationship with your friends and family. Sometimes the relationships go on for some time before any money changes hands.
Geshwiler estimates that most business owners can carry on conversations with only a maximum of six potential backers at the same time. So he suggests coming up with a list of six organizations or people you would like to have backing your company and approach them with an eye on getting to know one another. "As one drops off for one reason or another go to No. 7, then 8," he says.
Eventually the six will narrow to one or two relationships where the timing, the style and strategy and the gut feeling seems right on both sides. Those will be your lenders or investors.