Your Butt on the Line
Brian Jersey had it all. A rising young executive, Jersey was the director of marketing for Prodigy Internet in White Plains, New York. There he had his own secretary and oversaw a $40 million budget, two ad agencies and a staff of seven. And he had the kind of salary and bonus package that came with the job-circa 1995, that is, before Internet option mania took hold of the country.
Call it the inexplicable entrepreneurial spirit, but Jersey, now 39, chucked it-job security and all-in 1996 to start 1-800 BIRTHDAY, a reminder service that would also sell gifts. Jersey felt that 1-800 BIRTHDAY had the same potential as 1-800-FLOWERS, except in a niche that had yet to be exploited.
Jersey says he was confident he could make a go of the venture. So confident, in fact, that he took a 50 percent pay cut (to $84,000)-funded by his initial investors-to get the business off the ground. "It was a dicey move," he says. "My son was just two months old when I started the business, I was still paying off graduate-school loans. Despite my enthusiasm, I just knew that the $300,000 I'd raised from the initial investors would never be enough to get the business to the finish line."
Jersey's first effort was substantial enough, however, to get investors to take 1-800 BIRTHDAY's business model seriously and throw in another $1.1 million in 1997.
But that wasn't quite enough, and without plenty of capital for marketing, the company ran low on funds, and things started looking grim. Nonetheless, Jersey personally guaranteed a $100,000 loan, ran up $50,000 of expenses on his personal credit card and began deferring his $84,000 salary. In short, Jersey put himself in a position where he had a lot to lose-and the only way out was to succeed.
What Price Risk?
Should his risk-taking strategy be considered ill-advised and dangerous? Not from the perspective of raising additional equity capital to fund the business, says Michael Reisert, president of the J. Michael Reisert Group Inc. in Fort Lauderdale, Florida. According to Reisert, who has been helping companies raise money for more than 30 years, "Where most entrepreneurs fail to raise capital is not putting themselves at a sufficient level of risk to entice investors to do the same." Remember, when a business fails, the equity investors usually take a hit on the full 100 percent of what they put in. With the service-oriented businesses of today, there are usually very few hard assets to liquidate. And what is left over from asset sales usually pays lenders, often at just cents on the dollar.
Reisert adds that when you consider most businesses are funded by angel investors, and not professional venture capitalists, the aversion to risk is even higher. "A venture capitalist is losing someone else's money," he says. "But angel investors are different. They're self-made. They often grew their own businesses the hard way. They have a real appreciation for positive cash flow. When you add it all up, they hate to lose money."
The ways entrepreneurs can put themselves at risk may seem fairly obvious, but Reisert says many entrepreneurs still think all they need to bring to the table is the idea and that outside investors should ante up for the "privilege" of investing. In truth, however, the entrepreneur must finance that idea with whatever funds he or she has available-whether he or she has $5,000 or $500,000. By doing so and taking on some risk, the entrepreneur makes the venture viable for outside investors. Here are some reliable, albeit hair-raising, techniques:
- Liquidate savings. If you've got it, give it up. There's just no way an investor is going to put in tons of capital that's totally at risk while all or part of your nest egg sits safely in CDs and blue-chip stocks.
- Take out a home-equity loan. Investors love this one because they know that nothing makes an entrepreneur work harder or smarter than the prospect of the bank repossessing his or her home.
- Get a bank loan. If you can actually get a bank to lend you money, you'll be demonstrating the kind of chutzpah investors like. Why? Because any bank loan will require a personal guarantee, or the guarantees of friends or family members, which tells investors that somebody else is at risk as well.
- Sell a vacation home. Is there a risk in selling a vacation home? Not really. However, it can still mean a lot to investors because it shows you've given up part of your lifestyle for the business. More important, the only way to get back to that lifestyle is to succeed.
- Take out a margin loan against your stock holdings. If you have, say, $100,000 in blue-chip stocks at a brokerage house, the firm will give you a loan of up to $50,000 almost instantaneously-assuming you have applied for, and received, so-called "margin privileges." Margin loans are relatively cheap, usually prime plus one to three points, and perhaps the easiest loans in the world to secure. They're also probably the most dangerous. Here's why: If the value of the blue-chip stocks collateralizing the loan falls from, say, $100,000 to $75,000, the brokerage firm will ask you for cash to make sure the "coverage ratio" of the collateral remains at 2-to-1. In this example, it would ask for $25,000 in cash. If you don't deliver the cash in short order, the brokerage firm will sell what stocks you have left and pay off the loan. The sale of the stocks could trigger enormous capital-gains taxes, with the whole scenario causing untold financial problems. Once again, it's this act of risk exposure that not only funds businesses but is critical for attracting the other investors that will be needed down the road.
- Quit your job. Nothing demonstrates personal commitment like leaving the safety of the corporate nest.
Back at 1-800 BIRTHDAY, Jersey hung on. By the latter part of 1998, he didn't have much to work with-but then, he had lots to lose, so somehow Jersey kept the business afloat. Then, near the end of the year, he was introduced to executives of The Fingerhut Companies, one of the largest database marketers of gifts and housewares in the United States. "Finally, somebody got it," says Jersey. In 1999, Fingerhut took a 20 percent stake in 1-800 BIRTHDAY, a move that was instrumental in Jersey righting the company-and helping take the company to the Internet in the form of iBIRTHDAY.com. Today, Jersey feels there were three reasons he was successful in raising money from Fingerhut.
"First," he says, "1-800 BIRTHDAY is a great idea." No surprise there; what else is the founder of the business going to say? "Second," notes Jersey, "it had a management team that the investors could believe in." Ditto. And finally, he says, "I believe one of the reasons Fingerhut invested was because [1-800 BIRTHDAY] was led by an incredibly motivated person with a lot at stake, who needed to succeed in order to avoid making a serious dent in his career, ego, home life and pocketbook."
It's important to keep in mind that taking risks does not mean committing senseless acts in the name of ambition. Jersey, who might be considered perhaps a cautious risk-taker, went out on a limb in measured doses. Specifically, during 1998, when the company was running out of money and venture capitalists weren't showing even a whiff of interest, Jersey himself didn't go in any deeper either. "Sure, I could have taken out a home-equity loan, but it would have been crazy because I couldn't have gotten the business to the finish line with the proceeds from the loan. So why risk everything if you can't succeed?"
Jersey's initial investors were thinking the same thing, and Jersey empathizes: "I'd only be willing to take risks if others were taking risks alongside me."
When it comes to raising money, risk-aversion/risk-assumption behavior can turn into a Mexican standoff-everybody waiting for someone else to make the first move. But ultimately, because the investors can wait forever or look at other deals, it's the entrepreneurs who'll have to move first, and get whatever skin they can into the game.
Add up your personal assets minus liabilities. Decide which of these you are willing to put at risk, and determine how far these funds might take your business. Estimate the total cash needed to fund the business. The difference is how much capital must be raised. The formula shows how much personal risk must be assumed.
David R. Evanson's newest book about raising capital is called Where to Go When the Bank Says No: Alternatives for Financing Your Business (Bloomberg Press). Call (800) 233-4830 for ordering information. Art Beroff, a principal of Beroff Associates in Howard Beach, New York, helps companies raise capital and go public, and is a member of the National Advisory Committee for the SBA.