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The 6 Biggest Mistakes in Raising Startup Capital

Avoid these traps to increase your chances of securing funding and keeping investors happy.
September 20, 2007
URL: http://www.entrepreneur.com/article/184350

In the movie Little Fish, a video store manager played by Cate Blanchett applies for a bank loan to buy the business and expand into online gaming. When her application is rejected, Blanchett hurls a framed photo of the loan officer's child across the room in fury. Anyone who's suffered a similar setback knows the feeling.

The business landscape is littered with would-be entrepreneurs who've stumbled in their search for startup capital. Many requests are denied. Those who pass the test frequently have unacceptable strings attached. Some deals that close come back to bite the business owner in the form of onerous debt, insufficient revenue share or worse.

Part of the problem lies in the nature of the startup endeavor. Freshly minted entrepreneurs are typically major risks for lenders because they lack business experience, collateral to secure the loan or both. Neither family, friends, banks, venture capital firms nor angel investors are interested in losing their investment. You can't blame them for not wanting to take a risk on a venture without a reasonable probability of return.

On the other hand, many financing efforts fail because of avoidable mistakes that are made in pitching potential lenders, structuring the agreement or managing the money once the deal is done.

Steering clear of these missteps can increase your chances of success, both in obtaining startup funds and keeping the money flowing. Be sure to avoid these blunders:

1. Half-baked business plans-- There's nothing worse than going into a money meeting unprepared. If you haven't put the time and energy into writing a full-blown business plan complete with elements, such as a cogent business description, financial projections and a competitive market analysis, the people with the cash won't put the time into evaluating your proposal.

The SBA is a good source for learning how to write a business plan as well as sample formats.

2. Focusing too much on the idea and too little on the management-- It's not enough to convince potential backers that you've invented the next must-have gadget or can't-miss clothing store concept. You also need a team that can generate the revenues to repay a bank loan or provide an exit strategy for a VC or angel investor. Many business novices ignore the second part of the equation; that can doom their money quest.

The greatest racehorse in the world still needs a great jockey to a win a race. The same principle applies in business. Showing that you have recruited a top-notch salesperson, a skilled marketer, an accountant with startup experience, other key personnel, and even outside experts like an attorney or business coach who can supply professional guidance is essential to finding a funding source.

3. Not asking for enough money-- In a 2004 U.S. Bank study of reasons for small business failures, 79 percent cited "starting out with too little money" as one of the causes of their collapse. That's often because entrepreneurs who are wet behind the ears don't realize that they should calculate their borrowing needs based on their worst-case scenario instead of their best-case forecast.

An old accounting axiom says that everything will take twice as long and cost twice as much as you expect. While that may be an exaggeration, new business owners are frequently too optimistic about how soon they will begin to fill their cash pipeline and how fast the money will flow. If you're underfunded, you won't have a cushion to tide you over in the event of slow initial sales or unexpected market conditions.

4. Having too many lenders or investors-- One of the hazards of securing financing from multiple sources is managing too many relationships and expectations. It takes time away from your core business. These not-so-silent partners may have conflicting interests or demands and the consequences can be devastating.

This is particularly true when you raise money from friends and family. One hairdresser I know borrowed money from seven or eight relatives to open her own salon. The business was successful, but there were perpetual battles over how the profits should be distributed. The arguments couldn't be settled to everyone's satisfaction, so the salon was forced to close.

5. Failing to get the proper legal agreements-- This is arguably more important than a prenuptial agreement for a couple with significant individual assets. Every lender or investor eventually will need his money back, and a legal document covering everything from the terms to the timing can avoid the kind of acrimony just described.

6. Poor cash flow management-- Too many new business owners burn through their seed money too quickly and fail to reach cash flow-positive status in a timely manner. Some causal factors, such as late product deliveries and economic downturns may be beyond one's control, but the executive team is clearly at fault for others, such as unnecessary spending and overly optimistic expense/income forecasts. Financial sponsors don't take kindly to that sort of mismanagement. And if they turn off the tap, all of your hard work may go down the drain.

There are other pitfalls to avoid, but the bottom line is this: Play by the lenders' rules to get them to open their checkbook, but protect yourself at the same time. There's no point in launching a business that will eventually sink under the weight of your investors' demands. If your business plan is good enough and you approach the right people, you should be able to whistle all the way to the bank.