Fatal Flaws

Red flags that make potential financing sources think twice

Magazine Contributor

November 1, 1996 8 min read

This story appears in the November 1996 issue of Entrepreneur. Subscribe »

Of the 800,000 or so new businesses that are formed each year, investment banker Robert Shuey of La Jolla Securities Corp. in Dallas says only a tiny fraction successfully raise outside capital.

A quick look at certain benchmarks would seem to bear this out. For instance, last year there were about 700 initial public offerings (IPOs)--a goodly number, but not when compared to the number of start-ups.

Then there's venture capital, a concept that gets a lot of attention but, in reality, is not an option for the majority of small companies.

Even the number of small private offerings--either partnerships or private equity placements--is tiny in comparison to the rate at which new companies are being formed. According to the Securities and Exchange Commission (SEC), about 10,000 Regulation D forms are filed each year. Though this is not a precise count of private deals, Regulation D forms provide a good estimate of the number of attempts.

And so, when you add it all up, the number of financings is not that great compared to the overall level of entrepreneurial activity. The fact is, not a lot of companies successfully negotiate the perils of the capital markets. As almost anyone will tell you, there are a thousand ways for a deal to go wrong but only one way for it to close.

But what is it precisely that keeps many companies from raising money? In a word, warts. Every deal has them. The only question is, are they fatal or just ugly?

The Dirty Dozen

Investment banker Shuey keeps a tally of 13 unwritten no-no's that more or less represent his "wart list." (Actually, there are 12; the 13th states that the presence of any of the preceding 12 will cause immediate deal implosion.) Some of Shuey's rules relate strictly to IPOs--the penultimate goal for most, but not all, companies, since many entrepreneurs would be happy to simply raise a $100,000 dollop of equity. Therefore, the following discussion eliminates some of Shuey's rules and, where practical, homogenizes them so they apply to raising money in general.

These, then, are the warts that could make the financing sources you're wooing think twice:

1. You have no money. "Companies that cannot afford the dry hole expenses of the deal," says Shuey, "will likely never raise any capital." By dry hole expenses, Shuey refers to the legal, accounting, promotion and travel costs that are part and parcel of every fund-raising effort. For an IPO, these expenses might be $250,000. For a small private placement of perhaps $100,000, they might be $7,500. If you don't have the walking-around money to get the deal done, you're destined to sit on the porch and simply watch the action.

2. You've already shot yourself in the foot by attempting to sell a half-finished transaction. This is not to say the old adage about falling off the horse and getting right back on again doesn't hold merit. But in the arena of capital formation, broken deals can make strange and sometimes unworkable bedfellows, says Shuey. For instance, if you have tried to raise money and gotten halfway done, it's highly unlikely that an investment banker, venture capitalist or other intermediary will ride over the hill like the cavalry and finish the deal. "It's somebody else's busted deal," says Shuey. "Nobody wants to fix it for you because they would simply rather find another that isn't broken." If you want to raise money, he says, you'll have to scrap previous efforts and start again fresh.

3. You've overshopped the deal. No matter where you live, when it comes to early-stage financing, it's a small town. Heck, it's even a small country. "Everybody talks to the same attorneys and accountants," says Shuey, "so it's only a matter of time before you find out the [entrepreneur] who was in your office in the morning was in a competitor's office that afternoon."

Not that entrepreneurs shouldn't shop for the best deal; on the contrary. It's just that, to use Shuey's analogy, "the last available girl at the ball may not want to dance with you after she finds out everyone else you asked said no." Shuey's advice: Whenever practical, use a targeted rather than a scattershot approach, and pick off your funding sources one by one.

4. You think your idea is worth more than it really is. Shuey recalls one entrepreneur who was developing a new retailing concept and thought it was worth $100 million. Shuey talked to a lot of institutional investors, and they came up with a value of $60 million. Unsatisfied, the entrepreneur hired another investment banker--who got him a valuation of just $40 million. The entrepreneur walked again . . . and then went bankrupt. "The lesson," says Shuey, "is when a professional investor offers you real money for an unproven concept, you take it. If you hold out for the highest possible value, you become an unfundable deal."

The Numbers Game

The fifth area where entrepreneurs mess up in raising money is inadequate financial reporting of either past results or future projections. It's hard to pinpoint one area where the warts pop up on a financial statement because so many subtleties make up the mosaic of a company's financial picture. But let's start with a few of the more obvious ones.

First, who prepared the historical financial statements? "If the income statement, balance sheet and cash flow statements have been internally generated, as opposed to being prepared by a CPA," says Shuey, "the company is basically unfundable from outside sources until [an outside CPA prepares the documents]." It's not that management isn't capable of generating financial statements. But the use of a CPA brings with it another verification that the company is for real, even if the statements are just a compilation. And if your financial statements are prepared by a "Big Six" accounting firm, so much the better for convincing outside investors the statements are what they say they are.

Another fatal flaw with respect to financials is a profit and loss statement that shows a profit but, upon further scrutiny, indicates a loss is more accurate. How could this happen? Several ways.

For instance, under the guise of "matching" expenses and revenues, many entrepreneurs are tempted to "defer" certain expenses incurred for product development until the product is actually introduced. The net result is that the income statement doesn't show all expenses, hence making profit much easier to attain.

Some companies understate their returns and allowances on sales--which are often extremely large when a company sells to national discount chains, which have a reputation for returning unsold product--resulting in inflated revenues. And sometimes, companies show extraordinary gains and losses from sales of equipment or trademarks that do not appear to be aboveboard transactions.

In short, there are lots of ways to show a profit, even if you're not trying to cook the books. But if you're trying to raise capital, today's net income can be tomorrow's wart.

With respect to IPOs, Shuey says if he sees something in the financials that he feels the SEC will make the company restate, thereby turning what was once a profit into a loss, "the company is unfundable, and we walk."

Finally, many companies render themselves unfundable with unrealistic financial projections. If a company has been growing at 15 percent to 20 percent annually, it's hard to believe it's suddenly going to start showing increases of 40 percent to 50 percent per year. But financial projections even more unrealistic than this are common. You might be able to fool your dotty uncle into thinking you will have $300 million in sales by year five, but a sophisticated investor, particularly one who has run a company, will believe you're simply naive and take his or her risk capital elsewhere.

Personality Flaws

Many times the company doesn't have warts, but the founders and senior management do. When you're raising capital, personalities play a big role--perhaps a disproportionately big one. Why? Because with equity capital, where the investor owns a piece of the company, you're really talking about a partnership.

Happily, in the pursuit of riches, a lot of personality flaws that might otherwise prevent the development of friendships are overlooked. Some of these qualities include single-minded devotion to work and career, an enlarged curiosity with regard to minutiae, poor social skills, a dry personality, no personality, lack of fashion sense, poor hygiene . . . you get the picture.

But one personality trait that is never overlooked by sources and finders of capital--and the one wart that will absolutely torpedo a deal--is an entrepreneur who knows it all. "If our investors are in the deal, the entrepreneur has to be able to take my input constructively," says Shuey. "If somebody can't take advice from others because they know it all already, then we can't do business."