Little-Known Funding Faux Pas
Ten things entrepreneurs often overlook when trying to raise capital
Every entrepreneur believes in their heart of hearts that their business is truly worthy of getting funded. Thus, they can't understand why this one aspect of building a business is so hard. Surely everyone should be able to see what an outstanding opportunity is being offered by your business! What is it that investors see that keeps them from investing? Why do so many entrepreneurs seem to make the same basic mistakes over and over again?
I've spent several years listening to entrepreneurs pitch their deals and I've read more than my share of business plans. To this day, it amazes me the consistency of errors entrepreneurs make when presenting their investment opportunities. Here are 10 common mistakes I'd highly recommend avoiding:
1. Investing too little in your own business. When an investor sees that an entrepreneur has invested little or nothing in their own business, it sends a big signal to them that perhaps they don't really believe in their own idea. What constitutes an acceptable investment? Well that depends on a variety of things. Different types of business require more capital than others (e.g., a medical device company would require more capital than a hair salon). The degree of sacrifice represented by the investment. In other words, how much pain will the entrepreneur feel if this business fails?
2. Investing too much in your own business. Believe it or not, you can invest too much in a business. Just last week I spoke with an investor who had invested $2.2 million into a company that after three years in business was only doing $100,000 a year in sales. Worse, the company needed another $1 million to reach breakeven. The investor didn't want to invest any more, but he had paid $12 a share for his investment and, at best, an outside investor would pay no more than $1.50. He was stuck. His choice was to either walk away from his $2.2 million or invest the next $1 million and hope it would be the last money needed. The lesson? Don't let yourself get trapped into being the only one investing in your deal. If that's the case, there may be a good reason why you're the only one who believes in your business.
3. Paying yourself too much (and/or accruing unpaid salaries). One of the worse signals an entrepreneur can send an investor is that they're living off the investments of others. When investors see an entrepreneur who has made a limited investment in their business, yet they're paying themselves $200,000 a year--not on sales revenue, but investor capital--we're strongly inclined to pass on the deal. Some entrepreneurs try to get around this by accruing a differential between what they feel is an "affordable" salary and the salary they feel they're truly worth. The difference is expressed as a debt to the business. Investors generally find this offensive and won't invest under those conditions.
4. Not proving sales and sales potential. There's a saying that investors want to see that "the dog will eat the dog food." In other words, if your product won't sell, then you don't have a business. For some reason, a lot of entrepreneurs seeking capital don't seem to understand this concept. Yes, there are cases where businesses need capital before they even have a product to sell, but that's not the issue here. The thing that'll turn off an investor quicker than a cold shower is a business that either has a salable product but has made no effort to sell it, or they've discovered that the market potential for the product is far less than anticipated.
5. Failure to recognize the "sale to value ratio." Another thing that'll turn off an investor is to see that the entrepreneur has sold off the majority of his business before they've even had their first VC round (we all know that VCs are the ones we're supposed to give up our control to!). What these entrepreneurs fail to realize is the sale-to-value ratio. That is, you never sell too much of your business when the valuation is low. The trick is to only sell off enough to help you get to an important milestone where the value will increase significantly and the next round of capital will buy a lot less of your business.
6. Hiding Intellectual Property (IP). Businesses that try and put all their IP into a separate holding company and only license the IP to the company seeking investments don't fool investors. Generally, investors want to know that if management fails to achieve their objectives, the investors have the option to sell the IP and get some of their money back.
7. Incorporating unwisely. A number of entrepreneurs have been fooled into thinking that it's a good idea to incorporate in states like Nevada where there are no state income taxes. On the surface it sounds like a good idea, but from an investor's standpoint those states often have other laws that aren't favorable to investors and discourage investing. Be sure and investigate whether or not the state you're considering is investor friendly. If not, it may cost you more than you save.
8. Incorporating at all. Qualified investors won't invest in a DBA--you must have a corporate structure in order to legally sell stock. Generally, investors prefer to invest in "C" corporations because they're the most common form of corporation. In recent years, LLCs have become popular due to their tax incentives. If you decide to go the LLC route, just make sure your lawyer structures the operating agreement to read as much like a "C" corporation as possible. Investors tend to not like LLC investments because they refer to shares as "units" and shareholders as "members."
9. Not having a strong management team. Investors will place strong emphasis on who you've attracted to join you in your vision and whether or not they have invested, contributed and/or bought or used the product.
10. Not having outside investors. Finally, investors will be looking at who else has invested in your business. How much have they invested? Did they invest more than once? How impressive are your investors? Are they "A" players? As an entrepreneur, you're truly known and respected by the business you keep. If your investors are deemed as sophisticated and knowledgeable, then you will be respected and, with any luck, a check will soon follow.