Fatal Flaws Red flags that make potential financing sources think twice

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

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

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

Even the number of small private offerings--either partnershipsor private equity placements--is tiny in comparison to the rate atwhich new companies are being formed. According to the Securitiesand Exchange Commission (SEC), about 10,000 Regulation D forms arefiled each year. Though this is not a precise count of privatedeals, Regulation D forms provide a good estimate of the number ofattempts.

And so, when you add it all up, the number of financings is notthat great compared to the overall level of entrepreneurialactivity. The fact is, not a lot of companies successfullynegotiate the perils of the capital markets. As almost anyone willtell you, there are a thousand ways for a deal to go wrong but onlyone way for it to close.

But what is it precisely that keeps many companies from raisingmoney? 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 unwrittenno-no's that more or less represent his "wart list."(Actually, there are 12; the 13th states that the presence of anyof the preceding 12 will cause immediate deal implosion.) Some ofShuey's rules relate strictly to IPOs--the penultimate goal formost, but not all, companies, since many entrepreneurs would behappy to simply raise a $100,000 dollop of equity. Therefore, thefollowing discussion eliminates some of Shuey's rules and,where practical, homogenizes them so they apply to raising money ingeneral.

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

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

2. You've already shot yourself in the foot by attemptingto sell a half-finished transaction. This is not to say the oldadage about falling off the horse and getting right back on againdoesn'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 andgotten halfway done, it's highly unlikely that an investmentbanker, venture capitalist or other intermediary will ride over thehill like the cavalry and finish the deal. "It's somebodyelse's busted deal," says Shuey. "Nobody wants to fixit for you because they would simply rather find another thatisn't broken." If you want to raise money, he says,you'll have to scrap previous efforts and start againfresh.

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

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

4. You think your idea is worth more than it really is.Shuey recalls one entrepreneur who was developing a new retailingconcept and thought it was worth $100 million. Shuey talked to alot of institutional investors, and they came up with a value of$60 million. Unsatisfied, the entrepreneur hired another investmentbanker--who got him a valuation of just $40 million. Theentrepreneur walked again . . . and then went bankrupt. "Thelesson," says Shuey, "is when a professional investoroffers you real money for an unproven concept, you take it. If youhold out for the highest possible value, you become an unfundabledeal."

The Numbers Game

The fifth area where entrepreneurs mess up in raising money isinadequate financial reporting of either past results or futureprojections. It's hard to pinpoint one area where the warts popup on a financial statement because so many subtleties make up themosaic of a company's financial picture. But let's startwith a few of the more obvious ones.

First, who prepared the historical financial statements?"If the income statement, balance sheet and cash flowstatements have been internally generated, as opposed to beingprepared by a CPA," says Shuey, "the company is basicallyunfundable from outside sources until [an outside CPA prepares thedocuments]." It's not that management isn't capable ofgenerating financial statements. But the use of a CPA brings withit another verification that the company is for real, even if thestatements are just a compilation. And if your financial statementsare prepared by a "Big Six" accounting firm, so much thebetter for convincing outside investors the statements are whatthey say they are.

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

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

Some companies understate their returns and allowances onsales--which are often extremely large when a company sells tonational discount chains, which have a reputation for returningunsold product--resulting in inflated revenues. And sometimes,companies show extraordinary gains and losses from sales ofequipment or trademarks that do not appear to be aboveboardtransactions.

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

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

Finally, many companies render themselves unfundable withunrealistic financial projections. If a company has been growing at15 percent to 20 percent annually, it's hard to believeit's suddenly going to start showing increases of 40 percent to50 percent per year. But financial projections even moreunrealistic than this are common. You might be able to fool yourdotty uncle into thinking you will have $300 million in sales byyear five, but a sophisticated investor, particularly one who hasrun a company, will believe you're simply naive and take his orher risk capital elsewhere.

Personality Flaws

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

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

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

Contact Sources

La Jolla Securities Corp., 8214 Westchester, #500,Dallas, TX 75225, (214) 692-3544;

Securities & Exchange Commission, Washington, DC20549, (202) 942-2950.