Why do not buyers help your small enterprise?
There are many different ways for a business to raise money. Unfortunately, they are rarely easy and it can be frustrating and daunting. Understanding the general reasons for different types of investors could save some of that effort and frustrations.
Lenders are fixated on the likelihood that a loan will be repaid. This generally means regular income that is sufficient to cover principal and interest payments. They also seek security for some assets – either for the company or, if they are insufficient, through a personal guarantee from the founders. Your confidence in available earnings and the value of assets increases when there is a relationship that has established trust and when there is a credible financial history. As a result, debt is rarely an option for the newest businesses.
There are very different goals and criteria for participation. You may have family and friends who care about the relationship as much as the returns, and they may just have a venture investment. But for seasoned angels, professional investors, and venture capital firms investing other people’s money, the investment is likely one of many in a portfolio.
When looking at a portfolio of early-stage companies, an investor expects that some of them will die. However, the health of the portfolio is determined by oversized returns on a small number of investments. In the very early stages of business, a venture capital investor can expect to lose their money seven or eight times in ten. However, he does expect those who do well to return at least 10 times their cash and hopefully 30 or 50 times their original investment. A venture capital investor in companies that are still growing but 2 or 3 years old can expect the worst mortality rate to be exceeded and more likely 2 or 3 in 10 companies to work out. If they can get 3 to 5 times the return, the portfolio works very well.
This math directly gives the criteria an investor uses to consider a company. I write “Consider” on purpose as that is not the criterion for whether or not to invest. It becomes much more strict – through the team, the market, the idea and the business model. But just to get into a conversation, there are a few basics that get a company in or out of scope.
Tips for Attracting VC Investment
Growth: The business offering needs to be one that has the potential to grow very quickly. If a company wants to add five to fifty times its value, it needs to be innovative and in a large and fragmented market that is growing fast enough for that innovation to have room to grow. For example, a chain of barber shops is unlikely to have any real innovation, and it certainly won’t be in a high-growth market.
Frame: Oversized returns result from sales growth, but also from a healthy margin, with returns increasing exponentially with scaling. The fixation of the VC market on technology is based in part on the expectation that a market is not geographically limited and that a solution can expand across borders, regardless of whether it is county, country, or continent. And this with relatively little additional investment for each new area, which results in economies of scale. Compare this to a sector like restaurants, where investing in space, furnishings, and the right location are a big part of the formula for success and each new location feels like a whole new business.
Return on investment: The rate of return is a factor in how much you get and how much you invest. So take two companies with the same growth potential. Let’s say a manufacturing company that needs a large amount of cash to get up and running and another, let’s say an e-commerce company that goes direct to the consumer, is building a strong brand but not a fortune of its own and therefore requires less cash in advance. The second is a more attractive investment. That’s not to say that high net worth companies will never get equity funding, but it certainly is tougher for them.
Outputs: To get a return on an equity stake someone has to buy that equity at some point. So an investment initially needs confidence that the founder is motivated to sell and that the company can generally be packaged and sold to a commercial buyer or private equity firm. While every company is initially heavily dependent on its founders, a business model that always will, or where competitive advantage is derived from human capital, is unattractive for venture investments. For example, professional service companies or creative agencies find it difficult to find external supporters.
VAT: Often a venture capital company has a certain tax bracket that it promises to its investors. In the UK, government-backed tax systems – the Seed Enterprise Investment Scheme (SEIS), Enterprise Investment Scheme (EIS) and Venture Capital Trusts (VCTs) – help investors mitigate the risks of investing in companies at an earlier stage. There are conditions, however, and if the company does not meet the HMRC’s criteria, the VC cannot find a place for them in its portfolio.
For example, to qualify for SEIS, a company must have been in trading for less than 2 years. Both SEIS and EIS are subject to restrictions on the financial services business or those where a large portion of the business’s value can be traced back to real estate. A company that may pay good dividends in the future is not as attractive under SEIS or EIS as a company that can make a big exit, as dividends are taxable for the investor under this scheme, but one-time capital gains are not.
Hence, venture capital investors reject many proposals that contain the ingredients of a great business that could be very successful and bring great income to the founders. Simply because they lack the qualities of an attractive equity investment to complement a high risk, high growth portfolio.
While it is always disappointing and frustrating to hear that someone is not endorsing your business, it helps separate the judgment of the company from that of a venture capital decision.
Are you interested in participating?
The startup series, hosted by smallbusiness.co.uk, offers companies the opportunity to secure an equity stake of £ 150,000 to £ 250,000 each month. To learn more, click here.