Key Factors to Consider When Raising Capital
By Pedro Garcia and Ronan P. O’Brien
Organics continue to present one of the most attractive business opportunities in the food industry. Despite recent worries about economic growth, inflation and consumer spending, the organic industry is still growing. Investors are keenly aware of this growth opportunity and the success of many notable companies continues to attract capital to this sector. While the overall picture for organic is favorable, the bar keeps rising, and the best prepared—and best funded—will have the opportunity to be a lasting success.
Adequate funding is a prerequisite for both young and more established companies. The former must secure enough funds to gain a solid footing, while the latter needs the capacity to seize opportunities that might otherwise be forfeited to more aggressive competitors. Therefore, having a sense of your capital requirements as well as what funding sources are available needs to be part of ongoing strategic considerations for every business. Here are some ideas that could help you frame a successful capital strategy.
Equity vs. Debt Financing. There are two main ways businesses can get financing— either sell a share of ownership in your company (equity financing) or take out a loan (debt financing). Despite the recent retrenchment in lending by many banks, borrowing under loans and similar debt instruments continues to be the simplest and cheapest source of funding. However, since most credit capacity is directly correlated with business size, loans only become an attractive option for companies with +/-$2 million in operating income. Therefore, the smaller the company, the more likely it is that its most viable source of financing will be equity capital. Surprisingly, borrowing is frequently an overlooked alternative even for larger companies; many business leaders just seem to be negatively disposed to loans because they have to be paid back and carry a current interest cost. However, the prudent use of loans can help you avoid many of the challenges that can result from having the wrong equity investor. The fact is that equity also has to be paid back and it often gives investors ownership and other rights that are more costly and intrusive than those required by lenders.
Match Your Equity Funding Need with the Right Investor Pool. If loans are not available or their terms are not adequate for your business, you should turn your attention to the private equity market. The top sources of private equity include individual or “angel” investors, angel groups (several angel investors informally working together) and institutional funds, such as venture capital groups. In contrast to angel investors, institutional funds are formal partnerships of investors that pool large amounts of money and hire full-time professional staff to search out and manage investments. If your equity requirement is less than $3 to 4 million, chances are that you will be more successful courting angel investors than venture capital funds. Institutional funds generally cannot afford to spend time on an investment unless they can put several million dollars to work. Furthermore, institutional funds will generally be more critical and skeptical of your business, more demanding of your time, more intrusive going forward and harder on investment price and terms than angel investors tend to be. One place you can go to find information on angel investors is the Angel Capital Association (www.angelcapitalassociation.org), a trade association which offers a directory of angel investment groups in North America.
Teaming up with the right institutional fund can be a significant achievement for emerging businesses. However, success depends on a solid foundation. Reaching that $3 to 4 million institutional funding threshold depends on more than just your funding requirements, it is also a function of the scale and momentum of your business and the likely revenue trajectory over a four-to seven-year horizon. Currently, there is no resource that provides a comprehensive list of institutional funds. However, some investment banking firms may have their own proprietary lists and relationships with many institutional investors.
Another option is to partner with a larger and more established company. Examples of successful strategic investments that allow the ongoing independence of smaller companies are not common though. Major companies are interested in smaller creative companies that can provide access to new markets and capabilities, but more often than not they seek immediate control or at least a path to control in the future, thereby seriously limiting the investment “exit” options for company founders. Plus, larger companies normally have complex bureaucracies, meaning that the deal has a higher chance of getting caught up in red tape or passed around from one executive’s desk to another several times before any concrete decisions are made. Because of these challenges, this option is often unreliable and not the best choice if you need a more predictable path to funding.
Be Organized. The best way to achieve successful financing is to tell a compelling story to investors, and organized financial reports and business plans are the best vehicles to do so. An executive who has trouble explaining his/her company and articulating its strategy indicates that he/she does not have a clear understanding of the state of the business and where it is going. Think about what key variables (product pricing, distribution ramp-up, the impact of scale on production costs, etc.) drive your business and make sure that you are able to measure them accurately and consistently over a period of time. Investors value organization as it conveys control and confidence, and this will translate into a lower perceived risk in your business.
Another aspect of organization that is often overlooked relates to legal issues such as the corporate organization (e.g. partnership, corporation, etc), intellectual property (e.g. trademarks), employee agreements (e.g. compensation, confidentiality, obligations, etc.), and customer/supplier relationships (e.g. commitments, exclusivities, etc.). No one wants to spend extra dollars on legal fees, but an ounce of prevention equals a pound of cure as the cost of these seemingly small matters can balloon tremendously if you actually have a problem that delays or endangers a financing. Having a good business-oriented attorney with transactional experience can help you navigate these issues proactively.
Set (Realistic) Expectations. Serious capital raising efforts regularly take six to nine months to complete, so your funding needs to be staged accordingly. Before reaching out to any investors, you will need to develop a sound business plan that incorporates key commercial elements (such as the market opportunity, competitive environment, “going to market” strategies, etc.) within a sensible financial context (current cash need, future cash generation and eventual value creation).
In order to generate interest from investors you may be tempted to forecast financial results that are aggressive. Are they unrealistic? What if during the fundraising the company’s early returns reveal no hope of approaching the targeted growth rate? This situation is likely to jeopardize the entire financing or, at the very least, put you in a weak position that forces you to compromise just at the time when you need maximum negotiating leverage.
Another frequent mistake is the failure to plan toward “breakeven,” that is, to ensure there is sufficient financing to take the company to profitability so that the business can support itself. Some companies make the mistake of getting just enough cash to get them by for a short time and then after they have gone through that money, they have to look for another investor. This is not only a lot of work, but it makes it seem as though you did not properly plan or gauge your spending. This of course doesn’t sit well with the initial investors or the new investors you may approach. Unrealistic expectations can also take a toll in larger and profitable companies that raise money. In the face of such failures, equity partners can become distrustful and employ greater oversight of the business, turning the most attractive equity partners into the worst in-house enemies. It is a given that a portion of any financing will be wasted because not everything works out according to plan, but you can also be prudent by including a cushion for losses within the plan itself.
The third dangerous miscalculation involves valuation. The fact is that the market will determine the valuation of the business and what an equity financing will cost. Unfortunately, often the valuation is not determined until the end of a process, when investors have full information on the business and are able to make that judgment in negotiation with the entrepreneur. If your expectations are not aligned with market realities you can waste a great deal of time and hurt your relationship with many investors.
Preserve Your Options (but Not to a Fault). Entrepreneurs “fall in love” with investors much more often than investors fall in love with companies. There are countless instances of financings falling through at the last minute, often because companies prematurely narrow the field to only one investor. This leaves the company exposed to real or fabricated problems that may result in a less favorable outcome (often a higher cost of capital). Business leaders like to think the financing is substantially done even before the check clears. Optimistic thinking can be a great ethos in driving an overall organization toward growth, but, there is no place for giddiness in a financing negotiation.
Also, it’s important to weigh the benefits of seizing the money that is available today versus continuing to hold off for a potentially better deal. Raising money is stressful and takes up much of your management’s time that could be better used growing the business. Entrepreneurs often undervalue the benefit of a quickly consummated fundraising that enables management to get back to work. Often is it best to follow the adage, “raise money when it is available, not just when you need it.”
Be Patient. Most of the highly successful companies in the organic products industry built that success over many years of hard work. While product life cycles in this market have shortened, many business leaders are impatient to a fault in their drive to be the first to market on a national basis. Being the “first mover” has clear advantages, but the breakneck speed at which many seek to grow stresses organizations to the point of forcing mistakes. Building a solid and profitable business model that does not depend on the convergence of many factors that are beyond your control (and regular cash infusions) may not be immediately “sexy,” but it establishes a solid foundation and allows you to retain control of your destiny. Raising too much money too early in a company’s development often results in giving up too much equity in your business.
Get Advice. Major financial transactions by any business can significantly affect the value that its owners receive, and successful management of the capital-raising process can mean the difference between a great outcome and a mediocre disappointment after years of hard work. For most entrepreneurs, their expertise and “value added” is based on business skills such as product development, marketing, sales and distribution. Financial structuring and negotiation are a specialized disciplines and it is unreasonable to expect every business leader to become an overnight expert in these matters. Furthermore, many times the opportunity cost of losing focus on the business while carrying on a transaction can be very costly and even undermine the financing itself. Just as with any other aspect of your business, you will benefit greatly by getting the best possible advice from your trusted sources and delegating the effort to someone with the expertise and capacity to deliver the best possible result.
Do what you can to avoid joining the long list of entrepreneurs who raised money without understanding the implications of crucial yet very complicated legal concepts such as “preferred stock participation,” “antidilution,” “option cost allocation,” “supermajority voting,” “clawbacks” and “ROFRs.” Before your head starts spinning, realize that most people don’t know what these terms mean unless they went to law school or frequently work with financing agreements. However, this “legal jargon” (which would take a textbook to explain properly) can surface when you least expect it and can greatly affect each stakeholder’s interest. For example, a multimillion dollar financing was recently scuttled at the last minute because the company did not anticipate early-on that the investor it selected expected to receive additional ownership in the company through a backdoor equity mechanism called “preferred stock participation.” In effect, that financing would have cost almost double the initial presumed price. To safeguard your negotiating position it is recommended that you reach out to attorneys, accountants, and other business leaders you know and trust to connect you with professional financial advisors that can help you improve your chances of completing a successful deal. This together with the proper preparation and organization can provide the funding partnerships you need to grow your business.
Pedro Garcia is a managing director and a partner in the investment banking firm of Hadley Partners, Incorporated (www.hadleypartners.com), where he specializes in capital raises and mergers and acquisitions within the food industry. He also serves on the board of directors of Frontier Natural Products Co-op. He can be reached at Garcia@hadleypartners.com.
Ronan P. O’Brien is a partner with the law firm of Seyfarth Shaw LLP (www.seyfarth.com), where he advises businesses and entrepreneurs on venture financings and mergers and acquisitions. He can be reached email@example.com.