Investment in a startup, an early stage business, happens based upon assessment of potential of the startup. Potential of a venture is the possibility of it becoming a:
Beinvestible guidelines enable an entrepreneur to self-assess the attractiveness of his venture for outside capital.
Capital requirement could arise on account of different reasons such as for
Therefore, the purpose of raising capital clearly needs to be identified.
Raising capital impacts businesses and owners in different ways. Whist it implies prospect of improved business condition and shareholder value, it could also throw open challenges such as loss of control, reduced management freedom, increased reporting requirements etc.
Having identified the purpose of raising capital, areas where the capital would be employed should be clearly defined. This could be for purchase of capital asset, product development or employed for working capital depending on the need.
Different sources are available to raise capital. Depending on the need and impact, an owner needs to decide whether loan, equity or a mix of both financing is required. Typically, a loan would involve fixed and determinable principal and interest repayments, whereas equity could mean dilution of interest in the business but with improved net worthiness.
The extent of capital required will be in line with the purpose and business need. For example, if you are starting a new business, capital requirement may be higher due to initial capital and set up costs. Relatively, a smaller injection of capital may be needed to overcome gaps in the current working capital requirement of existing business.
If you have exhausted the options of personal and other alternative sources of raising finance, the purpose and extent of capital required as discussed above could determine the stake holding you are ready to part with the investor. Generally, a majority stake would entail a holding of more than half of the shares which could also lead to management control.
Private equity funds typically invest in businesses with proven track record and looking at expansion. Venture capital or Angel investors typically tend to invest at start-up or early stage of business and hence are willing to undertake more risks. Accordingly Venture capital expects the returns to be high. Similarly, other alternative sources could be from family and friends or from a community. Raising from family/friends may be simpler and faster but could give rise to rift/conflicts. Community sources may restrict funding only to certain business activity and may require the owners to be actively involved in the community.
The business model could involve several products, their unique features, pricing strategy, costs, revenue stream etc. It is important to have comprehensive information about the model.
Evaluation of your main customers, length of relationship, business volumes with them etc will be critical. Normally, dependence on single customer or supplier is considered risky for continuity of business and hence diversification of customer and supplier base is essential. Further, terms of trade like pricing, credit, rebate, discount etc with the customers and suppliers are clearly defined and agreed.
Have you considered the following:
Knowing and identifying the general marketplace for your product/service is very important to quantify the demand for the business. Rate of growth of an industry is another important parameter to forecast the demand. Further, knowledge of current market share and vision for the future, industry barriers if any etc will be critical as these are matters of paramount importance from investor’s perspective.
Most entrepreneurs do not know enough about their competition. An investor will be wary if you do not understand your competition. A list of competing products and the various companies that produce them is the starting point. Pay particular attention to their sales volumes, their market share and the financial strength of your competitor. Typical question that an investor would ask are, “What advantages do you have over your competitor? In terms of price, performance, services, and warranties, how do you compare with your competition? What advantages does your competitor have over you? Are there substitutes for your product? What is the price differential between your product and the product of your competitors? Are any competitors just entering the industry? If you plan to take a market share from the competition, how will you do it? How do you expect the competition to react to react to your company?
The core management team is clearly identifiable with responsibilities they handle. The background, track record and experience of management team and their commitment to the business objectives are pivotal to growth and future of the organization.
Since SMEs’ are often run as family concern, the ownership structure is clearly defined to avoid confusion. In case of limited liability companies, the ownership structure is 51% belongs to local and 49% to the expat. In many cases, the local partner only acts as a sponsor, whereas the business is run by the expat. This entails continued re-investment of profits/ funds by expat to ensure sustainability and growth.
A well laid down succession plan is critical from an investor’s perspective. A venture may be profitable but may not be investible in the absence of a succession plan. Ideally succession plan is prepared in consultation with all stakeholders setting timeframe and milestones. The plan details the proposed new structure, key management changes, steps to be taken to mitigate business risks etc.
Cash flows are critical to ensure continuity and growth. Conversion cycles regarding inventory, receivables etc are important to determine revenue stream and cash flows. Similarly, payables and costs are analyzed before arriving at margins. From an investor’s perspective, current cash flow and future cash flows based on projections will be critical.
One of the parameters by which success of an organization is gauged is by understanding how effective the systems, processes, controls and reporting are within the organization. These in essence reflect the culture of the organization and how far the management team and owners are committed. Organizations which are disciplined and who have sound and robust information reporting system will find it easier to attract investors as these provide high level of comfort.
As part of the financial discipline and reporting, it is important that the books of account are duly audited every year by a reputed auditor. Audited financial statements of the track record provide immense comfort from an investor’s perspective.
There could be myriad of expectations from an investor depending on the business model, but fundamentally will include the following aspects:1
Management capability- This could include reputation in the market, business background and experience, resourcefulness etc.
Product and market- The uniqueness or specialty of the product or service offered will be critical to evince interest of any investor. Equally important will be matters relating to technology, acceptability of the product, sustainability, market growth rate, competition etc will be viewed critically.
Business model & risks- The model of business operation such as sourcing from suppliers, customer base, credit terms, pricing strategy vis-à-vis competition, logistics, warehousing, revenue model etc will be screened in detail. Business risks associated with all the aspects mentioned will be closely looked at and studied. Organizational capability to handle the model with risks will be critical.
Financial strength of the business based… on current net worth, debt/equity ratio, operating ratios, liquidity issues, rate of return etc will be matters of paramount importance from an investor’s perspective.
Valuation and exit options
Another very important consideration an investor will be interested in is the current valuation, what value can be expected of the investment say after five years and the exit options available. The exit options could include selling to an existing or new investor, sale of business etc.
A well prepared presentation and great delivery are critical to successful financing. The first presentation should have no more than 20 slides and a message that takes 15-20 min delivery followed by Q&A. The ability to manage the idea and the meeting time is an indicator of the entrepreneurial skills. Presentations should not be product-centric. The entrepreneur is building a company of which the product is a foundational element. Investors are evaluating investment in an entrepreneur who is establishing a business. They are not investing in a product.
Slides for presentation may be in the following order:
a. Title page with the name and logo of the company, the name and title of your presenter, and a one-line description or tag line about the company.
b. Business overview – the elevator pitch of one or two short sentences or bullet points. Communicate what you sell in succinct language.
c. Management team – current and proposed – talent & experience, with one line background on each member.
d. Market – what is the market opportunity and trends, and what are the customer pain points.
e. Product – How the product will solve the pain.
f. Product value proposition – who pays, how much and from where, and annualized revenue streams.
g. Competition – who, how strong, and differentiation factors. Include both direct and indirect competitors.
h. Customer segments – how many, who are they, purchase behavior, distribution process to access, how attracted, converted and retained.
I. Customer acquisition strategy – timeline of customer acquisition and resources required.
j. Business model – with emphasis on organization capabilities required to make business work and development / acquisition assumptions.
k. Organization capability development – strategy, time line, and costs.
l. Strategic relationships, if any – to make the business work.
m. Barriers to entry – how competitors may react and will be kept at bay.
n. Financial Overview – top line revenues and expenses, EBITDA, two years back (for existing businesses) and five years out (no excel tables).
o. Use of investment proceeds – where will the investment take the business.
p. Capital structure & valuation –Current investment and investors, investment sought, and basis of suggested valuation.
q. Summary – a review of strongest features, narrowed to the 4 or 5 most important points.
Post the pitch, there will be due diligence carried out by the investor through consultants on market, financial, technical and legal aspects, culminating at a valuation. Based on the results and in principal agreement, a Memorandum of Understanding (MOU) is entered into detailing all the aspects of the agreement. Matters relating to management and running of business, decision making, reporting, etc. post the investment are all agreed in the MOU.