When you’re an investor being asked to provide millions of dollars in capital to a growing business, you want a lot of details about how that money will be used.
“I would bet 90 percent of the capital-raising deals that we get introduced to, there is a pretty good idea of how much money they want and a sense for where they will spend the dollars to provide the highest impact for the company,” says Michael Paparella, managing director at Signet Capital Advisors. “But they haven’t nailed it down with any specificity. That is the piece that creates confidence in the eyes of the investor.”
Paparella has more than 20 years of experience in investment banking, strategy development and M&A, as well as raising capital for middle market and large cap organizations.
“Investors want to know with a fair amount of precision the purpose and use of those funds,” Paparella says. “That will help determine whether or not it’s the kind of investment that is going to provide an acceptable return.”
In this Dealmaker Q&A, Smart Business Dealmakers talks with Paparella about the three things every investor wants to know before providing capital and what to consider if you’re leery about giving up equity in your business.
What should companies understand before seeking to raise capital?
There are three attributes that every investor will look to when thinking about making an investment. This is true whether it’s a capital raise or whether it’s someone trying to sell the company.
They will look at the quality, depth and breadth of the management team. They will examine the past financial performance of the business — or the future if it’s a capital raise for a startup to see the projected financial performance of the business. The third piece is the growth opportunity that company offers.
Not only are these the three most important points to consider, but they are also probably in that order, the most important.
Investors will almost always try to assess the management team because more than a concept or a business, they are investing in that team. Most companies —whether it’s a startup or a company that has been in business for generations — do not have a well-defined three-year growth strategy where they can articulate how they are going to continue to grow the business, the industries, geographies, products and services and customer types. Being able to nail that strategy on a capital raise for a startup is really important. If you’re selling the company, it’s something that adds value to the business. It enables investors to see the light at the end of the tunnel of how that company is going to get from where they are today to where that investor wants to take them in the future.
How do you know how much capital you need?
The amount you need depends on the goal. The problem with raising more than you need is you’ll give up more equity than you needed to. It’s typically not a problem if you don’t raise enough and then need more. If you’re able to make progress, as you make progress, the company becomes more valuable. Therefore, for a same-dollar amount, you’re giving up less equity. The potential danger for not raising enough capital is if the company has not performed as it said it would on that initial capital raise round, it may become more problematic to actually raise the capital you need. It’s definitely a balancing act.
It’s both an art and a science. The science portion is you start with creating a three-year strategy and then layer in a financial model that mirrors that strategy to identify all the cost components and scale it for growth to determine what you think your need is going to be. The art part of it is where you then take a step back and look at it just from a gut feel to see if it makes sense. At that point, you can determine maybe you don’t need as much as you thought because you see in your financial model that in month 18, you probably reach a cash flow generation point that will self-fund whatever you need for the remaining 18 months. So maybe you don’t need 36 months of capital.
What if you’re concerned about selling equity?
If you don’t raise the capital, you may still be successful and be able to piece together the quantity of funding that you need slowly, making progress until you get to the point where the company can self-fund. In that scenario, you don’t give up much equity and you stay in control of the business. If that’s important to you, that’s probably the way to go. The negative is you won’t grow as fast. You face potential competition that speed to market could avoid.
If you raise a lot of capital upfront and you give up some or a lot of equity for that capital, you’re in the market quicker. You have a higher likelihood of success and a higher likelihood of that success becoming a larger business than you could do on your own. You have more capital and you have outside expertise that came with that capital from institutional investors. It really comes down to personal preference and risk tolerance.