By Andrew Maxwell
In recent blogs, I have tried to address many of the questions raised by entrepreneurs looking for financing. You can download a guide that we prepared for entrepreneurs pitching to the Dragons in CBC Dragons’ Den. In this blog, I will answer the two specific questions raised in the previous blog. How do you raise large amounts of money without giving up too much equity and how do you develop an exit strategy to maximize the likelihood of receiving investment?
How do you raise large amounts of money without giving up too much equity?
In a previous blog, I identified that you can decide how much money you need to raise from third party equity investors, by first working out the negative cash flow for the first three years of the business, and then identifying sources of non-equity finance (debt, government grants, customer advances etc.). From this you can calculate how much cash in exchange for equity you need to raise. However, if you ask for all of this at the beginning, then your equity will be significantly diluted. However, if you obtain the same amount in stages, then you can give up a smaller amount of equity if you have increased the value of your company at each stage. This puts you in a better equity position and increases the likelihood of being able to attract further investment subsequently.
A worked example:
Initial company valuation $500,000 – $2 million investment required: investor requires 80% of company’s equity (limits your equity and precludes raising larger amounts at subsequent rounds).
Initial company valuation $500,000 – $2 million investment required, raised in tranches ($250,000; $500,000; $1.25 million).
$250,000 received from investor for 33% of company.
Company uses this to attract IRAP funding and complete prototype – company value increases to $1.5 million.
$500,000 received from investor for 25% of company (You retain 50%).
Company uses this to attract first customer and leverage debt financing, to increase company value to $3.75 million.
$1.25 million received from investor for 25% of company (You retain 37.5% or more than double the equity had you raised the $2million at one time).
How do you identify an exit strategy to increase the likelihood of receiving investment?
While achieving business milestones identifies points at which you can increase the value of the business, it also helps you develop a realistic exit strategy, by focusing on company valuation, how you can determine it and increase it. Valuations are based on the price someone is willing to pay for your business, and in practice, most start up exits are due to a sale to a third party. Planning for this exit strategy is both a pre-requisite for obtaining an investment and helps you make decisions once you have obtained the investment that make such an acquisition likely. Potential investors expect you to suggest an exit strategy, both because they figure you know the business and industry better than them and because they want to see you are conscious of the need to develop a business strategy that aligns with the exit strategy.
In general, I assume that your exit strategy is an acquisition by another industry player as this is the most frequent scenario. The three most common acquirers are: direct competitors (who offer similar products or service and can consolidate), suppliers (who see how your business can enhance the value of their solution) and distributors or customers (who understand your business and can expand it faster than you). Identifying these potential partners helps you make decisions around business value and encourages you to develop an ongoing strategy that maximizes the likelihood that they will be interested in making an offer to acquire your business, whether this is to remove you as a competitor or enhance their own market position by increasing their product or service offering.
In this blog, so far I have discussed strategy and finance issues that affect the likelihood of receiving an investment offer. However, there are many other factors that both impact the likelihood of receiving an offer and the likelihood of the business achieving success once the investment has been received. Specifically, the investor is looking to develop a good “chemistry” with the entrepreneur, both to take the risk of making the investment, and to act as a “litmus test” of how future interactions will develop. Many have likened the investment process to “courtship” and the post investment interaction to “marriage”. In the next blog, we will discuss how the investor relies on signals during the courtship process, to decide to get married, based on their anticipation about how both the future business and interpersonal relationship will develop.
Andrew Maxwell is currently working at the Canadian Innovation Centre and pursuing a Ph.D. in the area of new venture creation at the University of Waterloo. In his spare time, he enjoys teaching technology entrepreneurship at UTM and the University of Waterloo.