SME challenges of raising cash

Written on the 28 September 2009

IF you’re like a lot of business owners and know how to develop your business but you just don’t have the funds to do it, you will be looking for external finance.

If you have already exhausted your personal savings, maxed out your credit cards and extracted as much as you can from family and friends, you will be off to the bank for some finance.

What you will find is that the banks are not in the risk business and will be only willing to advance money if you put up a personal guarantee, your home and business assets as security.

So for many entrepreneurs, angel finance or venture capital seems the logical path to finance their business development. But this is a challenging exercise.

Few venture capital firms invest in smaller firms, preferring to fund larger businesses in industry roll-ups, consolidations, management buy outs and public to private ventures.

They prefer financial engineering plays to the hard graft of growing an emerging business. The early stage and emerging business finance is undertaken by only a few early stage venture capital funds and angel investors.

Even so, the numbers which are invested in nationally are in the tens not thousands.

Private equity investors look for businesses which are both investor ready and investor attractive.

An investor-ready business in one which has all the information needed to be evaluated and monitored.

The entrepreneur will have a formal business plan and understand his or her competitive advantage and will have systems in place to manage the business.

But to be investor attractive is a very different proposition. This means that you can meet the investor’s objectives. Each angel investor and VC firm will have their own preferences for how much they invest, where they invest and which industries and which stages of growth.

They want to limit their level of intervention, leverage their experience and networks and only take on ventures where they can see a good return on their funds invested.

The higher the risk, the higher the required return on funds invested. Given that early stage ventures are inherently risky, investors typically want to see an average ROI of 17 per cent to 25 per cent.

To achieve that across a portfolio of investments, some of which will be failures, they are looking for a target ROI of 30 per cent to 40 per cent. That means that a business has to double its value every two years to be investor attractive.

What few entrepreneurs appreciate is that the external investor is primarily interested in two things; the expected ROI and how they liquidate their investment.

Private companies have no market for their shares so the liquidity event must be an initial public offering, achieved by about one-in-10,000 early stage ventures, or a sale to another company, a trade sale. Thus a business which takes external angel or VC finance will effectively be up for sale within a few years.

To be investor attractive you need to have high growth rate potential and offer a very good trade sale opportunity.

You can see now why there are so few deals. Very few emerging companies can meet the requirement of a high ROI and a good trade sale possibility.

But for those businesses which have strong intellectual property or deep expertise and can be sold to a large corporation based on high growth potential, external finance is a very attractive way to build personal wealth.

Even if you end up selling your business as part of the deal, you will have the money to build or buy another or become an angel investor yourself.

 

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