July 23, 2013
Jennifer is a pastry chef, so naturally people are always asking her about her favorite recipes or how to make their cake rise. As an investment banker, I don’t get those same questions. However, part of my job is to meet companies at all stages of their life-cycle and the most common inquiries I receive are a) what is my business worth, which we will cover in another post, and b) how do I finance my business for growth. These are natural questions for any business owner to have, but for small business owners, who often have not been through a successful sale or fundraising process with another enterprise, these issues can seem daunting and where to go for information is not obvious in this case.
When you think about funding a business there are two sources of capital that are most commonly employed — debt and equity. Let’s take debt first. Debt is money borrowed, most often from a bank, that is secured by the assets or cash flow of the business. The benefit of debt is that you get access to capital without having to sell any ownership interest in the company. The downside is that failure to repay the principal or interest can result in the loss of your business, so approach debt with caution. Debt tends to be the financing instrument of choice for more mature businesses, those that have predictable and sustainable cash flow.
Since debt is not widely available for small companies, selling equity is the most realistic option for financing a business. Where you raise that capital will depend largely on the risk the party purchasing the equity is being asked to assume. The first fundamental risk a company faces is concept risk — what are you planning to make and sell. The costs associated with a company at this stage are quite variable. It is very hard to recruit others into paying for this risk, so concept risk is most often assumed by the founder.
Once the company has a clearly defined product or service, the next risk a company faces is product acceptance risk – will someone buy your product? Capital recruited at this stage is often for equipment and sales and marketing costs. Given the limited financial base that companies at this stage often find themselves, selling equity is expensive. As such, entrepreneurs often look to friends and family to help fund these costs. As a company starts to build traction angel investors (which can be sourced from services like CircleUp), incubators and investment societies (such as Keirestu Forum) can become sources of capital.
Companies that make it past the acceptance stage face different challenges and require a larger capital base to support growth. Potential investors are also being asked to assume a different set of risks, namely oriented around people and distribution. This is where institutional investors become a viable source of capital. Established investment firms can help recruit seasoned operators to a business, and they can leverage relationships to expand distribution quickly. Where a company turns depends on their revenue base. Small consumer investment funds, that invest $500,000 to $2 million, look at companies with as little as $5 million in revenue if they are ramping quickly. Larger consumer funds, which invest at least $5 million, tend to target a minimum of $10 million of revenue.
Knowing where you are in your company’s development cycle, and the risk you are asking others to assume can help guide you to the right pools of capital to source equity. The chart below can serve as a useful reference.
Bryan Jaffe is a Managing Director in a boutique investment banking group that focuses on working with public and private mid-size consumer retail companies.