The company of strangers: should your business bring in investors?

March 2015

Often the difference between a good business and a great one is having a solid business plan in place along with ample capital to execute it. The business plan allows business owners to map out the strategic direction for its growth, the capital required to deliver its desired outcomes and any gaps in capital that need to be funded.

In the majority of cases, those gaps can be filled by speaking to banks and financial institutions to implement a funding arrangement to meet the needs of the business, while still allowing the business to retain full control over their business development.

However seeking out investors offers an opportunity to leverage off the experience and resources that often come along with investor funding that may be otherwise hard to source. An example of this may be experience at the C-suite level, such as CIO or CFO, or investment or enhanced banking arrangements that can properly support the business's potential.

Identifying when you need investors

There are many reasons for seeking out investors. Unfortunately most businesses will seek out investment funding at a point that it is most critical or for the wrong reasons. Many seek funding for the business when it is in financial distress and gaining investment in that circumstance is always hard. Neediness is never a good starting point for negotiations and few investors will be prepared to take the risk to save you.

Investors do, however, offer an opportunity in the right situation to close the gap. The question is "at what cost?"

Funding from investors is typically sought to fund growth where:

Major investment is required
The business cannot service its growth or capital requirements and the requirements are greater than what it can fund on its own.

On most occasions, investment is needed to build out scale and take advantage of the potential of the business.

In many cases the owners can only afford to fund a portion of what is required but the scale they need will make the difference between an okay business and a great business.

Understand the investors' expectations

Every business operator knows that they should have a business plan in place. Most don't.

Before seeking investors you need to get your house in order. With a strategic business plan, your business can track performance, growth, deviations from the plan and an array of management information that will help you know the point at which you need investment – either as debt or in another form.

A strategic business plan will also inject some reality into "blue sky" entrepreneurialism and flush out many of the issues that potential investors will inevitably question. A strategic business plan will also help shore up the business case and demonstrate that the growth path has been worked through.

This is a big stumbling point for many entrepreneurs seeking investors and is important because there are more ideas for how to chase capital than there are capital chasing ideas. Business owners get one opportunity to pitch to investors and are often competing with a range of unrelated or different opportunities.

Investment types

There are generally two types of investment: debt or equity.

Debt Investment is paid back in some form and can be structured in many ways, from traditional interest payments to profit sharing.
Equity Investment is what most people think of when they consider bringing in investors, where there is an injection of capital into the business and that buys equity in the business. This usually means a degree of management participation or control and there are many ways of structuring these kinds of arrangements depending on the motivation of who's involved.

Of course, this is an oversimplification of the types of investment, which can have many permutations, but the above points are indicative of what can be available.

A third type of investment that is gaining increasing ground is crowd funding, where investment is sourced from many, many investors via platforms such as Kickstarter and Indiegogo (https://www.indiegogo.com/) to develop innovative products. These businesses generally start and stay lean, but actively seek input and feedback from the market place whilst the development roadmap unfolds.

Where do you look for – and find – investors?

Family and friends

The most common investor for SMEs is family or friends investing out of loyalty and often a belief in the skill set of the business operators. The key problem with family and friends as investors is that often the details of the investment are loose. Trust is high and everyone has a belief, at the beginning, that the other party will act in their best interest.

If family and friends are investing, you must put in place the same level of formality to the arrangement as if strangers were investing. It prevents confusion and upset.

Another reason for a high degree of formality is that on some occasions, the person looking to unwind or exit the arrangement in the future will not be the person who entered into it. It's important to ensure that the exit provisions are clear.

What's important to understand is that needs and intentions can change for many reasons and it's important to have some safeguards in place and have arrangements in place should the unexpected happen, such as the death of a partner or family investor.

Commercial investors

Commercial investors come in many forms – angel investors, venture capitalists, private equity, or investment by associated parties. At the SME end of the market, angel and venture capitalists dominate.

Angel investors

Angel investors tend to operate at investment levels between $100k and $500k. Angels are generally individuals looking to for a great idea from a start up that they can capitalise on.

Private equity investors

Private equity investors are at the other end of the scale and look to invest tens of millions - generally with established businesses reaching for another level and expectations of high growth.

Private equity generally looks for a compound internal rate of return on capital in excess of 30%. They look for high returns and an identified exit timeline. They want confidence in return on capital and ultimately, return of capital.

Some things to look out for

Where do business owners typically get tripped up during investor negotiations?

Insufficient formality around the agreement – misunderstandings and boardroom battles over direction take the focus off achieving growth
The wrong structure at the beginning – a bad deal won't get better
Exit clauses - look at what the deal looks like at the end of the investment not just at the beginning
Not being able to fulfil the stated plan - be certain about what you're offering
What are you giving away? Often business owners are so keen to secure the investment they forget about what they are giving away.
Control and how much the investor can achieve over time and the influence they have - you don't want to be voted out of your own company once it's successful
The level of management control and influence exerted - infighting and debates about direction will only take the focus off the big picture
Arms' length remuneration for existing principals that are seeking the investment and for additional board members.

In general, commercial investors will seek a regimented approach - shareholders agreement, restrictions around what can be done without their consent, and a clear exit path.

Get advice about potential investment opportunities

Bringing investors into your business is not an area you should approach without expert advice. Contact us on 02 9957 4033 for more information or to speak to one of our business professionals.

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Disclaimer

This article is provided for information purposes only and correct at the time of publication. It should not be used in place of advice from your accountant. Please contact us on 02 9957 4033 to discuss your specific circumstances.