Six Ways to Attract Financing
No matter where you’re trying to scare up business capital, the market is competitive. Banks make slim margins on business lending, so they want to make sure their risk is as low as possible. Venture capitalists and angel investors are thinner on the ground than they used to be before the 2008 crash. They’re willing to take more risk than a bank might, but they’re also looking for a bigger payoff.
In a climate like this, it’s foolhardy to approach the funding process without doing everything you can to make your business attractive to lenders and investors. A little bit of extra thought and preparation up front can make all the difference.
1. Understand the investor.
Nothing turns off potential investors and lenders faster than a businessperson who’s wasting their time. So if you’re looking for capital, do your research and seek out sources that are likely to be interested in working with your business.
“VCs are particular about the industries or areas in which they’ll invest,” says Patrice Kloss, a partner at the Oppenheimer Wolff & Donnelly law firm in Minneapolis. “And the same thing [is true] if you’re looking for angel investors. Your quintessential angel investor might be a retiree who made some money from an industry, knows that industry, and would be willing to invest in a company in that industry. Typically speaking, it’s an easier target to go to somebody who actually understands your industry, so that you don’t have to teach them the ins and outs.”
Also, different types of funding entities prefer companies in different stages of growth. Joy Lindsay, president of StarTec Investments, LLC, a private venture firm based in Minneapolis that specializes in early-stage tech funding, notes that banks are highly regulated and can usually only invest in companies that are cash-flow positive and have an ability to pay back a loan month to month. Startups that are just getting off the ground often have little or no revenue, so they need to seek equity financing instead. That’s where VCs and angels come into the picture.
Banks get paid back at the same interest rate no matter how well a business does. But because VCs get paid more when a funded business really takes off, they can afford a little more risk, explains Jonathan Zimmerman, a partner at Minneapolis law firm Faegre Baker Daniels. “A certain percentage of deals are going to be worthless, a certain percentage are going to just get your money back or get some moderate rate of return, and then you’re going to have a handful of home runs that are going to really provide your returns,” he says.
But not all equity-financing entities are working with startups. “We are dedicated health care investors, and our fifth fund [which the firm is currently investing in] is a dedicated late-stage health care fund,” says Gregory Glarner, venture partner at Affinity Capital Management in Minneapolis. “If it’s a medical device company, you have to be largely through the regulatory process and/or in early commercialization, if not broader commercialization. From a services and IT side, it means you have existing customers and revenue. Historically, we have done some seed and early-stage investing, but we are not doing it currently.”
2. Be grounded in reality.
Both bankers and investors like to see cheerful growth projections, but only if they don’t defy the laws of economics and common sense. “It has to be reasonable,” says Michael Zenk, president and CEO of Venture Bank in Bloomington. “If, in your particular manufacturing industry, gross profit margins are 25 percent and you’re saying ‘We’re going to have 70 percent gross profit margins,’ well, how in the heck are you going to manage that? You’re not going to be borrowing any money, not from us.”
Lindsay agrees: “You just lose credibility if you’re presenting projections that are unrealistic or margins that are unrealistic, or if your marketing expenses are so low but yet somehow you’re going to miraculously generate sales.”
When you’re making projections, investors and lenders like to see that you have a specific, deep knowledge of your particular industry. You should demonstrate that you know the competition, understand industry trends, and fully grasp the contingencies and conditions that could affect your ability to make money.
David Prince, senior vice president and regional director of commercial banking at Associated Bank in Minneapolis, says bankers understand that there is seasonality and cyclicality in business, but they need to see that businesspeople get it, too. If there are changes in cash flow, it’s important for a company to be able to explain it, he says. “That really gives a bank a confidence level that they really understand the levers in their business and what’s driving it.”
3. Have your house in order.
Because banks get paid back on a monthly basis, they’re highly interested in a business’ cash flow. They demand professionally prepared, timely financial information. Jeanne Crain, president and CEO at Bremer Bank in Minneapolis, says this information can be generated internally or it can come from an accountant. But either way, it’s critical not just for the bank, but for the business itself.
“Some businesses look at it as a chore,” she says. “But from a comparably small amount of time invested to keep good strong records for financial, there’s such value that you can reap for your business and for your banking relationship.”
Zenk says he needs to see monthly financials to understand a company and know how it’s operating. “But we also know that if they’re not getting financial information to us within 30 days, they can’t manage their business,” he says. “Too many businesses think that the reason they’re doing financial information is for the bank. No. You’re doing financial information to manage your company, to know what your gross profit margins are.”
Many businesses, especially new ones, get behind on their monthly financials because they are facing so many other challenges, Zenk says. But if they get a couple of quarters behind, then suddenly need to double their credit line in order to make a big sale to a new customer, they’re going to be out of luck.
“I’d say, ‘Jeez, I wish I could help you, but we haven’t seen financial information for six months,’” he says. “And then they scramble to put it all together, and then they lose the sale. So it hurts them, because they haven’t made that a priority. And that happens all the time.”
For smaller businesses, or startups where there is no track record of financial recordkeeping and money management, the personal finances of the principals will also come under scrutiny. “How they’ve handled their personal obligations, how they handle their personal assets and liabilities, is very meaningful to us,” Zenk says. “If someone needs to borrow $200,000 and there are a lot of what-ifs, we’re going to look at them personally and say, ‘Well, you haven’t paid your personal obligations on time.’ They’ll say, ‘Oh, yeah, yeah, I understand that, but I’m going to pay the business loans on time! Don’t worry!’ But it never happens that way. The way they handle their personal obligations is exactly the way they handle their business obligations.”
Venture capitalists are less focused on monthly financials than bankers are, partly because they get paid back differently, but also because they often invest in companies that are too new to have an established track record of financials. But Zimmerman says they still like rigorous recordkeeping, because they don’t want any surprises during the due diligence process. His advice: If you’ve issued stock, make sure the documentation was done correctly and is readily available. If one of the entrepreneurs has a criminal charge in their background, explain it up front.
“When you’ve got a venture investor or bank giving you a terms sheet and wanting to do a deal, you want to close the deal as quickly as possible so somebody can’t change their mind,” he says. “The more work you do up front to prepare yourself for that, the faster you can get your deal done and the fewer surprises will come through in the process. That increases your likelihood of getting money substantially.”
4. Demonstrate credible management.
Investors and bankers are unanimous on one point: They all make decisions based on their confidence in a business’ management team. “You often hear venture folks saying that you can take a great idea with a bad management team and it doesn’t go anywhere, but you can take a mediocre idea with a great management team and the company can be very successful,” Lindsay says. “Because we only invest in Minnesota companies, a lot of the people that we’ve invested in are people that we’ve known or can easily check references with. But certainly people do background checks and check references. You definitely want to call people who have worked with them before, as you would if you were hiring somebody.”
Investors who deal with startups like to see a track record of accomplishments. Glarner says he’s looking for management teams that have “been there and done that—they’re experienced, they’ve had previous successes.” In the absence of a string of successful startups, investors will look for a preponderance of relevant experience.
“The area of med tech is somewhat of a small world, and people know people,” Kloss says. “I think it’s helpful to be able to show that you worked under certain people who are well respected in the industry, or maybe you’re formerly from Medtronic or formerly from St. Jude Medical.”
Not only should the management team have relevant experience; they should also be, in Glarner’s words, “broad and deep,” with the ability to fulfill all the necessary management roles. And if they aren’t, they should be smart enough to bring additional people on board to round out their team. Some advisors, like Faegre Baker Daniels, will work with entrepreneurs to build a stronger management roster.
“We work with them all the time on that, in terms of helping them to identify talent, to connecting people together so they can meet the right people to fill in the talent gaps they have,” Zimmerman says. “For example, if the founder’s a technology guy, that person may not have experience on the financial side of the house, running a balance sheet and an income statement. So they may say, ‘We’re going to have to find a CFO who has that experience and maybe has HR experience as well, that they can bring to the table.’”
5. Be less taxing.
In general, banks aren’t picky about how a business is incorporated. But for investors, it can make a world of difference whether your business is an LLC, an S corporation, or a C corporation.
“They do not like S corps and LLCs, typically,” Zimmerman says. “The biggest reason is the pass-through of the gains and losses.”
He explains that a startup is expected to burn through a certain amount of money before it becomes cash-flow positive. But an S corporation that spends $1 million in its early stages will end up passing through $1 million of losses to its investors, even though its real value may have increased. Conversely, an S corporation that makes paper gains may inadvertently saddle its investors with taxable income at a time when they don’t want or need it.
“If a company has, let’s say, $10 million of taxable income this year, they may have built up $50 million of net operating losses for tax purposes and be able to offset the gains against the losses,” Zimmerman explains. “But the venture capital fund may have had another deal in their portfolio that went sky-high that year, so they may have huge income taxes and no losses to offset it. They may not have cash to pay the taxes, so they don’t want that.”
“StarTec can’t even invest in an S corp,” Lindsay says. “And an LLC, it really varies. Some angels like LLCs because you get to claim losses on the investment as long as it’s not making money. But often the company [when it’s making money] ends up distributing some of the cash to its shareholders to pay tax on it. We prefer not to do that.”
Lindsay says she has encountered some investors who want companies to be incorporated in Delaware because of the state’s friendliness to investors. Delaware is known in the investment community for having a well-developed body of business law and court systems in place to expedite disputes, so many investors prefer it. However, if a company is mainly seeking investments from within Minnesota, being incorporated here will generally be fine.
6. Put skin in the game.
Banks and investors are looking for expertise in a business’s management team, but they’re also looking for commitment: a drive to see the business through, no matter what obstacles lie ahead. And that, Prince says, means the principals should be willing to put some of their own capital into the growth of the company. It seems disingenuous to ask a bank to pony up money if you won’t do it yourself.
“Thousands of times in my business career, I’ve listened to an entrepreneur’s spiel about how I’m going to make all this money, how there’s no risk to the bank because it’s a slam-dunk,” Zenk says. But then when I ask them to pledge the $150,000 equity in their home, they say, ‘I can’t do that! It’s too risky!’ It doesn’t work that way. In the very best scenario, the bank today makes 1 percent return on their assets, so if we make a $100,000 loan, the best we can hope for in this marketplace is to make $1000 on it in a year. If we make that loan and the business fails and we lose that $100,000, it takes 100 years to earn it back. So the business owner has to be willing to pledge whatever they need to pledge. They do need to have skin in the game. It has to be crystal-clear to them that this is their risk.”