INVESTORS' NEEDS

INVESTORS' NEEDS

Anyone lending money to or investing in a venture will expect the entrepreneur to have given some thought to his or her needs and to have explained how they can be accommodated in the business plan.

Bankers, and indeed any other sources of debt capital, are looking for asset security to back their loan and the near certainty of getting their money back. They will also charge an interest rate that reflects current market conditions and their view of the risk level of the proposal. Depending on the nature of the business in question and the purpose for which the money is being used, bankers will take a 5- to 15-year view.

As with a mortgage repayment, bankers will usually expect a business to start repaying both the loan and the interest on a monthly or quarterly basis as soon as the loan has been granted. In some cases a delayed repayment of up to two years can be negotiated, but in the early stage of any loan the interest charges make up the lion`s share of payments.

Bankers hope the business will succeed so that they can lend more money in the future and provide more banking services to a loyal customer.

It follows from this appreciation of a lender's needs that bankers are less interested in rapid growth and the consequent capital gain than they are in a steady stream of earnings almost from the outset.

Since most new or fast-growing businesses generally do not make immediate profits, money for such enterprises must come from elsewhere. Risk or equity capital, as other types of funds are called, comes from venture capital firms, as well as being put up by founders, their families, and friends.

Because the inherent risks involved in investing in new and young ventures are greater than for investing in established companies, venture capital fund managers have to offer their investors the chance of larger overall returns. To do that, fund managers must not only keep failures to a minimum, they have to pick some big winners, too—ventures with annual compound growth rates above 50 percent—to offset the inevitable mediocre performers.

Typically a fund manager would expect in any ten investments one star, seven mediocre performers, and two flops. It is important to remember that despite this outcome, venture capital fund managers are only looking for winners, so unless you are projecting high capital growth, the chances of getting venture capital are against you.

Not only are venture capitalists looking for winners, they are also looking for a substantial stake in your business. There are no simple rules for what constitutes a fair split.

It all comes down to how much you need the money, how risky the venture is, how much money could be made—and your skills as a negotiator. However, it is wise to remember that 100 percent of nothing is still nothing. So all parties in the deal have to be satisfied if it is to succeed.

Venture capital firms may also want to put a nonexecutive director on the board of your company to look after their interests. This means you will have at your disposal a talented financial brain, so be prepared to make use of this resource. Their services will not be free. You will either pay in the fee for raising the capital or you will pay an annual management charge.

Since fast-growing companies typically have no cash available to pay dividends, investors can profit only by selling their holdings. With this in mind, the venture capitalist needs to have an exit route, such as an initial public offering or a potential corporate buyer, in view at the outset.

Unlike many entrepreneurs (and some lending bankers) who see their ventures as lifelong commitments to success and growth, venture capitalists have a relatively short time horizon. Typically they are looking to liquidate small company investments within three to seven years, allowing them to pay out individual investors and to have funds available for tomorrow's winners.

So to be successful your business must be targeted to the needs of these two sources of finance, and in particular to the balance between the two. Lending bankers ideally look for a ratio of $1 of debt to $1 of equity capital, but they have been known to go up to four or five times that ratio. Venture capital providers will almost always encourage entrepreneurs to take on new debt capital to match the level of equity funding.

If you plan to raise money from friends and relatives, their needs must also be taken into account in your business plan. Their funds can be in the form of debt or equity, but they may also seek some management role for themselves. Unless they have an important contribution to make, by virtue of being an accountant or marketing expert or respected public figure, for example, it is always best to confine their role to that of a stockholder. In that capacity they can give you advice or pass on their contacts and so enhance the worth of their (and your) holding, but they won't hold down a job that would be better filled by someone else. Alternatively, make them nonexecutive directors, which may flatter them and can't harm your business. Clearly you must use common sense in this area.

One final point on the needs of financial institutions: They will expect your business plan to include a description of how performance will be monitored and controlled.

Copyright Ramon M. Ignacio 2008 All Rights Reserved