Startups and small businesses are critical to innovation and economic growth. Between the beginning of 2017 and mid-2019, startups generated $3 trillion in global economic value, and according to the U.S. Small Business Administration, there are over 30 million small businesses in the U.S. that employ roughly 60 million people.
Capital and investments are the fuel for this growth, and the answer to the question “When is my company ready to raise capital?” is one that every entrepreneur needs to ask, and oftentimes, they need to ask it more than once.
In short, founders or business owners need to be prepared to pass an evaluation and screening process from investors. Investors are entrusting the founder to protect and potentially increase the value of their investments, and it is critical to clearly communicate the vision and plan to build that trust.
At NextSeed, we receive thousands of applications regarding capital raising readiness each year, and we ask a number of questions to diligence the business and its entrepreneurs. Only a small percentage are ultimately approved to list on the platform, and investors are then able to engage with the business before investing. While there are nuances based on industry, market dynamics, geography and investor audience, there are certain themes that apply under most scenarios. In this article, I share some of my observations in the hopes that founders and small business owners can confidently approach NextSeed or other investors.
Stage of the Company
Founders frequently ask whether they can raise capital based on a concept alone, while the company is pre-revenue or with a minimum viable product (MVP). The short answer is “yes,” but to whom and how you pitch will be different.
Aside from your business plan (which we’ll dive into shortly), the thing to bear in mind is that different investors have different appetites for risk. That appetite can be based on a particular investor’s previous experience with similar endeavors, the investor’s view of the asset class vis-à-vis her overall portfolio, and many other factors. Those factors will shape the investor’s view of the terms of the investment opportunity.
So, a useful follow-up question is, “What investment terms will be acceptable to both the investors and founders, and what structure will give the business the best chance for success?” Answering this question involves pricing the security to provide for a risk-adjusted return to investors.
Risk vs. Reward – How the Deal is Structured
There are multiple ways in which to structure a securities offering in order to balance risk and reward. Most commonly known are equity and debt. Equity investments are associated with determining a valuation, such that an investment of X dollars affords the investor Y percent of the company’s equity. Sometimes, that involves additional rights for investors related to oversight, voting rights, and rules for dividend distributions. Debt investments are ascribed an interest rate and payment terms based on the risk factors analyzed in the underwriting process.
Businesses need to have cash flow to make payments on the debt, and there is a limited time period in which payments are due. With both equity and debt, these options are often reserved for companies with operating history, industry comparables and generally accepted “at-market” terms.
However, for conceptual, pre-revenue or MVP companies, the lack of historical performance data makes it challenging to determine a valuation as there is no way to benchmark the business against comparable companies’ metrics; e.g., EBITDA multiples or revenue multiples. At the same time, earlier stage businesses’ cash flows may not support debt service obligations. Convertible notes and SAFEs are convertible securities that provide a way for early stage companies to navigate these issues. These securities offer investors the potential upside of equity while reducing the finance and legal complexity for businesses in trying to negotiate a valuation early on. (Read more about these security types in the Education Center).
In summary, investors—including those identified via NextSeed—can be excited to invest in companies at any stage. The key is to determine a set of terms and structure that can create conditions for a successful raise. While we at NextSeed typically work with founders and business owners to help hone in on an effective plan, we like to see that they have done their homework on different types of securities and have developed their own sense of the right approach.
Business Plan: A Good Sense of the Business Model and Go-to-Market Strategy
Investors like to know that the founders or business owners they back truly understand the space in which the product or service sits. This understanding is generally reflected in a thorough business plan or investor presentation that not only discusses the product or service itself, but also covers the business model, go-to-market strategy, and traction and contains a deep dive into the market, industry and competitive landscape.
The business model is paramount, as reasonable investors will wonder how the business will make money, and in turn, how the investor will make his or her money back (and potentially more). Does the company make and sell a product, or is there a subscription-based or recurring revenue model? What is the pricing schedule and why? Similarly, a go-to-market strategy and execution roadmap informs the investor of the action items the company will take to capture and grow market share by attracting new or more customers, and it explains the various marketing activities and channels through which this will be accomplished. Investors will also expect to see that the company has done its homework on its customers. Is there traction in the form of successful beta testing? Have there been any successful sales or purchase orders?
Sources and Uses
A business that is ready to raise capital will know what amount it is seeking in the securities offering and how the proceeds of that offering will be used. The business may access capital from multiple sources and in multiple forms, and the appropriate mix of debt and equity will vary by industry and stage of the company. For example, real estate projects are likely to have higher debt loads than early stage companies.
An infusion of equity capital from the founders themselves is also often viewed positively, demonstrating commitment.
The uses of capital will specify how the funds will be deployed. These will be estimates, but the more clearly you can convey how your spending ties back into your plan, the better. If you are hiring individuals, you should have estimates for the necessary compensation packages for the different roles. If you are putting funds towards manufacturing or construction, getting an estimate from a potential factory or contractor will demonstrate that your estimates are grounded.
Additionally, one of the most important factors includes an estimate for how much working capital will cover your operating costs, and more specifically, whether you will have enough time to either ramp up to cash flow positive or reach a milestone for a subsequent financing round. Investors will need to feel confident that your experience and research have provided you with sound reasoning for these estimates and timelines.
Financial Projections Based on Empirical Data
Financial models allow the investor to determine whether the terms of the offering may or may not be acceptable to him or her. They also allow investors to determine whether the numbers are aligned with the business model and go-to-market strategy.
It is critical that any assumptions utilized in the model be based on some form of empirical data. Such data may include the management team’s prior experience in related industries or data from comparable companies. Earlier stage companies with novel products or services may have difficulty finding any meaningful data. In these cases, founders can use judgement in developing assumptions, but must be prepared to provide defensible explanations when challenged by investors.
Investors tend to place a lot of emphasis on the team. The reason for this is that for startups and growth stage companies alike, things often do not go according to plan. The COVID-19 crisis is a case in point for almost every business in existence today. Investors want to feel comfortable that whatever curveballs may come at the company, the management team can figure them out.
At NextSeed, we are heavily focused on relevant industry experience and whether the team is well-rounded. For example, if the founder of a brewery is a former beer master and makes some of the best beer on the planet, does he know how to distribute it and is he familiar with the regulations in the regions where the beer is to be sold? If not, is someone else on the team experienced in this area or is there a plan to address the gap?
Finally, I would like to touch on legal considerations. There are two sets of legal documents that founders and business owners should familiarize themselves with if they plan to raise capital. The first set of documents are the formation documents, including the Company or Operating Agreement. The second set of documents include the investment related documents, such as the Purchase Agreement or Subscription Agreement and Disclosures.
While NextSeed has a legal team and can assist with the preparation of certain investment documents, depending on the complexity of the transaction the company may need to rely on its own counsel to take on tasks such as amending and restating the company agreement to allow for the capital raise. Additionally, it is worth founders and business owners speaking with their counsel about their growth plans and whether certain legal structures may be preferred based on those plans. For example, if a company anticipates multiple securities offerings that may include institutional or sophisticated investors, then it may be preferable that the business be structured as a C-Corp—in such cases this would likely be the preference of NextSeed.
In conclusion, while there are some differences based on industry, market dynamics, geography and investor audience, there are also basic commonalities that we see among companies that are ready to raise capital.
Prior to raising capital, companies should assess the following characteristics of their business and offering: 1) security type as defined by the risk/reward parameters that an investor might warrant, 2) articulated business model and go-to-market strategy with empirical research, 3) financial model that is driven by thoughtful market and operating analysis and defined uses of capital, 4) experienced team with the skill set to execute on the vision, and 5) grasp of the legal requirements of raising capital.
If you believe that your business meets the above criteria and are interested in discussing a potential securities offering on NextSeed, please complete a brief prequalification application here.
About the Author
JP Yorro most recently co-founded Airspace Experience Technologies and served as Chief Commercial Officer. Previous experience in management consulting, investment banking and private equity, $5 billion in equity commitments. Served for seven years overseas as a U.S. intelligence officer. Received dual MBA/Master of International Affairs degrees from Columbia University.