Polygon Partners
Raising Capital - Traps for young players
#6. Poorly communicated value
Typically in a capital raising project we need to communicate the value of the proposition three times:
1. Pique stage (previously “pitch” but that word has been devalued see mistake #5
2. Presentation stage
3. Pricing stage
First – what is value?
In pure, economic terms a business’s value is the “today value of the future cash flows”.
This means that, if you could be certain about all the future cash dividends which the business will produce, you could then simply discount those cash flows to allow for the diminishing time value of money, thus you would know the business’s value – simple!!
But – in the real world!
All commercial transactions involve some form of value exchange and require the parties to agree on “value”.
A good deal is when both parties think they got better value than the other. How can that be?
In each of these transactions, if the parties do not agree on “value”, the transaction does not proceed.
Value, therefore, is a matter of opinion:
It is simply a matter of “perception of future benefits”
tempered by “the risk that the benefits will not be achieved”
If value is a matter of opinion, then it follows that the party raising capital is obliged to encourage the investor to form the opinion that the value of the business is high enough, that a deal can be made that satisfies both parties.
In a capital raising context, value is whatever is agreed by the investor and the company. That’s it!
Communication
As in most important events, preparation is important – although consider Confucius’ “a diamond with a flaw is better than a pebble without”
Preparing?
Future Cash flows
As a founder, your challenge is to infect the investor with some of your passion and also to have all the bases covered in terms of anticipating their requirements for risk aversion.
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Before engaging with potential investors you should have a comprehensive forecast of your business, with one output being a time series of (free) cash flows or dividends. There are ways of putting such forecasts into a spreadsheet model which automatically adjusts for changes in input parameters. This can be quite valuable during the price negotiation phase of the project. Many professional investors will need to find an exit within a fixed timeframe, so your forecast / model should include a value crystallisation event such as a trade sale or IPO within 4 or 5 years. The (discounted) cash flows from that event are included in the valuation calculation. |
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Once a realistic forecast and cash model has been created, the only other issue is dealing with perception of risk, because perception of risk determines the discount to apply to the forecast future cash flows.
Free Cash Flow - ??
Better, more experienced analysts will use Free Cash Flow (FCF) as the important forecast metric, not Profit nor EBIT nor value per user (so 1990s) or any other approximation. A technical discussion of FCF is beyond the scope of this article.
Discount factor – it’s all about perception of risk.
During dot com boom one 1998-2000?, an associate of mine had a simple diagram explaining the step process of creating value. His model showed the stages of risk mitigation:
This model is a great tool to “reality check” your assumptions.
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It is a good idea to list all the potential risks to your business plan (timing of disclosure not withstanding), and carefully assess the likelihood of each risk being realised. Even if only to have covered them off in the material presented to investors, or to avoid embarrassment when surprises are raised during negotiation.
You can then aggregate all those risks and use the result as your discount factor in your valuation argument. |
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My experience of professional investors is that, for early stage businesses, they will generally want conservative forecasts and then discount them at an annual rate of around 40%.
Putting it into action
OK – now it’s time!
· We have a solid business plan with comprehensive forecasts
· We have a risk assessment document identifying risks and detailing how we are going to mitigate them.
What now?
In my article about engaging the wrong advisors I asked about experience preparing documents.
I have received “Information Memoranda” with numbers and risks detailed from page one, with no contextual discussion of any kind!
BZZZZZZZZZZZZZZZZ – wrong! You don’t want to put them to sleep.
First: Pique their interest
In Australia, we have a chain of big box DIY stores where people go for all sorts of hardware and garden supplies. As you get out of the car in the carpark you are assailed by the smell of fried onions so you automatically go to the charity BBQ at the entrance and buy a sausage in bread snack.
No one drives across town to Bunnings to buy a sausage in bread!
Everyone who goes to Bunnings buys a sausage in bread! |
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That smell of fried onion is the epitome of “Compelling”. Make sure you have a compelling piquing statement or “elevator pitch”. Think fried onions – don’t mention the sausage.
Second: Present
We are still not using the documents we prepared earlier. This time we are hitting the high points, smell of onion again; what’s the pain; how many people feel it, what would they pay to relieve it; how you are addressing the opportunity. NOW – high level numbers (the promise of future rewards)
Give some idea of price expectations but only summarily.
Finally: only after they have expressed interest in dealing
So, now they are a “buyer in principle” conditional only on terms.
Sit with them and go through the forecasts, adjust the levers to reflect their questions, address the risk concerns and come to an agreed range of values.
If there’s a will, you can use a structured instrument to address unbridgeable gaps in expectations.
In my forthcoming article #7 DIY Corporate Finance, I’ll explore things like convertible / converting preference shares, redeemable converting shares etc.
Feel free to message me for more info on this topic.
Traps for young players. Negotiating from a position of weakness
Raising Capital - Traps for young players
#5. Negotiating from a position of weakness
Raising capital is an exercise in sales. An important part of any sale is negotiating terms and conditions
A successful capital raising creates a relationship that could last for years. Why wouldn’t you take care and get it right?
If you type “negotiation” into Google you get about 150 million hits. If you read the first dozen or so you will find that the guidelines distil down to a variation on:
Preparation
- Have a strategy
- Understand your needs and goals – in context
- Understand the other party’s needs and goals – in context
- Plan to disclose more rather than less – but time it in accordance with your strategy
Engagement
- Put your high level pitch
- Listen to their high level pitch
Reflection
- Consider all you’ve learned in the Preparation and Engagement phases
- Modify your strategy accordingly
- Modify your disclosure plan
Negotiate toward a mutually acceptable outcome
- Be prepared to walk away
- Make sure you take something if you are giving something
- Consider the difference between needs and wants
Agree
- Put it in writing
Now let’s see some of the ways inexperienced business founders put themselves in a weak position for this important negotiation:
1. Leave it too late
We often come across founders who have run out of cash and had to take investment / rescue money under onerous terms. These situations often end in tears for all parties as the “tough” investor hasn’t followed the rule of working toward a mutually acceptable outcome.
How has the Founder created a position of weakness?
Preparation
- Have a strategy – In the absence of time tactics is all you have.
Negotiate toward a mutually acceptable outcome
- Be prepared to walk away – Too late, you’ve run out of cash. Isn’t “any money better than no money”?
- Wants are irrelevant – need to survive
Reflection
- No time for reflection
Agree
- Put it in writing – often in these situations you sign what you are given and like it
Successful business owners usually have a very good plan of how cash is going to flow. Keep up-to-date cash plans looking as far forward as you can. Keep an eye on a worst case scenario and develop a capital raising strategic plan as early as possible.
2. Pitch Fests
These are very fashionable at the moment. Business founders stand in front of a roomful of strangers and divulge all sorts of information about their business. A common element is talking about their biggest problem or weakness.
Why would anyone do this?
It’s sort of like street prostitution as a spectator sport.
Generally investors are looking for something special not something that’s been offered on every street corner.
They call that Shopping. “It’s been shopped all around town, no-one has said yes so it must be crap!”
It’s not even time for negotiation but already rules are being broken:
Preparation
- How does this fit into your long term funding strategy? Probably not at all.
- Understand (know) the other party. Who is the other party? Do you even know who is in the room?
- How about the timing of disclosure? Probably blurt it out – warts and all – in the heat of the moment.
Engagement
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Did you stick to your high level pitch? Probably not, these events usually require answering detail questions to titillate the audience
- Did you even hear a pitch from an investor who was on your hit-list? Were they even in the room?
Leave the pitch fests to the business school grads with their need for affirmation from their peers. Seek out some feedback from someone who has trodden the part before you or from a professional advisor. There are plenty of startup functions which don’t require you to pitch – StartupGRIND (www.startupgrind.com) is one where you could introduce yourself to a founder who has been through the process. You might be surprised how many of them are willing to offer some advice.
3. DIY
Another challenge is preparing and managing an equity raising project whilst simultaneously trying to manage and grow an early stage business.
When are you going to have time to develop a strategic plan?
How are you going to understand your own needs let alone research ideal investors – it’s impossible to look inward from inside!
Traps for young players. Engaging the wrong advisors
Raising capital - Traps for young players.
#1. Engaging the wrong advisors / accountants / lawyers
Raising capital is an exercise in sales. Your first raising is perhaps the most important sale you ever make.
The suburban accountant who does your mum’s tax return might be very good at tax returns but when was the last time she prepared an information memorandum for a technology based service company that’s never made a profit?
The lawyer who has done all the family wills and property transfers for two or three generations might be very good at that stuff but when did he last draft subscription and shareholder agreements alongside partners from the country’s bigger firms?
So whose advice do you seek?
A professional investor?
As an investor they want to work with you to create value, however, in process of becoming an investor their aims will be to increase their share at your expense. It’s not personal, it’s their job.
I recently heard a partner of a very high profile VC firm say that they don’t invest in companies which have appointed an advisor! This from a person whose first start-up required the joint services of TWO investment advisory firms to get its first round of funding completed.
Trust me if it’s a good proposition at the right price they’ll invest!
A Collins Street Accounting Firm?
Where a company’s accounts are up to date, there will be no role for an accountant in a capital raising project unless an incoming investor requires an audit. In that case, they will probably tell you whose work they will accept.
You can do the company secretarial work yourself.
A Pitt Street Lawyer?
You will definitely need an experienced corporate lawyer. That is, one who does investment documents every week. The time to brief the lawyer is AFTER you have agreed the terms of the investment. Look out for my “Common mistakes in Commercial Agreements”
DIY?
If you are raising less than a couple of hundred thousand dollars? Then maybe.
Otherwise standby for Common Mistakes #5 “Negotiating from a weak position”.
A specialist investment advisor?
Highly recommended (and not just because I was one a long time ago)
Some of the reasons for:
· Will have a disciplined process
· Will have contacts in the right places
o an introduction from the right advisor will get you past all the VC gatekeepers
o A briefing from an experienced advisor will usually keep legal fees down
· Will know which investors to approach and which to leave alone
· Will be adept at creating the “sales” documents after challenging you to deliver a great business case
· Will have a reasonable knowledge of the law to help you avoid stupid mistakes
· Will be able to prepare an appropriately bullish credible valuation and investment rationale
If an advisor cannot demonstrate all of the above then perhaps they are not the advisor for you.
How much will it cost?
Gone are the days of good service on a success fee only basis.
There should be a component of retainer or progress payment plus a success fee. Ideally success fess will have some connection to the valuation achieved but this is not always possible.
Raising capital for early stage businesses can a time consuming and energy sapping experience, the space is littered with rookie mistakes such as unrealistic sales forecasts, poorly designed cost bases and powerpoint presentations that would put a glass eye to sleep.
If this article resonates with you, you have our permission to pass it on. If you email me, I’ll happily send you our Investor Engagement Process guide.
Keep an eye out for next week’s article where I’ll share more “traps for young players” including mistake No. 5 “negotiating from a weak position” don’t let that happen to you.