Situation: Over the last 5 years, You and your partners have built a nice sized internet services business – web design, e-commerce infrastructure, SEO, maximizing and managing social media, etc. for large to medium sized businesses. The business now employs about 30 people handling several dozen projects and you have gotten some nice recognition in your local market. Given the service / “pay by the project” nature of the business you have been able to fund the business with very little capital other than the sweat equity you put into it during the first year.
On three of the most recent projects, the clients were asking for similar web activity tracking functionality. They were not easy projects and took more time than usual, but the ending functionality was pretty impressive. As part of building out the functionality, you realized that it could be possible to build a software platform that accommodated those client requirements and more with the ability to plug-in additional functionality through future software modules. You estimated that it would take a group of 6 experienced software developers about 18 months to build the platform, document all the requirements and processes, map out installation and conversion protocols, and set up a roadmap for future modules. Additionally, you would need to build a small maintenance and support team, as well as potentially hire a software sales staff (you need your services staff working on existing projects and doing the installations and conversions.)
You are pretty excited about the prospects – you know several dozen large clients that would likely buy the platform and be great references for you as you build out this new business. You are also very tempted by the huge potential revenue growth that a software business unit could generate, revenue acceleration you would never get if you stayed as a services company. That said, the added investment in staff, technology and equipment would require you to raise $4 million just to get the product launched and the maintenance and sales teams put in place. After that it is likely you will need additional capital if the platform takes off. You don’t have the money, but you know half a dozen venture firms that you could approach. That said, raising outside capital means two things – (1) significant dilution and (2) someone else has a say in the business. Your two biggest fears. What do you do?
Maximize the likelihood of success - Don’t be afraid of dilution or outside opinions. Focus on valuation (cost of capital), the strength of the partner (what they bring beyond money), and hitting key milestones (doing what you say you will do).
One of the main reasons many young companies fail is that they are under-capitalized. Being under-capitalized doesn’t just mean a lack of cash in the bank to cover normal operations. I define it as “lacking sufficient capital and capital sources (i) to weather anticipated and unanticipated changes in the market (changes in the competitive dynamics, changes in the economy, changes in client needs, etc.), (ii) to capitalize on market opportunities that will require investments in staff, production capacity, product development, new markets, new business units, etc., or (iii) to fund normal operations over the long term.”
Great ideas and businesses need capital to develop and grow. In many young companies, that first capital comes from a Founder, friends and family, and business acquaintances. These early investors typically have a passion for the product / service and work closely to help the company grow. They have personal stakes in the business, financially and emotionally, that they protect dearly – sometimes to a fault. Assuming a company gets through the minefield of problems that confront the emerging business and is able to carve out a niche, land clients and build a viable business model, it often arrives at a crossroads…..
“Do I keep doing what I am doing and grow at X rate given my limited capital and cash flow, or do I bring in new money to capitalize on an opportunity, defend my market position, and accelerate my growth?”
In many cases, making that acquisition, building that new product, expanding production, hiring a new team, etc. requires capital a company does not have on its balance sheet. Some companies can borrow, some have to raise equity (sell a portion of the ownership), some have to do both. At that time, the company is forced to look at its business, the markets, and key milestones, etc. and weigh the benefits and cost of staying the course or bringing in new capital. Often the following thoughts go through a Founder / CEO’s mind as they wrestle with the above question:
On the “keep doing what you are doing side”:
“Bringing on debt at our stage adds a level of financial risk I am not comfortable with.”
“I won’t have to give up any ownership – I don’t want to be diluted.”
“Under the current market conditions I don’t think a new investor will pay me what I think their stake is worth” or said another way, “I would rather sell equity after we reach the next business milestone which appears to be right around the corner.”
“New capital will mean I have less control over the business, and I am not sure I trust VCs.”
“We are cash flow positive now, growing and investing is risky, particularly if we start burning cash again.”
“If I just tweak what I am doing now, I might be able to slowly invest in the growth opportunity and not have it distract the rest of the business.”
“I really don’t care that much about growing large – staying mid-sized still allows me to meet many of my personal goals.”
“Instead of making that acquisition, we will build the product / functionality ourselves.”
On the “bring in new capital side”:
“I will be able to capitalize on a major market opportunity and accelerate growth.”
“Competition is intensifying, new capital and a new partner will allow us to stay ahead of the game.”
“I will be able to bring in expertise that I need to take the business to the next level.”
“I will have a deep pocketed partner that can help me navigate uncertain business and financial waters.”
“I will have a partner that can introduce me to business people and opportunities I would not have access to otherwise.”
“I am OK with having a smaller piece of a potentially bigger pie, particularly if it increases the probability of success.”
Many owners / founders struggle with the concept of diluting their ownership stake, and naturally, the price that stake should be worth. While price and value are critically important and determine the amount of dilution, I contend that the struggle around dilution as a concept typically gets more focus than it deserves. It is the responsibility of the owner / founder / CEO to maximize the value of the business for all stakeholders. While bringing on new capital will dilute the various ownership stakes (dividing the company pie into more pieces), if done properly and with the right new partners, that capital should significantly increase the likelihood of success and ultimately make the ending pie bigger than it would have been in a capital constrained position.
In considering new capital, focus on three things: (1) make sure the cost of that capital is “market”, which may require you to hire an advisor to assist in valuing your business and comparing different sources of capital, (2) make sure you are bringing in the right partner - a partner that brings in more than just money, and (3) have an intimate understanding of the business milestones you need to achieve and how you are going to achieve them once you get the capital. Most of your energy should be spent on those points and you should spend a ton of time on them. If you come up short on any one of these points, you risk permanently damaging the business.
There are many examples of companies that ...
-Tried to build the software business on their own and missed an opportunity because it took too long;
-Didn’t bring in the capital necessary to hire the best developers in the business and struggled with product quality;
-Didn’t have the production capacity or working capital financing when the “tipping point” actually happened and they got massive orders from their top 4 prospects that they could not fill;
-Didn’t invest heavily enough to grow the business when they had a competitive advantage and now they are being marginalized as the big competitors come into the market with big balance sheets;
-Chose a partner that eagerly invested money at a great valuation, but didn’t understand the business and rendered decision making ineffective;
-Did not raise money when the capital markets were vibrant because they didn’t need the money for another year, only to see the markets freeze up and access to money disappear;
-Set overly optimistic goals or poorly thought out milestones in the desire to get a maximum valuation, only to significantly underachieve expectations and then lose control of the business.
Avoid being in this group by seeking partners (those with money and those without) that can best help you navigate evolving client / consumer needs and a dynamic competitive environment. Critically evaluate opportunities to grow your business, the milestones you need to hit to capitalize on those opportunities, and the money it takes to get there. Also recognize that capital isn’t always easy to access at the precise moment you need it – “raise it when you can, not just when you need it” is a good mantra to follow. If a certain opportunity or competitive situation requires that you raise money, make sure you thoroughly assess the costs and benefits of different kinds of capital. That may require you hire an advisor. Once the cost of that capital is reasonably known, focus more on how that partner is going to help you grow the business beyond just giving you money and less on the fact that you will be diluted and have someone else to whom you need to listen. Lastly, set realistic stretch goals for the team and create opportunities to ring the “success bell” often. If you do that, you will have then maximized the likelihood of success and be asking the right question - “How big of a pie can we and our new partners create?”
-Bob
