I am preparing for my presentation on raising capital for Fort Collins Startup Week (https://fortcollins.startupweek.co/) and once again wrestling with the challenge of how to explain that much of what people think they know about raising money is a myth. [Seats are still available at 1:30 PM on Wednesday, March 1 – title is Colorado Capital Communities]
There is an assumption built into every investment pitch that the entrepreneur is going to make it rich and that every investor in that business will also get rich. The assumption rarely proves true for either the entrepreneur or the investor.
In looking for facts to reject this assumption, I came across an article by Mark Perry (https://www.aei.org/publication/the-public-thinks-the-average-company-makes-a-36-profit-margin-which-is-about-5x-too-high/) where he describes data reported by Yahoo Finance (https://biz.yahoo.com/p/sum_qpmd.html). At the time of the article, the average profit of a business was 7.5%.
Consider the importance of this fact if the investor wants a high return on their investment such as a commonly stated goal of angel investors of seeking 10 times their money in five years. If the angel put up 100% of all the capital of an average business, they would only earn 7.5% per year, far less than their goal 200% per year. If part of the profits are allocated to the entrepreneur, then the return on investment to the investor is even lower.
The average business has to offer something more than a return on investment (ROI) in order to attract capital from angel investors. Otherwise, the angel investors will seek out the non-average business – the quick/large growth business – and make their investments with the ‘gazelles’ and the ‘unicorns’. Not the average business.
Failing to meet the investment criteria of angel investors and investment institutions, the ‘average business’ will need to look to other sources of capital. These sources may include their employees, customers, vendors and suppliers, distributors and resellers, allies and strategic partners or programs of local government and communities. In each of these situations, the business will need to demonstrate a benefit to the source of capital that goes beyond a simple cash return on investment.
If a business cannot offer an attractive package, then it is forced to bootstrap its growth by setting aside its own profits. This means that it cannot distribute any of its profits to its investors – making it that much more unattractive.
What if the business borrows money instead of giving up equity (ownership)? Even with the support of the government, a Small Business Administration guaranteed loan, is currently priced at between 6% and 8.5% (which does not include the time and cost of the business in preparing for and submitting the loan application). In addition, the business must come up with the at least 15% of the money toward which the loan will apply. Therefore, borrowing money may be more expensive than price of equity investment money.
If interest rates climb this year as predicted, investments in certificates of deposit and bonds will become a more attractive alternative to investing in the ‘average’ business. Even a CD with a 2% rate that is guaranteed compares favorably with a risky 7.5% profit rate.
Raising capital is hard. Raising capital by an ‘average business’ is more difficult because it has to compete against all businesses that are better than ‘average’. A good capital strategy and capital campaign will improve the likelihood of obtaining needed investment.
In addition, businesses must seek to reduce the cost and complexity of raising capital by taking advantage of small business programs and working collaboratively with other businesses that are also raising capital.
Dakin Capital Services LLC