Everything You (Don’t) Want to Know About Raising Capital

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https://hbr.org/1989/11/everything-you-dont-want-to-know-about-raising-capital

The infusion of capital—be it debt or equity, from private or institutional sources—can drive a company to new heights or at least carry it through a trying period. Many financing alternatives exist for small enterprises, and entrepreneurs should not be afraid to use them.

They should, however, be prepared to invest the time and money to do a thorough and careful search for capital. The very process of raising money is costly and cumbersome. It cannot be done casually, nor can it be delegated. And it has inherent risks.

The first of those steps is knowing the downside of the fund-raising process. Some of the problems faced by entrepreneurs are:

Raising Money Costs a Lot

This is the most underestimated aspect of raising money. Getting the cash in the bank takes time, effort, and creative energy.

The process is stressful and can drag on for months as interested investors engage in “due diligence” examinations of the founder and the proposed business. Getting a yes can easily take six months; a no can take up to a year, and cash flows out rather than in. Performance might suffer, customers neglected, and some problems overlooked. As a result, sales flatten or drop off, cash collections slow, and profits dwindle. And if the fund-raising effort ultimately fails, morale suffers, and key people may even leave. Even when the search for capital is successful, out-of-pocket costs can be surprisingly high.

Never underestimate these costs and the failure to plan for them.

You Have No Privacy

Convincing a financial backer to part with money requires sharing information. When seeking funds, you must be prepared to tell 5, 10, or even 50 different people your capabilities and shortcomings, how much of the company you own, how you’re compensated, what your marketing and competitive strategies are, and your personal and corporate financial statements.

 Although most potential sources respect the venture’s confidentiality, information sometimes leaks inadvertently—and with destructive consequences. 

Entrepreneurs need to make sure they need the money and are getting it from highly reputable sources. While you cannot eliminate the risk, you can minimize it by doing your own “due diligence” on the sources by talking with entrepreneurs and reputable professional advisers who have dealt with them.

Experts Can Blow It

Decisions like how much money to raise, from what sources, in debt or equity, and under what terms—all limit management in some way and create commitments that must be fulfilled. These commitments can cripple a growing business, yet managers might delegate their fund-raising strategies to financial advisers. The entrepreneur is the one who faces the consequences and needs to be selective about advisors. 

The rule of thumb is to choose individuals who are actively involved in raising money for companies at your stage of growth in your industry or area of technology and with similar capital requirements.

Money Isn’t All the Same

Although money drives your fundraising effort, there are other things potential financial partners have to offer. If you overlook considerations such as whether the partner has experience in the industry, contacts with potential suppliers or customers, and a good reputation, or how fast the investor can respond, you may shortchange yourself.

The search is never-ending

After months of hard work and tough negotiations, cash-hungry and unwary entrepreneurs might be hasty to conclude that the deal is closed with the handshake and letter-of-intent or executed-terms sheet. They relax the street-wise caution they have exercised so far and cut off discussions with alternative sources of funds. This can be a big mistake.

One must assume the deal will never close and keep looking for investors even when one is seriously interested. Continuing the search saves time if the deal falls through and strengthens your negotiating position, too.

Lawyers Can’t Protect You

The legal documentation spells out the terms, covenants, conditions, responsibilities, and rights of the parties in the transaction. The money sources make deals every day, so they are more comfortable with the process than the entrepreneur going through it for the first or second time. Covenants can deprive a company of the flexibility it needs to respond to unexpected situations, and lawyers- however competent and conscientious, cannot know for sure what conditions and terms the business cannot withstand.

About the authors

Jeffry A. Timmons is the Frederic C. Hamilton Professor of Free Enterprise Studies at Babson College and the Class of 1954 Visiting Professor at Harvard Business School.

Dale A. Sander is the senior manager of Ernst & Young’s San Diego office, where he consults with entrepreneurs in emerging businesses.