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Any successful small business will eventually run into the problem of scale, that wonderful dilemma in which the humble beginnings of the business are no longer able to accommodate growing demand. However, to properly scale the business will likely cost many dollars–many millions of them.
As you do not have that type of cash on hand, and the business is not at a point where it can re-invest in its own growth, you will likely have to seek funding from angel investors and venture capitalists, those deep-pocketed entrepreneurs who back the business ideas that they deem worthy.
However, just because an investor has money to back your enterprise does not necessarily mean you should cash their check right away. The following breakdown looks at 5 important considerations before accepting money from investors.
1. Understand the Type of Investment
There are two typical ways that venture capitalists will structure their funding: as a standard equity investment or as a debt security with warrants.
A standard equity investment is the most common form of investment and the most beneficial structure for you as the business founder. In a standard equity investment, investors will provide funding for an ownership stake in the business (issued in shares of stock). For example, if your business were worth $1,000,000 and a VC were to provide $50,000 in funding, he or she would have 5% ownership of your business. The VC would then experience gains or losses commensurate with the performance of the business.
An investor who structures his or her investment as a debt security with warrants gets paid as a portion of the company’s overall revenue. These investors will get paid even if the company is struggling, as a company can generate revenue without turning a profit. This type of investment protects an investor in the event that the company has a long road to profitability, but it can actually hurt the company’s ability to ever become profitable, as it acts as a debt more than an investment.
Therefore, when cultivating investors, be sure to find out exactly how they want the deal structured, as it will have a major impact on your business.
2. Find Out If the Investor Wants a Board Seat
Some angel investors can quickly become demons if they get on the company board and micromanage every aspect of operations. However, some VCs make a board seat a condition of their investment, with some small companies in desperate need of funding having no choice but to acquiesce.
According to Sam Willis, a business consultant who teaches people how to value a business, before taking the money and appointing the VC to your company’s board, it is important to do your homework. Find out if they have experience running other companies, have experience or training in your field, or have any other connections that could benefit your business. If there are any obvious red flags, it could be worthwhile to exhaust all other funding options before entering into a relationship that could set your company back.
3. Decide on Anti-Dilution Protection
Whenever a VC offers a standard equity investment, he or she is going to want some sort of guarantee that they will be able to protect their ownership share in the company. For example, if an initial VC owns 10% of all outstanding shares, but you were to sell some new shares to another interested investor, then the VCs 10% stake in the company is diluted.
To prevent VCs from losing their ownership share of your company, an anti-dilution clause is triggered. It usually takes one of two forms:
- Full ratchet – VCs are able to buy additional shares of the company at the lowest price at which they were ever offered
- Partial ratchet – VCs can buy additional shares at a weighted formula price that more closely reflects the current market price of the company’s shares
Partial ratchet anti-dilution protection is most beneficial to you as the founder, as it allows you to get paid more closely to book value for the stake in your company. However, VCs obviously prefer full ratchet protection, so be sure you understand which type is included before signing the investment contract.
4. Ask About the Status of Their Fund
Cultivating investors takes time that you could be committing to improving your business. Therefore, you do not want to waste time on prospects whose pockets are not deep enough for your purposes. Not only do you want to find out if the investment group has enough cash to cover the needs of your current round of funding, but you also want to ascertain if they are a prospect you can return to during subsequent rounds.
5. Make Sure You Can Follow Through on Covenants
Like anti-dilution protection, covenants are something that every VC is going to want in his or her contract. Covenants are promises to do (affirmative covenants) or not to do (negative covenants) something. While there is no end to the possibilities for what type of covenants a VC may want in the contract, some common covenants include promises to keep your business insured at a certain level or to provide investors with detailed quarterly reports.
The key with covenants is making sure that you can follow through with them, as failing to do so can put your funding at risk. And while it is reasonable for VCs to request covenants, make sure that they do not interfere with the day-to-day operation of your business, as having to jump through hoops just to do your job can become more trouble than it’s worth.
Before Accepting Investors’ Money, Know All the Facts
Soliciting outside investment is a fact of life for growing companies to reach their long-term goals. However, it is usually not a good idea to accept a VCs money at face value. Before cashing investor checks, it is critical to understand how the investment will be structured, find out if the investor wants a board seat, decide on the form of anti-dilution protection, inquire about the status of their investment fund, and guarantee that you can follow through on all covenants to ensure that the investment can do the most good for your business.
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