Rory Earley, CEO of Capital for Enterprise, explores how small businesses should approach venture capital.
Previously, we’ve looked at the reasons why many describe the banks as 'fair weather friends' and tried to understand why they often have to behave in the way they do. In particular we looked at the risks to you, the entrepreneur, that can come with trying to finance growth through a bank loan.
So, having recognised that the business plan might benefit from a slightly bigger section on risks and threats, where next? You know you need money, you know it may not be wise to get it all from the bank, and may not get it from there anyway, so you need to get it from somewhere else; the question is where?
Hard as it might be to accept, you may well need to get some finance that is more prepared to accept the risks of things going wrong but will consequently want to claim more of the rewards if things go as well as you plan.
Many businesses at this point simply assume 'that means venture capital, they will steal my business, make their money and leave me with nothing'. That’s a common view, hence the term 'vulture capital', picking the meat off the bones and leaving a bleached skeleton behind. Nobody wants to give the family silver away so there is a natural reluctance to consider sharing the ownership of your business with someone else, particularly someone you do not know and whose interests might be different from yours.
There are some real horror stories of entrepreneurs falling out with venture capitalists and there is no doubt that if things go wrong, they can go badly wrong. But there are also many examples of where the relationship has worked well for both parties. It is perhaps worth looking at what can go well, and what to look out for, before drawing any conclusions on venture capital as a source of funding.
The first thing that has to be said is tread carefully. Investors in small businesses tend to be professional fund managers or experienced business angels. Because they have done it before, they know what they are talking about, they know the language and they know where the risks and benefits are likely to end up. Most small businesses don’t go down the path of taking on new investors more than once or twice in their life. They therefore might not understand fully the implications of such things as different classes of shares, dilution, liquidation preferences, ratchets, step-in rights, observer rights, etc. These can be complicated but it is necessary to understand them. There are some great books out there that can help the entrepreneur to understand but, in this area, there really is no substitute for getting a good advisor. And a good advisor, if persuaded by your business plan, might even work for you and not charge a fee until the money you need is raised.
Next is discipline. Taking on an outside investor is taking on a partner. It means you have to do things in a way that meets both of your needs and, for some, that can be a culture shock. It will mean a business plan that is a living document, not just one to hand over and forget. It will mean proper management accounts and budgets that you will be expected to stick to, proper and regular Board meetings where the future direction of the business is discussed, agreed and ensured. But let’s face it, if the entrepreneur has serious ambitions about growing a business, he or she will have to do these things anyway – so there is no loss to starting early.
So what are the benefits? First, you get a partner, someone that is locked into the business as much as you are. They have to take the rough with the smooth. Second, you have a source of support and help. They want and need you to succeed as much as you do. Thirdly, and you need to make sure of this one, they have the money that can help you through those unexpected dips and, more importantly, can get you a step ahead of the competitors to make sure you really can succeed.
Some people talk about taking on an outside investor as rather like a marriage. And that’s not a bad analogy. You need to pick the right partner and go into it with your eyes open. The relationship will have its ups and downs, you won’t always get on but you will have some fantastic times and being together is a sight better than facing the world on your own. Where the analogy falls down is that most investment relationships intentionally result in splitting up, when one or both partners need to get their money out. Fortunately that still only happens in the minority of marriages.
Next time we will look at other sources of finance, those that fill the gap between straight bank debt and equity finance and, more importantly, where you can find them.
See also: Promising growth for SMEs