Steps to Growth Capital

This guide is designed to help you develop the plan, the materials and the confidence to go after the equity financing you need to launch your business opportunity and achieve your business goals.

Introduction

"Be patient; plan, plan, plan; pull together the background data and information to support your case; develop and use your communication skills; and get out there and make contact."

That's the advice of Chris Griffiths of Griffiths Guitars International*, a Canadian small-business entrepreneur who successfully found investors for his company.

If your company is the kind that interests investors, then this document can help you find equity investment for your company.

Finding Growth Capital: A Critical Path

1. Determine your financial needs.
   • Develop your business plan.
   • Determine how much money you need to pursue the plan.
2. Consider alternate sources of financing.
   • Review the types of financing available.
   • Build a financing package to suit your needs.
3. Show your investment potential.
   • Find ways to convey to investors your potential for growth and profit.
4. Demonstrate management capabilities.
   • Show that your management team can successfully manage the firm and pursue the opportunity.
   • Prove that your team is well balanced and that it can make the investment a real success.
5. Build an investment proposal.
   • Write and structure an investment proposal that attracts investors.
   • Communicate your vision, your passion and your potential for growth.
6. Identify potential investors.
   • Find investors you might approach.
7. Meet likely investors.
   • Develop a strategy for approaching investors.
   • Contact, follow up and meet with potential investors.
8. Negotiate the deal.
   • Develop your negotiating strategy.
   • Find a solution that satisfies both parties.
9. Close the deal.
   • Bring the agreement to a successful completion.
   • Undertake and pass due diligence process.

[*] All quotations used with permission of Chris Griffiths, Griffiths Guitars International, St. John's, Newfoundland, Canada.

Financial Needs and Performance

"You can't just ask for a million dollars...Writing a business plan is tough...it's very time consuming but it's critical. You simply won't get any further if you don't have an effective plan. It forces you to write your needs down exactly."*

Begin with a thorough, strategic business plan that projects your financial needs and performance into the future and answers these key investor questions:

• Where will you be in five years?

• How will you get there?

Preparing your plan, and accompanying financial data, can be time consuming. And it requires some special skills. Management and external advisors may be able to help in putting it together.

Forecasting

"I built a plan that required $3.5 million. People asked me if I could do it for less. So I needed the arguments to justify it."*

Investors will look very closely at your company's plan and projected financial statements to see if your business will generate an adequate return in a reasonable amount of time.

Your plan and financial projections must show, in detail, how you'll use the funds you get and how your company will perform over the next five years.

Determining Financial Needs

"You need to identify ALL your costs. It can be boring but I wanted to know my costs exactly. I interviewed employers to find out what salaries would cost, got the costs of phone lines and office equipment, checked out expected rent..."*

To finance your growth initiative, you'll need to know how much of each of these types of funds you'll need:

• working capital (for day-to-day, month-to-month operating costs);

• fixed costs (for equipment, buildings, etc.);

• special marketing costs (for advertising, promotions, etc.); and

• a financing cushion.

Projecting Performance

"You've got to justify the size of the market that you expect - and investors are going to be very skeptical about that."*

Investors will want evidence that you can really achieve the gains that you forecast. They'll be looking closely to see if:

• your analysis of expected future market conditions is convincing and realistic;

• the working capital needs, production capacity and personnel requirements you predict are consistent with the level of growth you forecast;

• the growth rate you forecast is reasonable for the market you're in and in line with current economic conditions; and

• your projections will hold up under different economic and market conditions.

Your investment proposal should include:

• annual projections for a period ranging from one to five years;

• a detailed monthly cash flow budget for the first year; and

• sensitivity analyses of your projections under different scenarios.

[*] All quotations used with permission of Chris Griffiths, Griffiths Guitars International, St. John's, Newfoundland, Canada.

Financial Options

"We remained very flexible about sources of financing. Of course we looked at bank financing, angels and other venture capitalists. But we also looked to suppliers for terms that would help... it's all financing."*

Your business expansion will likely tap into all three major sources of financing:

• conventional external lenders (e.g. mortgages, operating lines of credit);

• internal sources of working capital (e.g. improved cash flow, reduced inventory, better terms from suppliers); and

• external risk capital investors.

External risk capital investors, who will invest by purchasing equity shares, include:

• angel investors;

• venture capital firms;

• institutional investors;

• labour-sponsored venture funds; and

• some government corporations.

Cost, Control and Risk

"Of course, I want to hold on to as much of the company as I can, but I'm willing to sell shares...I'd rather have 60% of a very large company than 100% of a small one."*

Risk capital sources will finance businesses that conventional sources won't touch. Risk capitalists will assume some of the risk of growth. But they'll only do so for a price -- in financial return and in control.

When you consider different types of financing, the key questions are:

• How much will it cost?

• How much control will I have to give up?

• How much risk will I be exposed to?

Cost

Risk capital equity investment is:

• more expensive for the entrepreneur than debt financing (because the investor expects a high rate of return), but

• generally has a low cash cost for the company (because the investor will usually hold the equity for a number of years and then sell the shares in the marketplace).

Control

Equity financing involves a loss of control since equity investors will:

• be buying a portion of the company when they purchase shares;

• likely demand a presence on the board of directors; and

• probably want to be involved in management and decision making.

Not all entrepreneurs are ready to dilute their ownership -- are you? Before you answer, consider that in many cases the investor's active involvement can be an important resource, providing management experience, industry contacts and other benefits.

Risk

When you take on debt, you're adding risk because you're committed to scheduled interest and principal payments. On the other hand, if you accept equity investment, the investor assumes some of your financial risk. At the same time, you assume another type of risk -- the risk of losing too much control (e.g. selling too large a percentage of the company shares).

Investment Potential

Investors are looking for three things. You've got to show them how your opportunity will deliver all three:

• excellent growth potential;

• exceptional return on investment (up to 25% to 40%); and

• a way to get their money out.

When capital is in short supply, you will also need to demonstrate why your company is a safer and more profitable investment than other potential ventures they could support.

Proving Growth Potential

Investors will look for evidence that you can really produce the growth you project. One effective way to show them what you can do is to provide a situation analysis of your company. Analyse your company's:

• external business environment -- showing the threats and opportunities; and

• internal business operations -- covering the strengths and weaknesses of all key business functions.

Measuring Return on Investment

To show investors what return they'll earn on their investment, you need to show them what your company is worth today -- and what it will be worth in the future. The reason is, equity investors make their money based on the change in the value of the company. If the company's value increases, their investment value increases.

Measuring a company's value -- called "valuation" -- is a complex but critical process. You'll probably need the professional assistance of a financial advisor or business valuation expert to determine the company value.

Because the investor won't see any money until some years in the future, the best valuation method is one that assigns a present value to future earnings. The valuation method used most often for purposes of growth capital investing is called the discounted cash flow method. It determines a value by taking revenue forecasts and adjusting them to account for the risk the investor is exposed to and for the opportunity cost of using the money.

The specifics of your deal all hinge on the valuation of your company. The amount the company is worth will determine:

• how much investors will invest;

• how large a share they will get in exchange; and

• how much they are expected to make from the investment.

Getting the Investor's Money Out

Investors will be looking for assurance that they'll be able to get their money out of your company. You've got to include such an "exit strategy" in your proposal to show them how they can realize their investment. The exit strategy also affects how the valuation is calculated. Exit strategies for equity investment include:

• initial public offerings;

• sale of all the shares of the company;

• purchase of the investor's shares by a third party; and

• buyback of the investor's shares by the company.

Management Capabilities

"This is very critical... you need an exceptional management team to attract financing."*

Investors will look to see if your management team can implement your business plan and realize the investment potential.

They are not looking for an operation dominated by one person. Instead, they want to see a talented team with:

• a range of appropriate skills and experience;
• a solid track record in all key business functions;
• an effective structure;
• good communication, decision-making and consensus-building skills; and
• the ability to grow.

Assess Your Team

One of the key criteria for investors is that your team is able to take on the new challenges of growth. Assess your team's abilities and readiness for growth by comparing available skills to needed skills. You can do this using tools such as:

• management audits; and
• report cards of key management functions.

Prepare for Investors

You'll have to provide investors with evidence of your team's readiness and competitive advantage. Be ready for tough, specific questions about each management function:

• marketing/distribution;
• production/operations;
• accounting/finance;
• human resources; and
• research and development.

"I built the proposal based on two things: first, that the people I want will come when the investment arrives; and second, that investors believe that if the people I want don't come, I'll be able attract the people I need."*

Strengthen Your Team

If your team is weak in some areas, start planning to improve it now. You can strengthen your team by:

• upgrading your managers' skills;
• hiring new people;
• modifying team structures and roles; and
• bringing in outside directors and advisors.

"It's challenging at first. There's a catch 22, especially for start-up companies, because you need an exceptional management team to attract financing, but you can't get them together without money."

"I courted people on one side while I was building my business plan and making contact with investors. But I was honest with them; I explained that I wasn't in a position to make a concrete offer. So it was challenging, for me and for them."*

[*] All quotations used with permission of Chris Griffiths, Griffiths Guitars International, St. John's, Newfoundland, Canada.

Investment Proposal

"If I can't be creative in building my business plan and proposal, then I can't convince investors that I'll be creative in building the company."*

You need a concise and compelling proposal because it's what you'll use to grab the investor's attention.

The proposal may not be the same as your business plan. The business plan is often designed for an internal audience (namely your managers), to guide their work. The proposal is designed for an external audience, to sell your idea and raise the funds you need.

Investors want the proposal to give them an immediate understanding of:

• the terms of the deal;
• what makes the deal or opportunity unique;
• the balance sheet;
• the calibre of the people involved; and
• the characteristics of the company and the industry.

The Executive Summary

"The executive summary does most of the selling."*

The executive summary must be brief and complete in itself. If it's successful it will encourage investors to read more. It needs to show them:

• how much they can expect to earn from the deal;
• evidence that your team has the skills to execute the plan;
• how they can protect their interest; and
• how they can realize their investment.

Getting the Investors' Attention

"I kept the needs of the investor in mind, and I included graphics to explain the process because investors are not experts."*

The proposal needs to capture the investors' interest by providing them with the information they need in an attractive and easily understandable style. Pay close attention to the writing and visual presentation:

• Keep the writing clear and concise.
• Avoid jargon and explain technical information.
• Use graphics and formatting to help convey your message.
• Package the proposal so it's easy to read.

"I know they'll read the first three pages and make a decision whether to continue, but by packaging the proposal creatively, I'd already made an impact."*

Table of Contents

A typical proposal contains the following sections:

• Executive Summary;
• Company and Ownership;
• External Environment;
• Product and Services;
• Management Team;
• Financial Plan;
• Financial Structure and Valuation;
• Operational Plans; and
• Appendixes.

[*] All quotations used with permission of Chris Griffiths, Griffiths Guitars International, St. John's, Newfoundland, Canada.

Finding Potential Investors

Who are Potential Investors?

There are many different types of risk capital investors. Each one has different characteristics.

1. Love Money

   • Family and friends are important sources of capital in the early stages of business development.

2. Angel Investors

   • These individual investors may want to be silent partners, or they may want to be actively involved in the business by contributing their experience and know-how.

3. Venture Capital Firms

   • These companies are managed by professional venture capitalists and typically have particular investment strategies or preferences.

4. Institutional Investors

   • Pension funds, life insurance companies, banks and other institutions also provide risk financing.

5. Government-Backed Corporations

   • The Business Development Bank of Canada and others provide equity financing as well as counselling, training and mentoring to small businesses.

6. Corporate Strategic Investors

   • Major corporations sometimes invest in smaller companies when they're looking for strategic partnerships.

How Do You Find Them?

"I had already started contacting people while I was working on my business plan. I'd done years of networking."*

Networking

Let people know what you're looking for. Look for introductions or referrals from:

• business and personal acquaintances;
• professionals who serve your business; and/or
• a financial advisor with expertise in venture capital.

Valuable contacts can be made through:

• trade shows, conferences and investor forums;
• local Chambers of Commerce;
• industry associations;
• local and regional business development organizations; and
• investor associations.

"The first time I saw our lead investor was at a meeting with 150 people. When I heard he was going to be speaking, I registered for the seminar. Afterwards I introduced myself -- you can't be passive and wait at the back of the room -- I told him what I was doing and gave him my card. He probably doesn't remember it, but he was pleasant about it."

Media and Associations

Other possible sources include:

• the Internet;
• news articles on investment deals;
• professional and industry directories and listings; and
• local entrepreneurship centres or economic development units.

"When I contacted potential investors I tried hard to get to know them. I just stated my case in a very casual manner, I didn't try to pitch them. I tried to ask intelligent questions and get to know about them. That helps later on. Then I'd ask permission to forward my business plan in the future."*

Who Should You Target?

Find investors whose criteria match your situation. These are the key areas to look for common ground:

1. Stage of Development

   • Does your business's stage of development match the investor's criteria?

2. Capital Required

   • Does the amount you need fall within the investor's limits?

3. Industry

   • Does the investor have a preference for specific industries?

4. Geography

   • Is the investor located close to you?

5. Leadership

   • If you're looking to syndicate your deal, will the investor consider taking a leadership position?

Investor Meetings

"You've got to anticipate their questions and put yourself in their shoes."*

The first meeting with your targeted investor is the opportunity for you to make your investment proposal come alive. During the meeting, the investor will be looking for your belief in yourself and in your product or service. And he or she will be trying to judge your credibility and integrity. It's also an opportunity for you to learn about your potential investor.

The Agenda

Usually only a small group of people -- you and your advisors, your potential investor and the investor's advisors -- attends this first meeting. The 30 to 60-minute meeting might include:

• your formal presentation;
• a question and answer period;
• preliminary decisions as to the next steps, if applicable; and
• a tour of the facilities, if the meeting is held at your location.

Preparing for the Meeting

"My main advice is know your plan. You don't want to rely on someone else to put together the proposal and answer the questions. I knew I needed to be able to answer questions about current ratios, supplier terms and exit strategies. So I educated myself, and because I wrote the business plan I knew the three key parts very well: marketing, production and financing."

The first meeting is not a casual affair. You've got to plan the meeting and your strategy very carefully. To help prepare:

• Send the investor your proposal before the meeting.
• Ask in advance what the investor's needs are.
• Consider the details: meeting room, equipment, dress.
• Rehearse your presentation.

"I spoke for 20 minutes and then they asked some really brutal questions. They asked me if I had run a company of this size before. And then they asked me what I would do if I couldn't run it well. Those are pretty tough questions."*

The Investor's Questions

Be prepared for tough questions. In fact, intense questioning can be a sign of stronger interest. The investor will be looking for answers to questions like these:

• Who are you?
• What's your track record?
• What's your commitment?
• Do you have a solid management team and, if so, who is in charge of what, and why?
• Are the assumptions used to project revenue growth reasonable?
• Does your company have a competitive advantage?
• Is there a viable exit strategy for this investment?
• How will the financing strategy influence the business strategy?

Your Questions

You should be looking for answers to questions like these:

• Does the investor believe that your financial projections are reasonable?
• Does the investor understand your specific requirements?
• Does the investor need additional information?
• Does the investor have access to the type and amount of capital you believe is needed to fund your project?
• Does the investor plan to take an active or passive role in the management of your company?
• Does the investor have the experience and the ability to work with your management team to improve your firm's operating and financial performance?
• Is the investor someone you could talk to about the challenges, opportunities and threats that face your business?

Negotiations

"Be open minded and be willing to ask questions."*

The Term Sheet

Negotiations will begin seriously when you receive a "term sheet" from the investor. This is his or her response to your proposal, covering the main elements of the deal:

• how much the investor will invest;
• how much of that investment will be in the form of equity (shares) and how much will be in the form of a loan;
• details about the shares and/or loan, such as type of share, when dividends will be paid, or terms of loan repayment; and
• what features the investor wants to see in a new or revised shareholder agreement.

What's on the Table

"I had a feeling for how much I was willing to give up. It's one thing to ask about the future value of money and revenue projections and all that... But at the end of the day, investors want to take a big enough piece so that you feel the pinch, so you take their involvement seriously."*

1. Price

   • The value of the business and the amount the investor will pay, and the share of the business they acquire are central to the negotiation.

2. Control

   • Investors will be looking for ways to control their investment, such as representation on the board of directors or some type of involvement in decision-making. You as the entrepreneur have to decide how much control you can give up.

3. Performance Measures

   • You need to decide what measures and targets for success that both you and the investors accept, and then you need to hammer these out (e.g. sales volumes, cash flow levels, debt repayment).

4. Exit Strategy

   • You'll need to determine how and when the investor will be able to take his or her investment out of the business (e.g. sale of the company, initial public offering, share buyback).

5. Employment Contracts

   • Contracts to ensure that key players keep their positions may be part of the financing agreement.

A Negotiating Session

"Don't feel you have to handle it alone. Get your lawyer and advisors involved."*

A good approach to a negotiation meeting is to proceed along these lines:

• Open the discussion -- Briefly state the differences you see between the investment proposal and the term sheet.
• Focus on interest and goals -- Discuss your interests and listen to the investor's.
• Find common ways to calculate financial elements -- Some differences may be due to different assumptions or approaches in financial calculations. Try to get some clarity and consensus on these. Seek expert advice, if necessary.
• Create alternatives to benefit both parties -- Stay flexible and look for alternatives. Reserve time to explore possibilities and be creative about solutions.
• Keep the future in mind -- Be sure any deal you make leaves you with options for raising more funds in the future if required.
• Hold multiple negotiating sessions -- Use the breaks between meetings to develop alternatives, analyse the investor's position and get additional information to support your goals.
• Don't negotiate over the phone.

"Don't get caught up in the speed of it all, in thinking it all has to be done in a 25-minute conference call... I slowed down the deal and made each part separate: the offer and the counter offer were separate meetings, and I had consultations with my lawyer and advisors between each."

[*] All quotations used with permission of Chris Griffiths, Griffiths Guitars International, St. John's, Newfoundland, Canada.

Closing and Due Diligence

Assess the Deal

Take a good look at the deal from these standpoints:

• Your company's future -- Is this the best thing for you and the company, now and in the future?
• Financial needs and goals -- A good deal will be good for the financial health of the company, and it won't limit your ability to raise capital in the future or to embark on other ventures.
• Trust and chemistry -- This is going to be a long term relationship, so be sure you feel you can build a profitable and constructive partnership that will stay strong, even if the business hits a rough patch.

"This stage can be very taxing, especially the first round of financing, because everything has to be negotiated. Moving from the two-page summary term sheet to the nitty-gritty details of the 100-page shareholders agreement can be tedious and difficult."

Scrutinize Legal and Other Obligations

Be sure to consider:

• Legal issues -- Be sure you understand the legal implications of the agreement, such as what representations and warranties the company is prepared to give, the composition of the board of directors, the dividend policy, compensation arrangements, etc.
• Government regulations -- Have your lawyer check that all applicable regulations, restrictions and registration requirements are considered.
• Existing contracts -- See what effect the deal will have on existing contracts, such as licences, employment contracts, supplier contracts or bank loans.

"Sometimes there's a gap between what you agreed to on the term sheet and the detailed terms. That needs to be hashed out, and you've got to be rational and patient."

Due Diligence

Before closing the deal, the investor will conduct a due diligence review to verify your information and to obtain more data, if necessary. Every investor will perform the due diligence review differently. Some will have advisors (usually from large accounting firms) to perform the task, whereas others, often angels, will handle it themselves.

A due diligence review will usually include a detailed look at these main elements of your business:

• Financial Review -- your company's financial status;
• Management Review -- your management team's capabilities;
• Market Review -- your marketing plan and activities; and
• Operations and Technical Review -- your equipment, plant and processes.

"It takes a long time to build the shareholders agreement. But then one day you sign a few pieces of paper and a cheque arrives."

Build and Maintain Good Relations With Investors

It's important to remember that the closing of a deal is the beginning of a relationship. For that relationship to flourish, you need good communication and trust.

You should aim for a higher level of communication with your investor than what is required by your agreement. Make sure the investor gets all relevant information in a timely manner and is included in decision making.