By Michael Masterson
Last week, I suggested that it takes more than an idea – even if it’s a really fantastic idea – to attract potential investors. You need to prove that your idea has legs by turning it into a working model.
But then what? Once you’ve got a working model, where do you go for the money you need to turn it into a business?
In general, there are four sources of capital: venture capital firms, government agencies, commercial banks, and private investors or partners.
If you think your idea might be of interest to venture capitalists, check out the National Venture Capital Association (nvca.org). But for the average entrepreneur, venture capital isn’t a possibility. As Paul Lawrence explained in his article “Raising Capital for Small Business Ventures“:
“Yes, some venture capital firms will invest in new businesses, but such businesses are usually involved in technology or some other high-growth area. Frankly, for most small businesses, venture capital isn’t even an option. It’s rare for a small-business concept to have the kind of mammoth payoff venture capitalists look for.”
“Plus, the cost of doing business with these companies is high. It’s basic economics. Their risk is high, so their reward must also be high. Even if you were to interest a venture capital company in your business, you’d be aghast at what they’d want in terms of their ownership position.”
What about government grants? Tim Berry, author of Hurdle: The Book on Business Planning, points out that government funding agencies usually have “social” agendas. Grants and loans are available to minorities – especially minority businesses engaged in education, antidiscrimination projects, community services, fine arts, and other politically popular objectives.You can find out if your business idea might be a candidate for government money by checking into any of the government agencies whose purpose is to stimulate entrepreneurship. The best known is the Small Business Administration.
I wouldn’t advise taking this route, though. It requires too much bending to bureaucracy. Too much artificiality. Too much red tape. Getting these loans and grants takes months (or years) of filling out forms. And there are all sorts of reporting and regulatory requirements – enough to slow down even the most patient person. Plus, government-funded business projects have an extremely high failure rate once the funding is withdrawn. That’s because they begin with an idea, not a working model. And the idea isn’t good to begin with because it is based on social policy instead of being connected to profits – which is, after all, what fuels a business.
As for getting money from a commercial bank, I can make this short: Forget about it. The only way a bank will lend you money these days is if (a) you have excellent credit and (b) you can collateralize your loan with assets. If you have good credit and tons of money, you don’t need a bank loan. You can loan yourself the money.
This brings us to the fourth and final option…
Finding a Private Investor or Partner
At first blush, private funding seems like the least likely way to go. You may not know anybody who has money. Or if you do, you may not be willing to risk damaging the relationship by mixing it with business.
Some business experts advocate hitting up friends and family. I never did that, because my personal relationships were always more valuable than my desire for money. But I did ask business acquaintances to invest with me. My relationships with them were based on money, so I didn’t think it was inappropriate.
One of my first businesses, a house painting service I started with a buddy when we were still in high school, required a very modest investment. About $400 to pay for ladders and tools. We didn’t have the money, so we got a job with a painting contractor and saved up to buy what we needed. It took six months – and during that time, we were making all sorts of good contacts. We were getting to know paint wholesalers and equipment rental providers and even future customers.
When we were ready to go off on our own, we spent a few weeks knocking on doors and offering discounted service. Before we knew it, we had all the work we could handle.
Years later, I funded an idea I had for a new publication by asking my boss if he wanted to invest in it. When he found out I had no money of my own, he took 75 percent of the deal and made me sign notes to repay him the 25 percent (about $10,000 or $15,000) that I was liable for. I was a little unhappy with the arrangement at the time – but eventually I realized he was being very generous.
Once I recognized that when it comes to funding “good ideas,” money talks, I switched strategies. I decided I’d never attempt to sell an idea again. Instead, I’d sell a working model. Nowadays, when I’m looking for capital, I wait until some version of my idea has already proven itself to be profitable. At that point, I can go to any good businessperson and show him the numbers. Sales and cash flow can persuade in a way that market research and computer charts can’t.
The Difference Between Getting a Loan and Taking On a Partner
Let’s say you have proven your idea in the marketplace with a working model. The next step is to figure out whether you want an investor or a partner.
The advantage of taking on debt (getting a loan from an investor) is that you do not give up equity in your business. It can still be 100 percent yours. The disadvantage is that you will owe the money even if the business fails.
The advantage of accepting investment capital (taking on a partner) is that you don’t have to pay the investor if your model doesn’t work out in the bigger world. A second, often overlooked, advantage is that you will have someone to bounce ideas off. (The best investors are successful people in the industry you are entering.)
In between getting a loan and taking on a partner, there’s room to play. You might be able to structure a deal that has the best of both worlds – a loan that gives the lender a limited (though significant) upside if the business takes off. To get that, you would have to make some concessions. You may have to pay back some of the loan if the business fails, for example. Or you might take, say, 50 percent of the salary the business intends to pay you and use that to pay down the loan over time.
Ultimately, the guy with the money decides what the deal is. You’ll do better negotiating your stake if you present a very exciting and trustworthy picture of the business’s potential. And that will depend on having detailed financial reports on costs and cash flow and profits, if there are any.
Prepare to Make the Pitch
Before you can contact prospective investors or partners, you need to figure out how much money you need. Come up with three scenarios: ideal, less ideal, and minimum. Of course, there will be advantages in having the ideal amount of capital – but don’t get your heart set on that. Chances are you will get option two or three. Be prepared to work with either.
In making the pitch, follow Paul Lawrence’s SIPE process – Solicit, Interest, Persuade, Execute:
1. Solicit
Begin informally. Casually ask your prospect, “If I happened to come across an interesting business opportunity, would you like to hear about it?”
It’s important to note that you’re not asking him if he would invest in a business, but if he’d like to hear about potential opportunities. Since he won’t feel that he’s being pressured, it’s more likely that he will give you a positive response.
You also immediately rule out people who have no interest in any business proposals… without putting them (or you) in an uncomfortable position.
2. Interest
Give your prospect a one-sentence description of your business. A long-winded explanation can sound like you don’t have confidence in your business idea or that you don’t really know what you’re talking about. You then follow up with an estimate of the business’s profit potential and a couple of supporting statements that provide strong reasons to believe it is viable.
3. Persuade
If the person you are pitching seems interested, set up a second meeting to present him with a written proposal.
Make it short and to the point, no more than eight pages. If you are presenting it to the right person – someone already successful in the industry – he will not need more than that.
The proposal should have two goals:
- First, to prove the substantial profit potential of the business. Rely heavily on actual numbers. (If possible, have the numbers prepared by a neutral accountant.) Based on your working model, estimate your gross revenues, expenses, and profits over a three- to five-year period. If it adds up to a healthy estimated net profit, you’re off to a good start.
- Second, to demonstrate the low-risk nature of the investment. Although you can’t ethically or legally guarantee that an investor won’t lose his money, you can explain why there is a good chance he won’t lose it. Since much of your evidence is coming from a working model, this should be easy to do.
Although Paul doesn’t include this in his SIPE formula, I’d add this: Put some of your own money into the deal. Even if you haven’t got a lot, you should have something in it. As a rule, I never invest in a deal unless my partner has some “skin in the game.” The money you put into making the working model counts. But pledge some more money too.
4. Execute
Once your prospect agrees to the terms you’ve negotiated, arrange for a third meeting to sign a “deal memo” – a basic outline of your understanding. The main reason to have a deal memo is so that, in the future, there will be no debate as to what was originally agreed to. If your deal is large or complicated, you may want to have a formal contract. But in many cases, a deal memo is strong enough to be legally enforceable.
If none of the above works to get funding for your business, that tells me you didn’t begin at the beginning – by proving the validity of your idea with a working model. So go back to square one and do what you have to do. Meanwhile, I have some advice for you – a suggestion I’ve made many times in ETR. Steven Brandt, who taught small business management at the Stanford Graduate School of Business, states it this way:
“If you really can’t get your company going now, because you can’t pare it down and you can’t get it financed, then start down a path that eventually will lead you there. Work in a related business as an employee and keep your eyes open. Look for potential partners that you could work with in the future.”
[Ed Note: If you don’t want to worry about funding, you CAN start a business with just a few bucks, in your spare time. Learn how to get all the details – including how to set up a website, how to create products, low-cost marketing strategies, and much more – right here.
As a special thank you to our best customers, Michael has started a VIP service in which he gives insider business-building advice usually reserved for his private clients – a twice-weekly newsletter called Ready Fire Aim: The Michael Masterson Dispatch. If you have bought an ETR product or attended a conference and are not receiving Ready Fire Aim, please let us know by sending an e-mail to [email protected].]
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