SME superstar or investors’ bane?
- Wednesday, 17 February 2016 10:07
One of the most difficult aspects to starting a new business is when, and how, to raise money and it’s this question that separates the potential SME superstars from their peers.
Milestone funding–identifying key milestones and calculating how much capital you will need to raise in order to achieve these milestones–is the best way to determine and articulate how much capital you will need and when. SMEs that base their funding strategy on milestone funding are able to show how much money is needed and what they are going to do with it, inspiring confidence in investors that they will see a return on their investment.
The majority of experienced investors tend to overlook business plans and focus on the entrepreneur or business leader and his story, including any presentation materials, financial forecasts and an executive summary. This is logical since the majority of investors actually invest in people and teams rather than business projects or business plans. As such, the only goal of the first submission (business executive summary) to any investor is to obtain a face-to-face meeting. Keep in mind that the content and layout of the business executive summary needs to be well thought out and structured in order to optimise business owner’s chances of passing the first hurdle and meeting their potential investor.
Keep the initial document as brief as possible and limit it to a maximum of two to four pages. It must be easy to read. Images and charts speak a thousand words so optimise the use of visuals where possible. Keep the language simple and comprehensible. Remember that any word that has to be hunted for in a thesaurus is probably the wrong word.
Investors review so many deals that they become experts at filtering investment and business project proposals and a simple business executive summary will substantially increase the chances of you obtaining that initial face-to-face meeting.
The business owner should understand what an investor does and pre-empt what he wants to save both their time, and utilise the saved time to build a trusted relationship with their potential future investors while obtaining valuable advice. As the negotiations start, be a realist–no investor will provide the majority of capital in return for no control and a minority shareholding.
Once all this is done and the odds are stacked in the business owner’s favour, they need to accept that they may still not succeed with the first investor they talk to. However, it is a chance for them to learn from every professional investor they talk to and make use of their investment knowledge. Ask questions–what went wrong? What could you do better? What are the typical risks and pitfalls that you need to avoid?
Appreciating what an investor does and how he screens and selects investment opportunities will allow the business owner to understand what professional investors do, how they do it, what type of information they will seek and will make the difference between leaving with, or without, a cheque.
The principal investor, or general partner as they are known in the private equity industry, raises capital by approaching external third parties, or limited partners, for capital commitments. The general partners may also contribute some of their own capital to the investment fund from which funding will be made available to invest in your business, if you are selected as one of the investment fund’s portfolio companies.
The investor (the general partner or the fund manager) will tend to prefer a small number of external/limited partners, each contributing a significant amount to the fund. This normally limits the amount of time when having to manage and report back to his pool of investors and limited partners. Ideally, the fund would have a minority of limited partners, each contributing tens to hundreds of millions of dollars, depending on the size and strategy of the investment fund.
While limited partners make a commitment to provide capital, it is not all provided at once. Rather, as the general partner/fund manager identifies and acquires portfolio companies, the general partner calls committed capital from the limited partners into the investment fund. In an investor’s terminology, limited partners’ committed funds are referred to as ‘committed capital’ and paid out funds are referred to as ‘contributed capital’.
To make things a little bit more complex, many investment funds also refer to ‘first close’ and ‘last close’. First close means a certain amount of funding has been committed and the investment fund can begin to make investments in portfolio companies while new limited partners may still join by committing capital for a limited time. Final close means a second threshold has been reached for committed capital and new limited partners may no longer join the investment fund.
Finding that needle in a haystack
When an investor carries out due diligence of companies for potential acquisition, they will consider elements such as the company’s product/service, the company’s strategic fit within the investor’s portfolio, the company’s strategy, business model, the senior management team, the industry, the company’s financial performance, risk factors, a valuation and likely exit options. Due diligence typically intensifies in phases, with each phase sifting out unsuccessful investment opportunities and narrowing down on likely investment opportunities.
If the deal looks promising and no obvious show stoppers or red flags are identified, then the due diligence team will typically present the opportunity to the investment committee of the investment fund for an initial funding approval. Final terms of the deal with be negotiated with lawyers on both sides and the deal will transact, with funds being released and equity being traded.
The investor does not want to be the CEO of the company nor does he want to run the company day to day. He will want to take a board seat, he will encourage a reshuffle of senior management based on skills and performance, and he will provide active advice, support and introductions in respect of operations, strategy and financial management. He will want to drive revenue, sales, operational and financial efficiencies, optimising working capital, push expansion and any other key factors that will contribute towards generating a higher share value in the next three to five years.
The investor has purchased shares in the organisation with the sole intention of selling them for a substantial profit at a later date and some larger private equity funds have specialised teams whose sole objective is to improve the operational and financial efficiency of the portfolio companies so as to maximise resell value. These teams are commonly good at what they do but can also be quite ruthless.
How involved the investor is really depends on how big their investment is in the portfolio company. If the investor only owns a small minority stake, they probably won’t be very involved, leaving the lead investors to be most involved. However, if they own either a sizeable percentage of the equity or a significant portion of the entire fund is invested in the company; they will be much more engaged in improving the company for a profitable exit down the line.
The investor will produce regular reports on the performance of portfolio companies and will share these with his own investors (the pension and retirement funds, endowments, insurance companies, and wealthy individuals who all invested in his fund from which the business owner got their investment).
The end goal for the investor is to exit their portfolio companies at a substantial profit. Typically, the exit occurs between three and seven years after the original investment, but it could be shorter or take longer depending on the strategic circumstances, economic cycles, availability of suitable buyers and other factors.
Most exits happen as the result of either a sale or merger of the portfolio company (most likely), an initial public offering (only a small fraction go this way), a redemption (redemption rights are almost never exercised) and eventually a management buy-out (normally not possible). While the investor may do a lot of the coordination to sell the firm’s portfolio companies, they may also retain investment banks to handle the execution, especially when the transactions are large or complex.
Consider including the following sections in a business executive summary:
- A description of the problems or challenges the solutions or products resolve.
- A description of the market for the product or solution, including distribution and sales.
- A description of how the venture provides the solutions or products.
- A description of how a return on investment will be made for shareholders.
- The management team and their relevant experience.
- Any patents and/or trademarks and any intellectual property linked to the product or solution.
- Highlight any areas of risk and how else non-financial support may be sought from investors.
- The size of funding sought and how these funds will be utilised.
- Disclose other sources of funds already secured.
- If a valuation has already been calculated–how it was calculated and the valuation.
- Include your projected financials including revenue, cost of goods sold, operating expenses and anticipated earnings before interest, taxes, depreciation, and amortisation.
Source: Jan Bladen, Executive Advisor and Programme Lead, Abu Dhabi Global Market (ADGM)
Five things for businesses to consider when approaching investors:
When is the best time for SMEs to consider looking for investors?
When the SME can clearly demonstrate that an investment will help grow and prosper their business. Once the SME has a proper business plan and presentation noting certain measures to be implemented is usually when investors can be approached.
What are the merits of approaching a bank for funding vs. outside investors?
While bank funding might involve more time and effort in comparison to outside investors, the security they supply with regards to the facilities they provide is a definite merit. In addition, when receiving funding from a bank, the full company profit goes to the SME. It is rare for SME’s to get investments from banks in the UAE unless they are affiliated with an SME development company backing their idea. This is where the zero interest rates and constant mentor support of an outside investor can be an advantage.
What should SMEs look for in an investor?
SMEs should not only look at the amount of money they will be getting as an investment, but also additional points the investor will add to the project, such as mentorship, support, referrals, and longevity in investment.
What are the top five reasons SMEs fail to attract investors?
• Lack of preparation
• Not much enthusiasm
• Tardiness in meetings/presentations
• No background information knowledge on the market
• Not open to advice/tweaks