Background

Most entrepreneurs learn about obtaining and managing contracts, employees, and office and equipment leases as they go. Such things occur often enough that they are just part of being in business.

Raising capital or selling a business differs in that it occurs episodically and not regularly or even periodically. For this reason, we have included the following section as an informative guide for those who are seeking capital but are unsure of where, when or how to get it.

Typical Scenarios Faced By Entrepreneurs

As an entrepreneur you want to grow your business; or at least you feel as though you should. Consequently, you may be in one or more of the following situations and could benefit from timely access to funds to achieve your goals.

1. You are a Canadian technology company that performs R&D, and are, or may be eligible for a government tax refund.
2. You would like to extend credit to your customers for thirty to sixty days but this prevents you from making more sales.
3. You have or could get a large order if you had the money to finance it.
4. You want to acquire a customer list or other assets and want to pay for the asset(s) over a period of years.
5. You have initial sales and need patient capital to increase them but do not want to sell shares in your company.
6. You sell proprietary software and would like to allow your customers to pay for it over a period of three years.
7. Your business is not old enough to get a bank loan but you do have sales.

Use Of SME Funding

Another reason that the issue of raising capital may be on your agenda is that you have a specific business purpose in mind. The following chart ranks funding objectives by the percentage of firms that choose each one.

SME Life Cycle: Navigating the Capital Ocean

The above paragraphs feature reasons why you might be looking for funding, however, if you have not yet obtained it you are probably preoccupied by what's available and where to get it.

You may have already tried to get venture capital but found that it was not for your business. Your bank may have already turned you down. While neither outcome means that you do not have a good business opportunity it's clearly time for a second look.

To assist you with your search for funding the following reviews the available types of funding and the realities underlying their acquisition.

This is done within the context of the SME Life Cycle. Initially developed by Acorn Partners for internal use, we believe it is also an effective guide for those operating small and medium-sized businesses.

The SME Life Cycle features three distinct types of owner-managed businesses (lifestyle, venture capital bound, and foundation firms) and demonstrates how they enter, change and exit the world of ongoing business.

Visualize the central portion of the diagram as a body of water-an ocean on which each and every firm sails. It represents capital, the funds needed to start and keep going. The ocean is a global one with many seas, each with its own water temperature, risk of storms and dangerous reefs. Like different varieties of capital, there are significant differences between the seas yet they remain connected.

Central Idea

The central idea to keep in mind is that each firm is competing for space (funds) in the capital ocean. Firms vie for funds whether they come from those who gather them from others (bankers, venture capitalists, pension funds, and merchant bankers such as Acorn Partners), or principals (angel investors, friends and family, and suppliers).

Consequently, while there is a capital ocean, it does not mean there is an ocean of capital for you and your business. And you thought that you only had to compete for customers!!!

Underpinning capital markets modeled as an ocean are the following concepts:

1. A business' realizable potential reflects in large part its founder's intent.
2. The spread between the amount paid by customers and the business' costs determines the potential for success.
3. After entry a business' performance reflects management's capacity to do the work of running a profitable business as well ensuring that the work of making and selling what customers will pay for gets done.
4. Intent can change over time.
5. Management capacity can change over time.
6. Opportunities can change over time, for better or for worse.

Reaching enough paying customers before running out of cash - breakeven level - is the key to remaining afloat in both the long and short run. The "navigation charts" featured below can help you in your efforts to do so.

Navigation Charts

To navigate the capital ocean, we have provided you three charts complete with navigation aids for life style, venture capital bound, and foundation businesses.

Each chart provides insight into the sources and types of capital available to you as a function of your chosen growth objectives. This gives you some basic guidance on where, and where not to look for money.

Chart I: Lifestyle Business

The owner's basic intent is to earn a living and this drives their business' behaviour and performance. Such firms are typically solo consulting practices or "mom and pop" outfits such as a fast food outlet. Their choice of industry varies widely but is almost always a function of knowledge-not of being drawn to some shining opportunity.

A lifestyle business' basic means of transport on the capital ocean is a canoe. The key implication here is that there are very limited types and amounts of capital available to such firms. Basically, you have to paddle your own canoe and this is so for a very good reason. The business owner will not push growth fast enough or far enough to offer a competitive return to most investors. Bank prime plus three is the norm in such situations.

It is usually the case that risk capital is not available to lifestyle firms. However, for the most part this should not matter. Such businesses can and should grow at modest rates for many years. But they must do so within the constraint of retaining equity from profits, then getting a bank line of credit after two or three profitable years in business. (X-1) In addition, a very significant source of capital-supplier credit for sixty days-becomes available for some types of firms between the second and third year. (X-2) After three to five profitable years, equipment can be leased. (X-3)

If the owner has a significant net worth and is willing to give personal guarantees, funds from banks may be available earlier in the business' life. As an alternative, an owner can sometimes borrow funds from friends and family to get started or over the inevitable bumps along the way. (X-4)

In sum, for lifestyle businesses, capital with any sort of risk premium is generally not available. Community loan funds may be an exception, particularly in amounts in the four to low five figures. ($5,000 to $25,000)

However, there is another type and hence source of capital that can be of use from time to time, especially to manage seasonal peaks and valleys when a bank will not support a large order. It is called invoice discounting and is one of several products in the family of Sales Driven Financing© that Acorn Partners offers. It works for lifestyle businesses at any stage of development because invoice discounting relies on the credit strength of your best customers.

Chart II Venture Capital Bound Business

A venture capital bound business owners' driving force and the challenges to be surmounted are the polar opposites of those of a lifestyle business. These entrepreneurs want to create a huge amount of wealth for themselves and others in less than a decade, a feat not easily nor often done.

The ocean going craft of choice for VC bound entrepreneurs is a cruise ship-expensive and big. The challenge is that they must build, captain and crew it without losing control and sinking into the capital ocean.

Others have likened obtaining VC capital to your first jump from an airplane-but with the condition that you design and build your parachute on the way down!

VC bound firms have funding limitations just as lifestyle firms do; however, any similarity between the two ends here. Given their high growth objectives VC bound companies require large, repeated and timely infusions of capital. This is why they must have the ability to generate sufficient wealth quickly thus allowing them to pay investors a high rate of return.

In addition, those willing to fund venture bound firms are the polar opposite of those financing lifestyle firms. Expectations of returns that are three times one's investment within three years are the minimum. Twenty times the investment, returned in seven years (equivalent to fifty plus percent per annum compounded) is the norm.

Before starting out on such a voyage two questions are worth asking. First, does this opportunity warrant such a voyage; and second, if it does, is it really worth your while as a founding CEO to embark upon it?

A positive answer to the first does not automatically yield the same for the second. It is not axiomatic that founders will share in the wealth because they are founders. Address the second question within the context of the personal risk of losing control of your luxury cruise ship at any time after the first infusion of outside capital.

The chart to navigate these waters shows a linked path from early stage angel financing (X-1), through several rounds of venture capital (X-2), to investment banking (X-4) then to being listed on a stock exchange (X-5).

The chart shows you key navigation points along the voyage and the odds of reaching those points. Of course, the best strategy is to consider them while you are still on shore.

The key features of these navigation points are:

1. Angel capital from investors committed to getting venture capital. They probably have built a business that did so or at least contemplated it. Most likely they sold their business to another larger firm.
2. Venture capital rounds. If you are successful obtaining it-probably from a variety of venture firms. You then likely to sell the business so they can obtain their exit.
3. Multi-million dollar private placement from a pension fund.
4. Initial public offering. (X-4)
5. Bank and supplier credit. (X-5).

If and when you arrive at X-4 you are now entitled to sail on the shark-infested waters of a public listing with quarterly profits as your navigation guide.

Fortunately, detailed markers for the venture capital chart are well developed. Listings of firms and their investment interests are published by the National Association of Venture Capital Companies in Canada and the USA. As well, there is a plethora of material on the industry available from sources such as the accounting firms, governments, etc. A number of professionals within law and accounting firms have built their practice by specializing in venture capital backed firms.

For additional guidance in asking yourself the two key questions (is venture capital available for this opportunity and is it worth my while?), we have placed the following probability of arrival on each of the basic venture capital markers on the chart.

One: Less than five percent of firms seeking venture capital get it. Indeed some venture capitalists invest in less than one percent of the opportunities they see. Are you truly one in a hundred?

Two: Of those receiving venture backing only one in ten meets venture capital pay off expectations.

Three: Only one in a thousand venture-backed firms has a successful Initial Public Offering (IPO).

Four: You should write a brief written summary of why your opportunity is the one to beat the odds. Test it with people knowledgeable people who are working in your industry. Consult with buyers.

The next set of markers for you to place on your chart clarify the value to you of going the venture capital route. One thing to remember is that you will have to sell a significant portion of your firm's shares to angel investors just to get started.

Five: The value that an angel investor places on a very promising opportunity is between $1M and $2M. Obtaining the money comes at a cost. For instance, to get $500,000 you would need to sell twenty-five to fifty percent of the shares.

Six: At the end of the day, if and when you are a publicly listed firm, you can expect to own four percent of the shares as a founding CEO. The business would have to be valued at $100 million just to provide you with $4 million.

Seven: Your firm would have to be in the top quartile of listed stocks to do that. Why do you believe that you can push your way through most of the currently listed stocks to capture and then hold investors attention?

Eight: Consider the possibility that the odds favour you creating a lifestyle business that generates more assets for you personally. If you are convinced that lifestyle is not the best choice, then consider the foundation business route. This may lead to a situation even where your firm has venture capital potential over a longer period of time, and in the meantime, you can become wealthier by building a foundation business.

If you choose the venture capital option, Acorn Partners family of Sales Driven Financing© (SDF) products primary value is that it allows venture capital bound entrepreneurs to stretch the interval between taking on rounds of capital. This means that you pay less for the money obtained. For the same reason it is also useful when negotiating the sale of the business.

Chart III Foundation Business

Like the lifestyle business owner, foundation business owners are willing to take a quarter century to create wealth. Unlike a lifestyle owner, foundation business owners want to grow and pursue the opportunity as far as it, and their capability allows.

Another distinguishing attribute is that unlike venture bound entrepreneurs, foundation owners not only have time to change course while on the ocean of capital, they can go into port and buy a better vessel. It is worth noting that most substantial accumulations of wealth come as a result of building successful foundation businesses.

With the exception of venture capital, a foundation business can afford most forms of risk capital. However, unlike the charts for lifestyle and venture bound firms, some of the key sources of capital are not highly visible.

One of the hardest to reach is a key subset of the angel investor community. Unlike those who expect you to become a venture capital bound firm, these angel investors know they have to obtain their exit-return of capital and return on capital-from the success of the business itself.

As a foundation business, you can create significant wealth. Indeed, it is more probable that if you are successful you will create at least as much personal wealth for you and your family over the decades that you take to build the business than if you were venture capital bound. The combined odds of obtaining venture capital and being successful support this viewpoint.

Since there is no IPO, the issue for you and your investors is how to convert your shares to cash. You could choose to sell the business but may not want to sell to a larger company. Some founders have sold to those who worked with them and thus the business continues. Firms sometimes grow large enough that they create a market for shares solely amongst employees.

In sharp contrast to the venture capital chart, there is no distinct sequence amongst the key navigation points. You may have to create and change your course during your voyage.

There are two navigation markers you can employ at any time you feel the need, but again, they are more useful if you start to use them before you found the firm.

Marker One: Double check to see if you are not really a lifestyle business. To do so, ask yourself where you would prefer to spend your time on the activities required to build the business or those required to do the work required to satisfy customers. Put another way, are you more interested in building a bakery or baking pies? (X-1?)

Read the E-Myth Revisited (link to book in "books to read section") for insight into this question. If you would rather spend time doing the work required to produce and sell, then it may well be a lifestyle business that you want.

Marker Two: See if you are not really a venture capital candidate. Would you be willing to give up 25% to 50% of the shares of your business to get $500K. Answer yes and it implies that you believe that your reduced share of the company will be worth more than a larger proportion of a smaller company. You could be on the venture capital route. (X-2 ?)

Marker Three: Angel investment. This marker may or may not be one to sail towards at any given time. In the early years it may cost you a large percent of your company, however, it will also likely bring helping hands. Depending on the situation, hiring consultants might be cheaper.

If you have established a track record and can demonstrate recurring revenue then you may be able to borrow funds. At the earlier stages of this phase, you may have to give an equity kicker-in effect share some of the future profits.

Marker Four: Presuming that you respond yes to Marker One (you want to do the work required to build the business), and no to the angel investment offer, the next maker on this chart is one of the availability of a bank line of credit.

Your success in obtaining a line of credit is based upon maintaining profitable performance of the business over three consecutive years. Show losses and it will not be available. These are demand loans and can be called in any time you fail to meet the multi-page terms of your agreement. Further, you personally guarantee that regardless of what happens you will repay the lender. Put another way, increased funding from this source depends upon increasing retained earnings.

Marker Five: Trade credit from suppliers is earned much the same way as in Marker Four. This can be a significant source of funds for you at no cost. In effect your supplier becomes your banker. (X-5)

Marker Six: As you grow you will need funds that will be paid back over a period of years. Leasehold improvements added into your monthly rent are one example, computer acquisitions are another. (X-6)

Taken together, funds from the groups represented by Markers Four, Five, and Six form a foundation for your growth trajectory. However, they do leave you with one problem. They are not in any way linked to the opportunities you encounter. Typically they would not let you double your sales in a year or even take advantage of a larger order. Sales Driven Financing©, Acorn Partner's family of financial products, can help you when your rate of growth exceeds that allowed by the funds available from the sources in Markers Four, Five, and Six.

Marker Seven: This marker is unique to foundation businesses. It is equivalent to the IPO for the venture bound or the sale of the lifestyle business in that the original investors get cash for their equity. One way is to simply sell the business to another firm, an acquisition. Somewhat more complex to execute is a merger. What is involved is a change of ownership or at least controlling shareholder. This changes many if not all of the existing financing arrangements. These waters are relatively uncharted and stormy-but not impassable.

The voyage could include selling the founders shares to employees and creating a marketplace where the shares can be bought and sold. It could also include a onetime sale to the management group using debt to get the founder their cash, a leveraged buyout.

The reality is that the navigation markers for a foundation business are not all visible in advance-nor need they be. Because of the moderate rate of growth (25% per year), you do have time to identify new ones, place them on your chart and respond appropriately.

Perhaps the best way to detect the navigation makers and place them on a foundation chart is to cultivate a practice of meeting with a selection of peers from all three types of businesses and learn what they have done. As you continue your voyage, ask yourself one key question from time to time: what is changing and what has to change as a result? Is it your intent or management capacity? Is it what customers are now willing to pay for? You can then put new navigation guides on your chart or start to use one of the other two charts.

At any time Sales Driven Financing© products can be of help to build foundation businesses. In fact, foundation businesses are the class of business our merchant banking activities are designed to support. This is because the type of funding they require is usually beyond the banks but not venture capital.