Raising Money: IF versus WHEN
Recently, I have been thinking about the challenge of raising money if you are a successful but bootstrapped company. In the last year, there have been cases of successful companies (substantial revenue, cash flow positive, growing rapidly) accepting investment for the first time even though they were well beyond the stage when traditional start-ups seek their Series A round. These successful companies are pursued by VC’s and Private Equity to take their money, which is a different scenario from the start-up seeking their early rounds.
For the CEO (and often the majority or controlling shareholder), the prospect of accepting external investment means accepting a new boss. Those most affected are the people who started the company and have been the boss, or have had the ability to steer the direction of company and the Board. They have built a history of success and credibility that gives them autonomy to consult for advice when they want to but still act unilaterally when needed. They worry investment and new stakeholders may inhibit this freedom. They worry that they won’t like having a “boss”.
For shareholders of this successful company, they worry about valuation, dilution and commitment to the new investor’s timeline. They may be tiring of the journey and concerned that the new investor will want a new five to seven year runway to build an “exit” that gives an appropriate ROI. The shareholders may also worry that new investor will limit their flexibility to receive dividends that they are used to or otherwise take money out of the company’s retained earnings. . Alternatively, they may be concerned that the growing success of their company means that too much of their net worth is wrapped up in one non-liquid investment. As well, they may worry that they aren’t getting the appropriate valuation for their current shares compared to if they just waiting another few years.
With this as a backdrop, let me share a methodology that I have developed to sift though these facts and emotions to make the decision.
IF versus WHEN
One reason any change management decision is difficult is that people confuse and combine “if” and “when” decisions. Let me explain this with an example. In 1991, I was offered a job that would mean leaving IBM after 12 years. The offer was to join a group of ex-IBM employees who had started a company. It was a great opportunity and offer, but I struggled with the decision and eventually turned it down because I was unable to decide. Afterwards, I realized the turmoil was caused because I was trying to decide “when” I would leave IBM (this job offer versus some future job offer) before I had decided “if” I would ever leave IBM. As a result, I decided I needed to make the “if” decision first, at a time when I wasn’t faced with a job offer.
After 12 years at IBM, I found it very difficult to answer the question: “could I ever leave the IBM” until I reversed the question and asked, “Will I retire as an IBM employee?” Facing another minimum of 18 years at IBM, the answer suddenly became clear. It was “Hell No”. Now I had answered the “if” question. I was not going to retire at IBM. So the “when” question became: “Is this job that I am being offered now the right one”. Gone was all the emotion about leaving IBM.
Similarly, consider the emotion facing the CEO about having to now answer to outside investors… the emotion of having a new boss… the emotion of not being 100% in control…
First answer the question: “Will my company ever accept outside investment before we choose to sell it?” I can’t tell you what that answer will be, but I suspect in most cases because of requirements for working capital, growth capital, buying out tired shareholders or allowing shareholders to diversify their wealth portfolio, that the answer will be yes, at some point, investment will be required.
Now the question is “when” and is this offer from the right partner and the right offer to accept?
At this point, it is easy to get overwhelmed by the minutia of the negotiation over valuation and terms. Before you do that, I suggest you step back and consider the outcomes you want. Let me illustrate with another example.
Company A has $40M in revenue and is cash flow positive, reasonable EBITDA and a strong balance sheet. They estimate their valuation is 3X revenue or pre-money of $120M. They have an offer from an institutional investor to directly buy $15M of shares from investors at $10 per share and to invest another $15M into the company and take a total ownership position of 28% (if you reverse engineer the math, this works out to about a $100M pre-money valuation) .
Rather that debating the terms and valuation and get immediately bogged down in discussions that can derail the process, I recommend a different approach. Consider the outcomes that you want. You can be sure that the investor has modelled their planned outcome. Given the later stage size of the company, they are probably expecting a 3 to 5X outcome when they sell. If we assume 3X, they want a $90M return for their 28% holding and believe that this reasonable. That means, they expect the company to sell for about $320M, which means the original shareholder will receive 72% or $230M.
Instead of asking “Will we accept at $100M pre-money valuation?”, the two questions become:
“Is $15M of direct share purchase adequate to diversify risk and substitute for dividend over the next five-seven years?”
“Is a $230M outcome in five to seven years, an acceptable outcome?
By answering these questions, along with, “is this the right investor to partner with?” I think your CEO and Board will have a more productive discussion rather than worrying about loss of control, having new voices at the table, and arguing of the minutia of valuations.