Raising Equity Capital
At some point in your search process, you will need to raise capital from investors and, more importantly, propose how to pay it back with a favorable return. Raising funds can create a high level of anxiety since you will have to ask people (who are not your parents) for money, perhaps for the first time in your life.
In a funded search, you will need to find investors to support your 24-month search process and then, once you have a business under LOI, you will need to raise equity capital from them again to fund the acquisition. Self-funded searchers conduct their equity raise when they have a deal under LOI and not when they start their search.
When searchers have a willing seller and a business with good fundamentals at a reasonable price, there will be investors willing to support it with a cash investment. However, it takes persistence and effort to convince them to make the investment with you being the CEO.
Finding capital is a process very similar to the search itself: numbers matter. You have to start with a lot of prospective funders at the top of the funnel. One search team sent materials to over 200 potential investors before finding the 12 that eventually provided the acquisition funds for their self-funded search.
As one searcher says, “Dollars have faces!” Money is not the only contribution that investors can bring to the table. Some investors may bring a specific industry expertise or a background in a particular operational area such as sales or marketing. Other investors may have broader expertise and can act as mentors for you over the ensuing years. Investors with a special financial expertise can help you meet your financial objectives. You may need to tap their deep pockets to access additional funds when you need them. Set internal targets to yield the appropriate mix of “Time/Talent/Treasure” within your investor pool.
Find investors who will be partners, not adversaries. Be sure to thoroughly understand what challenges they have faced with their other investments to get a sense of what annoys them and how that matches you and your opportunity. Your business will be making money for them before it makes money for you.
An early temptation might be to raise funds from family members or close friends. While this accessible capital may seem attractive, you may want to consider how many future Thanksgiving dinners you may have to suffer through if their investment comes up short or has difficulties.
Relationships with investors may span a decade or more, so you will want to learn as much about them as you can. A discussion with them can determine how they have dealt with their other investments when business inevitably goes soft or the industry falls into financial crisis. If they have invested in other searchers, reach out to them for a reference. You certainly want to understand their time horizon for the investment to be sure they are aligned with yours. The 2013 Stanford study reports that a searcher runs the acquired business for 7 years on average; are your investors ready for that time frame?
Anticipating that some of investors may not be inclined to invest, keep cultivating additional investors, especially as you dig deeper into an industry. These new entrants with deeper knowledge of the markets and space may provide a source of confidence to your other investors.
It is also important to understand the relationships between your investors. Some may defer to others in your group for guidance, while others may have little-to-no contact or interest in the other investors. When the inevitable disagreement comes up, it will be good to know where the alliances are.
You can expect that some investors will turn out to be much more useful than you imagined, and others may disappoint you. Learn their investment objectives and have sufficient diversity to achieve balance among the investor pool. Be mindful of the future: over a 10-year period, the business, they and you will all change. A diverse group will help with this.
Start reaching out to potential investors early and add them to your investor contact list. You should put them on your quarterly update report so they have a sense of what you are looking at and your activity. It should not be a surprise when you come to them with a “deal” that you want them to invest in.
Soliciting investors when you have a deal under LOI
Be prepared to use a variety of methods to solicit investors. Know which ones respond best to phone, email, letters or even text. Clearly establish how much you are looking for in dollars and units. As with any “sales” effort, be sure to be direct and “ask for the order” more than once!
Investors often are looking for excuses to say “no” and you may not hear the truth about why they won’t invest. Some will not respond to your first inquiry to avoid investing…so be sure to reach out multiple times. In the follow-on appeals use scarcity to your advantage. Words to the effect of “…just a few more units left, and don’t want you to miss out…” may push them along. A non-response after a multiple solicitations probably means “no”. Initial persistence does pay, but after 3-4 attempted contacts you are best setting them aside for a future round of funding.
Set deadlines in your communications with prospective investors. You can always push the dates out, but conveying the message that “time is of the essence” will help prospects focus on the urgency of your appeal. Doren Spinner of Muir Beach Capital recounts that “they need to feel that the train is leaving the station and if their check doesn’t come in, this terrific opportunity will slip by, while they might be out there pursuing the ever-elusive better deal. Convince them that you’ve got a great deal and they should take a unit now, while there are still units to be had.”
Avoid a “roll-out” campaign when raising your capital to fund the acquisition; you just don’t have time to solicit in waves. Develop a list and hit them all at once. Cy Khormaee at Contastic found that “the money was easy or it was impossible”; if you are sensing a very hard sell, then move on to the next investor prospect on your list. However, give them an opportunity to say “yes” to something. Ask for suggestions of others to contact or to provide industry specific advice.
This is the time to practice putting your “sales hat” on. Not the time for a lengthy presentation of the pluses/minuses of the transaction, or the long list of risks, but a clear and enthusiastic commitment to make this happen. After-all, they will be investing in you as much as the business and unlike a startup, the business you buy has a business model that is proven. Showing persistence and confidence that the transaction will close with this seller can push those on the fence over to your side, with a check!
Don’t inundate funding sources with too much information. A two page teaser with a description, future prospects and expected returns can be followed up later with a much more detailed investment memo that you will need for your bank anyway. Expect experienced investors to push back on a number of areas. Provide immediate and thoughtful responses and listen to their underlying message – are they finding a reason to say “no”, or are they testing you to see how you react and how well you listen and learn? Put yourself in each investor’s shoes through this courting process – avoid boilerplate responses.
The deal terms you approach investors with should be very specific, with estimated returns and deal structure that include the interest rate, payment holidays, PIK elements, balloon time frame, equity conversion and penalties for missing payments. It is best to run these terms by a few sophisticated investors first who have made similar commitments to ensure that your appeal is at “market’.
Expect some push-back, as not all investors have similar objectives and many have preferred deal structures. Unless they are providing a significant portion of the capital, say north of 25%, you should stick to your campaign to find investors who will be compliant with your terms.
Always raise more than you need. Inevitably, a few days before closing, someone will drop out or be unavailable with funds. You certainly want to understand their time horizon for the investment to be sure they are aligned with yours. More importantly, you want a 10-15% cash cushion to tide you over the early surprises and hard times. Going back for more equity right after closing is a very painful situation. I have never heard a searcher say “I raised too much”! This will also give you the flexibility to turn down some funding sources when it makes sense to get a more optimal balance among your final investor pool.
Many individuals with a PE background are uncomfortable with the 60-80% equity terms that a self-funded searcher expects to retain. It is best to focus on other types of investors such as entrepreneurs, alumni affinity connections, mentors and senior/retired executives rather than trying to convert a PE potential investor to the search model. Time is too short to attempt to convince the PE types to see it your way.
For funded searchers, be careful to research the “standard terms” and not be embarrassed when an experienced investor calls you out on your boilerplate PPM with adjustment to terms. An attorney who has represented a recently launched funded search will have the best advice about “market” for vesting, equity targets, tax treatment and IRR hurdles.
Start early, get a sense of your investors
The structure of most self funded search transactions result in 20-50% of equity with a 8-15% coupon and the remainder coming from debt. Seller financing in the range of 20-50% with 6-10% interest rate coupled with a deferred payment schedule and balloon payment in the 5-7 year demonstrates their confidence that the business has a strongly sustainable model. Bank financing to make up the rest under the current climate has been generally favorable with 4-7% rates even with asset “light” collateral but historical EBITDA performance.
As in prospecting, you want to get to “no” fast so you can move on to more viable prospects. You may not hear “no”, instead something like “no for now”. When you hear a negative response, set aside your emotions; be appreciative, learn from the feedback and move on. You may need these prospective funders later on down the line. Don’t hesitate to ask them for introductions to other investors who might be interested.
Most investors will want to meet you in person. After all, they are really buying into the deal because of you, not the business. It is your “feet on the street” that will get the deal closed and the operating results that you are projecting. Some may not need to meet with you face-to-face. As searcher Paul Thomson of Scottish American says: “If you don’t meet, it becomes an impersonal relationship. Be prepared for it to always be that way! Is that what you are looking for?”
In a funded search, each investor seldom commits to their allocated percentage, often simply providing a rounded investment number. Moreover, about 30% of the investors simply roll their initial investment and don’t invest further. Other investors may fill the resulting funding gap who know the industry, or it may be necessary to raise from other traditional investors who know the model and will be influenced by the current investors.
Self-funded searchers generally set a unit value and drive to raise their capital from 5-10 investors. While seductive, an investor willing to cover half the units or more, may skew their influence over your actions as you operate the business. Stay the course, increase your outreach and persevere through the process to get a diverse investor group.
Your first LOI is the best place to assess the real commitment level of your investor pool. With a signed term sheet, you can confirm specific deal terms, business model, financial structure and projections. Whether your search is investor-funded or self-funded, it pays to get a sense early on as to where and how much your investors will be committing.
In my own search, I was unable to face raising equity from others – I could just not bear the risk of being unable to pay them back. This drove my need for 100% of the equity, and resulted in a smaller size business that was fraught with financial and operational risk. For self-funded searchers, signing personally on all your debt will be unavoidable; make sure that your significant other is on-board with this.
In today’s market, investors exist and are willing to support your entrepreneurial efforts. The skill set you develop to ask for money will be put to good use as you operate the business going forward.
Feel free to share some of your own best practices or experiences in dealing with these issues in the blog comments. I encourage comments and dialog, allowing all to learn from both my views and the views of others – a virtuous learning cycle. Jump right in!
I think you can raise too much as a funded searcher. I have seen searchers who raised somewhere close to $800,000. That precluded them doing smaller transactions; they never ended up doing a deal. Obviously not many searchers end up doing turnarounds, but the frugality of an innovative search, aligns well with that.
I hear searchers are asked a lot about having to ‘prove’ to brokers and other intermediaries that they have money. I found this a great indication that they aren’t who you should be spending time with. The best sellers identify with you personally, and realize on the deal date the money will arrive in the bank account or it won’t (the proof you have it).
Self-funded searchers show you how frugally you can do a really effective search.
I am interested in your thoughts on cultivating investors for a self-funded search. I imagine you should introduce yourself and meet early on, perhaps while you are forming the LLC and just starting. Can you solicit “letters of support” to help establish credibility with brokers and sellers? Do you have any sense of how many investors are “onboard” at first and make themselves scarce come LOI time?
Ryan, nice follow-up. In general, I do not see much value in anything more than keeping potential investors updated with your intent and progress. Your best opportunity to reach out is when you have your first “deal” so they can see the terms, your asking amount, returns and the nature of the business. This is the best time to “shake out” those that thought you meant $5,000 and not $250,000; I suspect at least 33% bail out. Have not see many searchers having to use a “support letter”, but hear many searchers worrying about it. Jim
Great article as always. A couple of a follow-up question based on Ryan’s comments and what you have written:
(1) In a self funded search what would you recommend as the best way to cultivate a pool of potential investors early so that the initial greet & meet and searcher’s background and intentions are at least out of the way? Coming from a PE background myself, I understand that most investors would be looking for deal/target specifics, but any successful ways to cultivate early relationships that you have seen pay off in this field?
(2) Second question is do you typically see additional equity incentive for the owner/operator in a self-funded search? If so what are the typical ranges versus a funded search?
Justin, there are a number of points of view about this, so am not surprised at these questions.
1. As a self-funder, you want to be cultivating potential investors from the time you consider searching all the way to closing! Just like in your search, these are “prospects”, so find a way to keep track of them all, with enough notes to remind yourself of their interests, family members, background and when/how you met them – putting faces on the investors! Of course, ask each of them for referrals to others and keep track of them. They all should be on your distribution list for your quarterly progress report.
2. As CEO in a self-funded search the range of equity that is yours varies from 51% to 100% with a typical amount at 75% which is all fully vested. Funded searchers are seeing 20-25% and 30% for dual searchers. This “carry” vests over time, with the final 1/3 tied to an IRR hurdle rate. As a caveat, larger size deals with EBITDA in excess of $3M will require higher equity checks that will drive these numbers down, in some cases into the single digits.
Thanks for the great content on EtA searching and operating.
You mentioned an 8-15% coupon for investors in a self-funded search.
Does this replace the 1.5x “step up” of the investors initial investment that we see in funded searches? It compensates the investors for taking the risk at the beginning of the search? And in a self-funded search its the entrepreneur that takes that risk and covers expenses in order to find a deal.
I’d love to get your insights on this.
Atish, thanks for the kind words and observation about the preferred return and step up in the two different models. Both generally have a preferred return which is designed to provide near term cash flow returns to investors. It is paid out to investors before the searcher sees any cash. It is “worth” a lot more to the funded search investor than the 50% step up on the initial capital. In a funded search, investors may be investing 10x their initial investment, easily outdistancing their step up. A self-funded searcher may retain 75-85% of “sweat equity” for sourcing, negotiating, closing, perhaps providing a personal guarantee (PG) and subsequently operating the business to create value for their investors. Clearly a much better return for self funded searchers if they can support themselves during the search phase that may take longer than a funded search and be focused more locally. Search on!!! Jim