Brian Hamilton: Is Your Capital Outrunning You?

Let’s say that we had no business, no business experience, and no business idea. What would these “assets” be worth to a potential investor or to us for that matter? Hopefully, your answer is zero. Now, let’s say we don’t have a business or experience, but we do have a good idea. What is this worth? Well, it could be worth a lot, but, more often than not, it is still worth zero or close to that. Would you feel good about investing in this or, if you are the entrepreneur, going after capital? Of course not. Finally, let’s say you have a business that is running and generating revenue, some business experience, and a good idea. This combination may be worth something to someone. As such, and depending upon the stage of the business, it may require capital.

The challenge starts when capital starts to outrun the development of a business. Think of the process like two trains, A and B, running along two parallel rail lines: the amount of capital you obtain (where Train A is on the line) should reflect the maturity of your business (where Train B is). It is nearly impossible to have the trains running synchronously, alongside one another. But, if you are seeking capital and if Train A is in North America, hopefully Train B is not in, for instance, Antarctica. Today, given the frothy market conditions that exist in raising money—as evidenced by seemingly crazy high valuations, especially among technology firms—we are reaching a point where the trains are not always in sight of one another.

Now, this may seem like common sense to you, but you might be surprised at how often sophisticated investors get this wrong, even some people at venture firms who are supposed to be “smart money.” Maybe this is one reason why so many of these firms have horrific returns in the long run. A study by Cambridge Associates showed that 10-year returns of U.S. venture capital firms fell to – 4.6 percent earlier this year. The 5-year returns are down slightly, too.

We can agree that it is bad if you cannot raise sufficient capital in your business to take advantage of opportunities that crop up. On the other side, if you raise too much money, you dilute your position in the company and, more importantly, will often spend the money too loosely or in ways inappropriate for a business at your level of development. This inappropriate spending often proceeds under the ill-fated assumption that you can always raise another “round” later, which may or may not be true since markets tend to change very quickly. Remember, the way you start to grow your tree is often the way it tends to mature. Entrepreneurs who get caught raising too much money can develop very bad spending habits, won’t develop discipline around finding the right customers and markets, and, by the way, can end up losing control of their companies to venture partners who are not always good at running companies either.

Here are some practical takeaways:

1. Obtain some market validation of your idea before you go and solicit someone’s money. Most ideas can be vetted with fairly simple and inexpensive market tests. See if the market (i.e. customers) will or might give you money for your concept before you take other people’s money—investment capital. Frankly, in most cases and for most people, you should at least have a product with some demand before you accept capital, and there are many inexpensive ways to develop a product if you apply some creativity.

2. Sell common stock before you sell preferred stock. In the beginning, this precludes the venture guys, which is usually a good thing. Preferred stock is extremely expensive money: it gives investors all the advantages of both common stock and bond holders. Yet, it is almost always bad for the entrepreneur and founders (On the other hand, if you have a pile of cash on hand, you should try to be a preferred investor). Venture rounds may be fine later on, but be cautious about what you are giving away at the outset. While recently watching “Shark Tank” on ABC, it turned my stomach to see prospective entrepreneurs giving away so much ownership of their new ventures for so little money. It is better to find “angels” or people who are wealthy and have built successful businesses in the past. These people will be more in sync with you, professionally and psychologically. Later on, you can raise professional money (or not) if you need to.

3. Know when “to go.” There are times in the business lifecycle when you must move very fast. Unfortunately, too many of us tend to think this urgency is constant, today, and momentous. Most great businesses take some time to percolate, some time to really understand their customers and markets. This can take a while, even years. There are very few overnight successes, and popular media does a great disservice to entrepreneurs by making them feel as if their businesses should immediately start growing by 1,000 percent every single year. Yet, when the time is right and you have the right product and market, there is nothing wrong with expanding quickly through capital infusion. Generally, you should raise the money you need to fund X amount of growth or development over Y time; have a plan when seeking capital rather than accept whatever terms come your way. This is not a perfect science and takes some judgment, but there are times when you can just look at a deal and tell something is amiss. If a company with no revenue raises $50 million, I become immediately suspicious. It usually indicates that the entrepreneurs or investment partners are on the wrong path. It is much better to raise money slowly as your business model progresses. Don’t forget, too, that if you do this and if your business is growing, you will be raising money successively at higher valuations, which means less dilution for current owners, not a small consideration. This is why companies are now going public using a “low float” strategy, selling only a small amount of stock to the public.

4. My friend Stan Pratt, founder of Abbott Capital and Venture Economics, once advised, “You should interview the venture fund/investor as hard as they are interviewing you during the process of raising money.” I remember thinking to myself, “That’s easy to say if you don’t need money.” Now, I realize the great wisdom in Stan’s words. It is so hard to develop discipline around this because most entrepreneurs want so much to get capital that they look beyond the pitfalls of a deal or the personality defects of potential partners. You must be extremely cautious and selective when evaluating potential business partners because they will be integral to your success or failure.

There will always be good and bad cycles in business. Today, we are in a good cycle to raise money, but that does not mean we should ignore basic concepts for how to properly raise capital. Trying to raise money in relation to your firm’s maturity—keeping Train A even with Train B—takes some discipline but will save you from stress and problems later.

Brian Hamilton is the CEO of SageWorks Inc. He blogs here; opinions expressed in this column are entirely his own.