You’ve likely heard the adage, “it takes money to make money.” While this is generally true, most business and real estate entrepreneurs will tell you it doesn’t always take your money to make money.
The idea of leveraging “other people’s money,” also known as OPM, has become extremely popular in the post dot-com world. From single purchases of real estate to multi-billion dollar private equity purchases, leveraging the money of others has become a distinct part of our financial culture.
If you are a person of vision who can create value in a business, real estate or any other type of investment transaction, the opportunities are truly limitless, regardless of whether you have the funds to do the transaction on your own. But raising funds from outside sources can be tricky. The Securities and Exchange Commission (SEC) has regulations that both protect and restrict average investors.
Potential funding sources range from banks and credit cards to friends and family to angel investors and venture capital funds. With so many avenues, it can be difficult for an investor to decide where to start.
Find your message
The first step in raising capital is to identify “what your story is and how well you can articulate your story,” Dave Parker, CEO and founder of 9SPACES, Inc., who has successfully raised millions of dollars for his own companies and others, said.
Angel investor Scott Greenburg, who invested with Starbucks and T-Mobile in their early stages, said the first thing he looks for in an angel investment is a message and a messenger.
Many entrepreneurs get caught up in the details and have trouble seeing the big picture; an advisory board can help simplify the message and turn it “into a story that you can communicate in a way that other people can repeat it,” Parker said.
Legal counsel is another crucial component to the initial team, Parker said. He recommended asking around to find out which attorneys are great at helping startups raise money.
It is worth the time and dollars spent to find the right attorney, Parker said. “It’s not going to be cheap to put together, for example, a private placement document or a pitch book, but getting their perspective just to help you even craft the message is incredibly valuable.”
An attorney can help determine which structure makes the most sense for the project or company. That structure needs to be in place before investors will fund the venture, Parker said. “You can talk to as many investors as you want, but until you have some of those things in place, like incorporating, no one will write you a check.”
Entrepreneurs should know whether the project will become a lifestyle business or a business they will sell, Parker said. Careful analysis of the market and projections for margins should be completed before approaching investors, and it should be clear that it is a company and not just a product being pitched, he said.
Specific documents to prepare include a business plan, executive summary, slideshow presentation and financial model. A realistic time frame for the project should also be set, according to Todd Millar, founder of Glenn Simon Inc., a real estate joint venture investment company in Edmonton, Alberta.
“First and foremost, I think you need to have your business plan in order…and then have a clear plan in place for your project. You’d want to include a detailed structure of risks and how you’d mitigate and manage those risks,” Millar said.
The executive summary should be a compelling one-page document that inspires investors to agree to a meeting, Parker said. Next, a slideshow or PowerPoint presentation must be developed that briefly and concisely conveys the opportunity and financial model to investors. Parker recommended Guy Kawasaki’s book The Art of the Start for tips on the presentation.
If the entrepreneur doesn’t have experience developing a financial model, another member of the team should be someone who can help with that, Parker said. “It’s important that you’re able to put some metrics into place that helps your investor understand what are the economic drivers in the business and how do you make money.”
Once a solid plan is in place, it’s time to look for funding.
Tap your personal network
The first and most obvious source of funding is yourself. Savings, home equity, traditional loans and credit cards are common funding sources. It’s important to factor the amount of interest charged on that financing into the investment’s projected returns.
“You are going to have to supply the initial funding to your company, by whatever means possible, and that almost always requires some degree of personal debt,” Frank Demmler, Associate Teaching Professor of Entrepreneurship at the Donald H. Jones Center for Entrepreneurship at the Tepper School of Business at Carnegie Mellon University, said in his article “The Most Frequent Source of Funding.”
After the individual investor is tapped out, family and friends are a natural next step. This can range from close friends and immediate family to friends of friends and business associates. Friends and family may not require the detailed presentation, business plan and financial model in order to invest, Parker said.
The best initial source of outside funding is “your immediate circle” of associates, friends and family, Millar said. “They know you…and they’re more likely to invest with you.”
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Money from friends and family is “respectfully called ‘dumb money’ versus ‘smart money,’” Parker said. This means it comes from people who believe in the entrepreneur and who won’t necessarily ask tough questions about the market and business plan, he said.
“No one’s going to invest in someone without a track record of successful investing unless they know them and love them and trust them,” Mark Mirkin, partner at Williams Mullen law firm in North Carolina who works with many entrepreneurs and emerging companies, said.
“Your friends and family have the added value of knowing you, knowing your reputation, and knowing, vicariously, your product,” John Humphreys, a business attorney with McCarthy Tétrault in Toronto, said.
“Where I would offer caution is when an investment ‘goes sour.’ That is, what happens if friends and family want their cash back, and you need it to continue on, or, where the product or company fails. It could be very problematic,” Humphreys said.
There are both pros and cons to raising money from family and friends, Parker said. “They’re the easiest people to raise money from, [but]…you don’t want it to ruin a friendship or hurt the relationship.”
The best way to protect relationships is to “outline all of the objectives for the investment in advance,” on paper, with signatures, so that each party’s expectations are clear up front, Parker said.
Professional contacts such as lawyers and CPAs can be helpful in connecting interested parties. “You need to tap into networked people,” including past business contacts and people who are cashed out of ventures and looking for new ventures, Mirkin said.
Approaching potential funders “cold” is far less effective than tapping an inside source or reference. Networking can also potentially avoid SEC regulations that restrict solicitation for investment offerings.
Any initial meeting with potential investors “has got to be based on either a strong recommendation of a mutual friend or associate and shouldn’t constitute a cold call, because if it’s a cold call, there’s a very skinny likelihood of success,” Mirkin said.
“You can’t do any general solicitation, you certainly can’t do any advertising, so you’re working on reputation and networking,” Mirkin said.
Expand your network
When your personal network is tapped out, the next group to consider are angel investors, “jokingly called ‘doctor, lawyer, rich guy,’” Parker said. These are independent individuals who invest in the early stages of private business ventures.
Angel investors are usually high net worth individuals who qualify as accredited investors, so pursuing them doesn’t typically create complications with SEC rules on solicitation.
Typical angel investments range from $25,000 to $100,000, Parker said. Having an inside contact at an angel investor group or an introduction through a mutual friend is likely to significantly improve the chances of success.
A variety of angel investor networking groups exist, and entrepreneurs can find local groups through a quick Google search, Parker said. He recommended university entrepreneur programs as another helpful avenue.
Before presenting a pitch to an angel investor or entrepreneur group, an entrepreneur should “go and listen to pitches that you see there…and after that, I would try to get on their schedule and present…[but] I would use the opportunity to go listen to other people present first,” Parker said.
The next sphere beyond angel investors are venture capital funds, which consist of professionally managed capital aimed at new and emerging business ventures. These pooled funds typically make much larger investments than angel investors, with investments often in the millions.
Because many venture capital firms specialize in industries, stages of growth and regions, Parker recommended that entrepreneurs research firms carefully to determine whether they fit that firm’s profile. “If they’re a late-stage bio tech fund, and you’re an early-stage IT company, you can call them all you want; it’s just going to end up as a very frustrating process.”
Most venture capital funds have formulas that allow them to quickly screen out deals and decide whether the deal aligns with their criteria, Parker said. “You need to understand whose formula you fit in.”
Even in the venture capital business, “it’s who you know,” Parker said in an article he wrote for OneAccord, a sales and marketing company in which he is a partner. “Most venture capitalists will consider your idea only upon referral from someone they trust.”
Present your pitch
After sources have been identified, it generally takes some negotiation and convincing to secure their investments. This means selling them on both the project and the person or team behind it.
“Finding and securing investors is all about two things: (i) your connections; and (ii) your product. If you have the right connections, very often with an investment banker, or with wealthy investors, then you can raise capital, provided your product/service [has] a reasonable chance of profit,” Humphreys said.
Greenburg said he looks for the character of the entrepreneur and a strong determination to succeed when deciding which projects to fund. He said he wants to know that the person would lose sleep over failures; he would not want to invest in someone “who can fail several times and never feel it.”
Confidence, consistency and integrity are three components entrepreneurs should strive for when seeking funding, Millar said.
Investor decisions are influenced by a variety of factors, such as “charm, charisma, the principals, timing, location…everything you can imagine,” Mirkin said.
A significant personal investment into the project and a track record of successful projects are compelling ways to convince outside sources to support the project. A financial commitment demonstrates that the entrepreneur has a personal stake in the project’s success and will suffer if it fails.
“Make sure that you have a good track record behind you or at least have some of your own seed money…invested up front,” Millar said.
When presenting a project, it is crucial to be organized, prepare for questions and provide references, Millar said. If no references from past deals are available, professional colleagues in the industry can suffice, he said.
In addition, “you can’t need the money too much,” he said. “Investors can smell desperation…and if they do, they’re going to run.”
Courting investors requires “a lot of time and commitment and negotiating and lunches and dinners and time away from family…getting to know these investors who really sort of become like family,” Mirkin said.
Plan for the future
Because networking and reputation are essential to the process of seeking outside funding, all projects must be conducted with an eye to future relationships. Successful projects and satisfied investors will spread the word and facilitate future opportunities.
“The best way to attract more capital is to have delivered above and beyond what has been expected of you,” Millar said.
If investors have achieved a successful profit with a smooth transaction, “they’re going to be calling you back and asking you…when’s the next deal coming up?” Millar said. “And they’ll be telling their associates about that.”
“Definitely under-promise and over-deliver…because that’s what’s going to make the investment good…and bring back and generate more investors,” Millar said.
Entrepreneurs who treat other people’s money with respect, putting their partners’ returns ahead of their own, will find repeat business easy to find, Millar said. “Then all the money that you need…all the capital, all the help, all the expertise you need will flow to you once you’ve done that, once you’ve put them first.”
“The thing that I do, what I try and focus on, is always putting my investor first,” Millar said. “In order to be successful…you have to find the win for that investor, and you have to look at how you’re going to make that profit after you’ve made that win for them.”
Accredited investors include individuals with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 in those years and a reasonable expectation of the same income level in the current year, or people with an individual net worth (or joint net worth with a spouse) of more than $1 million at the time of the purchase.
Certain types of entities also qualify as accredited investors, including banks, insurance companies, registered investment companies and certain types of businesses, trusts and employee benefit plans. (A more detailed definition is available on the SEC website at http://www.sec.gov/answers/accred.htm.)
Accredited and nonaccredited investors each offer certain advantages and disadvantages:
- Sophisticated, able to make educated choices and evaluate risk
- Receive less sympathy in court in the event of litigation
- Require less in depth disclosure
- Funding process happens faster
- Tend to make larger investments
- Small pool of accredited investors
- Harder to access; more competition
- Many project structures allow an unlimited number of accredited investors
- Less experience making educated choices and evaluating risk
- Often receive court sympathy in the event of litigation
- Require significant in depth disclosure
- Funding process happens slower
- Tend to make smaller investments
- Large pool of nonaccredited investors
- Easier to access; less competition
- Many project structures limit the number of nonaccredited investors
COMMON MISTAKES IN RAISING OUTSIDE FUNDING
- Not using an attorney
- Not having a backup plan (ideally, multiple backup plans)
- Assuming investors are on board before they make a financial or legal commitment
- Being deterred by rejections
- Acting too desperate
- Lacking confidence
- Not allowing process enough time (last minute)