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Sweet marketing music

Tanner Montague came to town from Seattle having never owned his own music venue before. He’s a musician himself, so he has a pretty good sense of good music, but he also wandered into a crowded music scene filled with concert venues large and small.But the owner of Green Room thinks he found a void in the market. It’s lacking, he says, in places serving between 200 and 500 people, a sweet spot he thinks could be a draw for both some national acts not quite big enough yet for arena gigs and local acts looking for a launching pad.“I felt that size would do well in the city to offer more options,” he says. “My goal was to A, bring another option for national acts but then, B, have a great spot for local bands to start.”Right or wrong, something seems to be working, he says. He’s got a full calendar of concerts booked out several months. How did he, as a newcomer to the market in an industry filled with competition, get the attention of the local concertgoer?

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by Scott Riser
November 2002

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Finance

business builder finance

No bootstraps: Where to look for capital to grow

by Scott Riser

THE DIFFERENCE BETWEEN success and failure for an emerging business often is the availability of enough capital to build infrastructure, fund research and development, and advertise the company’s products or services.

An underfunded new venture will, at worst, fail, and at best will be forced to rely on bootstrapping (funding operations from self-generated profits and cash flow). While bootstrapping is certainly a romantic notion, it is also likely to delay or prevent the growth of the business.

So where does the emerging business obtain sufficient capital to fund growth? The very nature of a start-up (untested new products, no operating history) limits the availability of traditional bank financing. Frequently the first source of financing for a new company comes from friends and family (F&F).

Obtaining capital from friends and family certainly has its advantages. Usually the investment is in the form of a loan, so the entrepreneur keeps full control of the business, and the interest rate is frequently lower than that which could be obtained from an unrelated third party (after all, Mom isn’t going to charge you credit card rates). Also, since asking F&F for money may not qualify as a “public offering” under the Securities Act of 1933, there are generally no SEC or state filing requirements and only limited disclosure requirements.

More pressure

The down side to borrowing money from F&F is really more emotional than financial. You are asking people who are close to you to make a decidedly risky investment with the possibility of the loss of all money invested, so you will feel even more than the normal pressure to make the business succeed. F&F who invest money in a business may feel entitled to have a say in the operations of the business even if they are not stockholders, which is an unwelcome distraction to a new owner trying to get a business up and running. So what happens if you don’t have the proverbial “rich uncle” to borrow money from to get your business going? Or if you have exhausted all your F&F sources and still need more money to start up or expand operations? The next step for many entrepreneurs is to look for “angel” investors. Angels are high net worth individuals who have made a full- or part-time career out of investing in emerging companies. While angels come in all shapes and sizes, they have certain characteristics in common:

• They almost always meet the definition of an accredited investor.

• They usually have business ownership or upper management experience and frequently invest only in industries with which they are familiar.

• They possess a considerable amount of business savvy by themselves and fill in gaps in that knowledge through association with highly competent legal and financial professionals.

• They want to make money.

This final point is what separates the “rich uncle” from the angel investor. While your friends and family may be driven by altruism as much as profit when investing in your business, angel investors possess no such illusions. Angels expect to make a 30 percent to 40 percent annualized return on their investment. As such, angel investment usually takes the form of an equity position in the company.

Sometimes angel deals are structured as debt, but it is high-rate debt (as much as 18 percent) and the debt (along with any unpaid accrued interest) is usually convertible to equity at a pre-determined ratio. Since dealing with angel investors almost always involves selling equity in the company, the concept of valuation becomes important.

Business valuation is a complex discipline and its discussion is beyond the scope of this article, but suffice it to say that you should engage a valuation professional and have an idea of what your business is worth before approaching angel investors.

Once you have a valuation in mind, and know how much money you are looking for, you can begin the process of approaching angels. An important topic that will emerge in these discussions is the concept of “pre-money” (before investment) and “post-money” (after investment) valuations. It is important that all parties to the investment discussion agree on these numbers, as it will affect the amount of equity in the company you have to give up.

After all, your goal in these negotiations is to get the money that you are looking for while giving up as little stock in your company as possible. Let’s say you are looking for a $5 million investment in your company, which you believe is today worth $10 million (the pre-money valuation). The postmoney valuation is therefore $15 million (the pre-money valuation plus the new capital invested). Using your numbers, you would have to give up 33 percent of your company to do this deal. But if the angel thinks your company is worth $10 million post-money, then it will want 50 percent of your company in return for the investment. Quite the difference depending on which term you are using.

Another characteristic of angel investors is the need for an exit strategy. Angels are not looking to be in business with you for the long haul. They have a short time horizon, usually no more than five years, and are looking for high-growth businesses with the potential to attract venture fund capital, be sold to a larger company, or go public. Your deal with the angel investor will likely include a provision for the company to redeem the angel’s stock upon the occurrence of any of these types of “triggering events”.

Identifying, attracting and then ultimately getting money from angel investors is a time-consuming process that requires significant planning and personal networking. Before even approaching the angel community, you need to have a polished business plan. The plan should include a detailed description of the products or services your business provides, a market analysis (including discussion of any barriers to entry in the marketplace), bios on management and directors, and historical (if applicable) and prospective financial information, among other items.

You should be able to boil down your business plan into a three-minute “elevator pitch” that you will give to your prospective angels. This elevator pitch is vital because, if executed successfully, it will open the door to further discussions with the angel, including a detailed presentation of your business plan, which could ultimately end up with the angel investing in your company.

Persistence is the key to finding angel investors. The Internet has spawned a host of “matchmaker” sites where angel investors and entrepreneurs can get together, but personal connections are really still the primary way that angel funding is obtained. Networking with accountants, attorneys, bankers, stockbrokers and other “gatekeepers” in the financial community is a good way of getting an introduction to angels. A couple of key points to remember when out looking for angel investors:

• If at all possible, avoid general public solicitation (such as advertising) as a method of attracting investment. This type of general solicitation potentially exposes you to complex, time-consuming and costly SEC registration requirements.

• Make sure that the personal and financial characteristics of the angel are a good fit with your personality and management style. Your deal with an angel investor will likely include a seat on your board of directors, so you want someone there whom you can work with effectively.

One financing source not discussed so far is the venture capital (VC) firm. VC firms are really just collections of angels or institutional investors who have pooled their money and hired a professional manager to invest it for them, so many of the concepts in dealing with individual angel investors also apply to dealing with VC firms.

Because the VC firms pool the money of numerous angels into one fund, they frequently have more money to invest than the individual angel. On the other hand, VC firms often require a higher potential return (40 percent to 50 percent), as they have to cover overhead and provide for the fund managerÕs salary.

While it is true that venture investment has slowed in the post-dot-com era, the money has not evaporated by any means. In fact, there is a significant amount of money on the sidelines, just waiting for the next big opportunity. If you have a good business model, you can get funding. All it takes after that is planning, persistence and patience to find the financing you need to grow your busines

[contact] Scott Riser, CPA, is a consultant with Virchow, Krause & Co. in Bloomington, where he helps emerging companies attract capital: 952.835.1344; sriser@virchowkrause.com; www.virchowkrause.com