Entrepreneurs should understand and compare their options when raising capital.
Most entrepreneurs will need to raise capital at some point in their careers, but they shouldn’t sell their souls to get the capital they need. I refused to give up the equity in my business to financial analysts that were trained to “pick the meat off of my bones.” Here’s an overview that may help entrepreneurs avoid selling their soul to raise capital.
If you need temporary cash for ongoing operations, consider getting a multi-year term loan or a revolving line of credit with a bank. I have had lines of credit with several name-brand banks over the years, and they’re all pretty much the same.
Banks will happily lend you money, but only if you can prove that you don’t need their money. Huh? Yes, it’s kind of dumb, isn’t it? And if they will give you a loan, they’ll usually only lend against your physical assets. So, if you don’t have physical assets (e.g., buildings or equipment) you’re almost certainly going to be out of luck.
Small regional banks are less regulated than the large national banks, so they’ll be slightly easier to work with. When looking for a bank loan of any kind, never deal with just one bank. Always, always, always pit two banks against each other for competitive quotes. This will ensure that you’re paying the lowest possible interest rates with the best terms.
A bank’s interest rates will be about the “cheapest” money you’ll be able to find. However, that cheap money will come with strings attached: the loan covenants. When you borrow the money, the bank will want to periodically review your financials to make sure that you’re not becoming too risky for them. If you accidentally violate the loan covenants you agreed upon, they’ll quickly tie your hands behind your back with a new set of contracts that will choke your business from doing what it needs to do. And if your numbers don’t turn around almost immediately, the bank has the right to demand full repayment of the loan, which could force your business into foreclosure.
Borrowing From Friends And Family
My favorite way to raise capital in the ’90s and early 2000s was to establish a “private lender program” that was only offered to my closest friends and family. I had an attorney research my state’s laws and then draw up the necessary loan paperwork for me.
I would borrow money from friends in $10,000 increments and would offer to pay an interest-only balloon payment of 2 points above the prime lending rate for a 12-month term, and 3 points above prime for a 24-month term. Sure, I paid a little more interest than the typical bank loan, but there were minimal headaches compared to dealing with bankers.
My friends and family loved my “private lender program” and were sad when I stopped offering to pay these great interest rates. The key to administering your own “private lender program” is two-fold. (1) You need to hire an attorney to make sure that you’re doing everything correctly. (2) You must repay everyone their principal with interest on time without exception.
I’d recommend starting small. For example, start a private lender program before you really need the money. Establish a cadence with your friends and family that you always pay all monies on time and are a person of integrity. If you do that, Thanksgiving and Christmas holidays are much less tense!
When my company reached about $2 million in sales, Private Equity (PE) firms started calling me. I was flattered by their calls and took them seriously because I didn’t know if I would someday need their help, and I didn’t want to burn any bridges. Looking back now, I was naive. There are thousands of PE firms, so only take their calls if you are serious about selling a percentage (or all) of your company.
I spent a lot of time explaining my company to about 200 PE firms between 2017 and 2019. PE firms amass large funds of money they want to invest for the purpose of generating a strong percentage return on investment (ROI) for their investors. This makes perfect sense. It’s all about math and percentages for them. Be forewarned that this could be a problem for you if their need for high growth-rate percentages requires them to value your company’s stock at a lower price than you’d prefer.
Ironically, an owner of a good-sized, reputable PE firm looked me in the eyes and actually said, “Man, there’s a lot of meat on the bone here!” Uh, hello? I told him that I’d prefer to keep the meat on my bones. We didn’t do a deal with his firm, but at least he was being honest with me.
As I pitched my company’s story to hundreds of PE firms’ partners and analysts, I found that none of them were able to understand my business. All of these people were highly intelligent, highly educated, and truthfully much smarter than I am. I’m just a lowly entrepreneur with an engineering degree from a non-ivy-league university. Even so, these very brilliant, well-pedigreed financial wizards could not calculate the true value of my business. Instead, they all ran the same generic math calculations and ratios that they probably learned while they were in college. Their goal was to ensure a terrific short-term ROI for their investors, which required them to value my company at fire-sale prices. I was unwilling to allow that to happen.
Was I being hard-headed? Yes, I was. Did I do a poor job telling my company’s story? Perhaps at first, but my presentation got better with time. Even so, every single PE firm ultimately insisted on valuing my business with the exact same short-term EBITDA math calculation, which didn’t apply to my highly-unique company.
To use an analogy, it was almost as if these PE financial hunters were highly skilled at hunting zebras because the results are highly predictable, yielding the most meat on the bone for a reasonable amount of effort. But, my company wasn’t your typical zebra. It was a growing elephant, as described in this press release.
I assumed that these PE hunters would be thrilled to find an elephant, as depicted in this Wall Street Journal article about Warren Buffet looking for his next elephant, but I was wrong. These PE hunters were so skilled at hunting zebras that their trusty math formulas created a blind spot that prevented each of them from spotting a much more valuable asset: An elephant.
The moral of the story when dealing with PE firms is this: Hone your story carefully and know your numbers, but don’t give up your equity unless their terms properly align with the true worth of your business.
If you’re thinking about selling stock in your company, find an attorney that has experience with SEC regulations and private offerings. Sometimes entrepreneurs will cut corners, but the penalties for incorrectly conducting a stock sale are enormous. So do NOT attempt this without a very strong and experienced attorney by your side.
We raised $15 million in a Regulation D stock offering to close friends and family. We hired expensive lawyers to make sure that all aspects of our stock offering properly followed SEC guidelines. Selling a minority share of our company’s stock to friends and family has been a blessing to all of us. They’re the ones who believe in our company and are rooting for our success!
If selling some of your company’s stock to friends and family doesn’t get you the full amount of capital you desire, the next step may be to look for a strategic investor or partner. A strategic partner will not only bring cash to the table, but they’ll also be looking out for your long-term future. Besides supplying cash, they’ll probably either bring products or services that complement your offerings, or they’ll bring a large customer base that can buy your products.
As an example, Patriot Software is in the accounting and payroll software business. In our case, we already have the technical core products that help American businesses. But now, we’d like to find the “right strategic partner” who will open doors to millions of potential new customers for us. That “strategic partner” might end up being a PE firm, a financial institution, or even a competitor for that matter. We just don’t know how this will play out, because we have just begun our search. So, maybe we’ll have another article for you to read someday!
Don’t Sell Your Soul
There are many more ways to raise capital than what I’ve listed here, but hopefully this article has helped you learn from our experiences. Regardless of the capital-raising path that you choose for your business, just remember that there are a lot of people out there looking to pick the meat off of your bones. Don’t let them. Stand firm and don’t sell yourself short!