Bringing in outside investors is always a challenge for an entrepreneur. Having built the business on a good idea and hard work, outside investors demand financial projections, evidence of traction and a clear indication of how their money will be spent. Most of this is part and parcel of good business practice, but it is worth understanding the questions investors are likely to ask, and why they’re asking them, so there are no nasty surprises.
1. What’s your unique selling point?
Investors, especially VCs, typically want to back winners, rather than ‘me too’ companies. First and foremost, you need to be clear on what is different about your business, why no-one else is doing it and why it’s defensible. That also means being clear about your addressable market. How big could you be? How easy it is to get to where you want to go?
2. What is your cash burn rate/runway?
Running out of cash is one of the top reasons for businesses failing. Even profitable businesses can fail if cash is not managed properly. Investors will want to be sure founders understand this and have good control of their costs. ‘Burn rate’ can be either gross (how much cash a company is spending) or net (spending with revenues added back i.e. how much cash a company is losing). ‘Runway’ is the amount of time until the business runs out of money, assuming the current income and expenses stay constant. It is a straightforward calculation that divides the current cash position by the monthly losses.
There’s no correct burn rate but investors will want to check the amount being raised can last until the business is profitable, or at least until the next fundraise. Raising funding takes time and is a distraction from the day to day running of the business. If you are raising £100,000, but are burning through £50,000 of cash a month, that would be a problem. The business needs enough cash to get to its next milestone. Eighteen months’ runway is a good rule of thumb. They will look mostly at net burn if a business has strong recurring revenues with low churn rates. If revenues are lumpy or risky, gross burn becomes more important and understanding which costs could be cut if things don’t go to plan.
3. What is your ambition for the business?
Investors want to find those companies that match their goals. Angel investors may not be looking for the same type of return as venture capitalists. An angel investor may want to turn £100,000 into £1m, while a venture capitalist is looking to create a ‘unicorn’ (unlisted companies with a valuation of $1bn+). It may be your ambition to create the largest possible business – and you may believe you have the addressable market to do it – but this is not the goal of every founder. Some may want to create a business they can pass on to their families, or a cash generative business to provide them with an income. There will be investors who share these goals, but for a harmonious partnership, the two need to match.
4. What is your personal motivation for running the business?
Investors need to understand why you’re there and what you hope to achieve. They need to see that you are passionate about the business and why. That means showing you are fully committed, rather than it being a sideline. They are likely to want to see that you have ‘skin in the game’, with your own money at risk in the business. That said, they will also want to see that you are remunerated appropriately. They don’t want you to be forced to abandon the business, or be unable to sleep at night, because you can’t support yourself or your family.
5. What is the quality and experience of the team you have built?
With early-stage companies, most investors see the team as more important than the business plan. Businesses rarely go entirely to plan and often need to pivot if the first idea doesn’t work as well as hoped. It is the quality and commitment of the team that will determine success or failure. The founder needs to ensure that the team is motivated and shares the vision of the business. Investors will also look at the type of people you have managed to attract and how much you are paying for them. If you have managed to attract some heavy hitters, who are willing to work in the business for a chunk of equity rather than a high salary, that says good things about the business.
6. How will you use the proceeds of your fund-raising?
Too often business owners are vague about the purposes for which they are raising money. They will give a loose split – 10% to technology and 20% to marketing, for example. This implies that the business owner doesn’t really understand how much they need to raise and why; they just feel like they could use a little extra cash in the business. You need to be far more specific in how cash will be allocated across the business. How much do you need to deliver your forecasts? What will it cost to build this individual bit of technology? What will that piece of technology allow you to do? How much will you need to spend on marketing to bring a new product to market? At each point, you need to have a detailed idea of how much it will cost. It’s fine to have a bit of contingency, but investors don’t want to fund ‘a strong balance sheet’ or a war-chest for undefined M&A opportunities.
7. What are your gross margins?
Any investors will want to know that your business can scale effectively. Gross margins are an important indicator of how this will happen and whether or not the business is profitable at scale. Fixed costs are high as a proportion of revenues in the early stages of a business so investors will want to ensure that this improves as the business scales up which is why they will focus on the unit economics. Investors will want to drill into contribution margin, which includes marketing, sales and customer services costs to understand which costs are truly fixed and which scale with the business. They will also want to know about working capital requirements and cash flow timings because this will influence how quickly the business can grow and how much funding it will need to do so.
Inevitably, this only looks at one side. When you take in outside investment, you are relinquishing some of your autonomy and you need to ensure that you can work effectively with your investment partner. At some point, things will go wrong and you will need to have uncomfortable phone-calls with them. It helps if you have a good working relationship, the same goals and can communicate with each other effectively. The right partnership should be mutually supportive and focused on building a strong and resilient business for the long term.
Looking for more information on how to prepare yourself for angel investors? Read our guide on how to find angel investors.
This article was a guest post for Seedrs by Paul Stricker, Head of Venture Capital at Smith & Williamson, who are the only professional services firm offering wealth management and accounting services to both investors and fast growing businesses, including the Seedrs’ portfolio.
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing as at March 2019.
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