Dr. Earl R. Smith II

Dr. Earl R. Smith II
Managing Partner, The Federal Circle
DrSmith@Dr-Smith.com
Dr-Smith.com

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After the rush of figuring out a new idea for your business and pulling together a team to run it, one challenge faces all entrepreneurs. They must find the necessary financial resources. For some, the ‘money hunt’ can come to dominate their activities. Others find solutions that allow them to at least launch the business. Many companies founder because the team never figures out how to meet this challenge. How you meet this need is one of the most important steps in determining if your company is at least going to have the chance to succeed.

Early-Stage Funding Options

One of the principal reasons that founders find such difficulty in meeting this funding challenge is that they try to skip stages in the process. Many of them try to raise funds far in excess of the levels that their current situation merits. Investors make a distinction between a business builder and a lazy entrepreneur. The latter generally has a poorly written business plan or a vague idea for a business and approached them looking for five or ten million dollars to their ‘idea’. The former has shown prudence, professionalism and a sense of proportion in their efforts. One get serious attention while the other is the butt of jokes.

For a very early stage company, true funding requirements may extend only to filling the need to perfect the value proposition and develop a prototype. During this ‘project’ stage, there is no clear demonstration that the underlying value proposition can be monetized. There are no customers who have indicated, through their purchases, that what the company is offering is worth the projected cost. At this stage, entrepreneurs need to tap the three ‘Fs’ to meet these needs; friends, family and fools. Approaches to other sources will, for the most part, result in a waste of time and energy with little prospect of success.

Good entrepreneurs understand that they have to develop their company to a certain stage before either angel investors or venture capitalists will give serious consideration to funding it. But the challenge remains. Even the three ‘Fs’ may not be enough to get it to that stage. At this point, founders need to become very creative in their approach. There are many other, early-stage sources that can be tapped. Here are just a few of them:

• SBIR and STTR Funding: For certain companies, government funding is a real possibility. These programs offer money for development of prototypes and even simply proof of concept. In fact, stage one of the SBIR program is exactly that. In return for the right to use the results, almost every government agency will fund such proof of concepts in areas that they are interested and for problems that they need solved. Stage two of these programs offer follow-on funding for further development. The company retains the developed intellectual property with only the above restrictions.
• Potential Customers: This approach is a first, major test of the value proposition that the company is promoting. The logic is, ‘if your product or service is as valuable as you think it is, your potential customers should have an interest in its development’. Many companies have been launched using this approach and never had to go the further step of raising venture capital. There are additional benefits of this approach. First, you get to test your ideas in the real world. Second, your potential customers will help you refine your value proposition. Third, they will help you expand your pool of potential customers through referrals and references.
• Joint Ventures: Another option is to find a well established company to partner with. Although there are dangers involved such as keeping control of the intellectual property, many companies have successfully managed this risk and tapped into significant financial resources. Joint ventures are particularly relevant for high-technology companies that have either cutting edge or disruptive technologies.
• Grants: There are organizations and associations which are dedicated to supporting the development of certain technologies. Many of these provide development grants to emerging companies. Although the amounts may be small, the restrictions on the use of proceeds are generally few. Some companies have accessed a fairly regular stream of these grants to support development of new innovations or functionality.
• Bootstrapping: Sweat equity is defined as the time and effort that a team invests in getting a business to the stage where investors will be interested. This means taking it beyond the ‘business plan’ stage by sheer force of will and dedication. It may mean that founders will have to go without a paycheck for some time or that they will make barter arrangements that will give them access to the resources they need. They may have to take out a mortgage on their house or invest their savings. Such bootstrapping demonstrates a determination to succeed that extends well beyond verbal statements of commitment.
• Business Plan Competitions: Many universities and associations organize business plan competitions. The prize is often funding in the form of a grant or award. These competitions have a number of benefits. The first is that they force the team to finely hone their value proposition and translate it into a professionally drawn business plan. A second is that it brings the team into contact with other, competing teams. This gives them direct experience with the dedication, resourcefulness and professionalism of other teams. A third benefit is that the competition is generally judged by people very experienced in the start-up game. Some may be investors who will take the time to help the team perfect its business plan and value proposition.
• Micro-loans: There are financial organizations that specialize in making small loans to start-up companies. They are specialized banks. The loans are generally small but can be very useful in developing prototypes or bringing key team members on board. For the most part, these organizations recognize that they are making relatively high-risk loans. Their purpose is to support entrepreneurial activity.

These and other funding sources can be very useful in getting a company through the early-stage. The objective of the founders should be to use them to develop the product or service to the point that the company will be of interest to investors who will look at it from a return on investment perspective. Investors will require a clear demonstration that the value proposition can be monetized and that the team is capable of managing that monetization. They will also look for indications that the team is very good at getting the most out of limited financial resources. Once a company gets to this stage, they are ready to start the hunt for larger amounts of funding. They have a number of options.

Funding a Going Concern

The good news is that the funding approaches for going concerns is much more organized than the early-stage sources. The bad news is that they are much more competitive and challenging. Here are just a few options:

• Angel Investors: Angel investors are generally high net worth individuals who have decided to make early-stage investment in emerging companies. Sometimes they operate individually and at other times they form angel investment associations. Many of these either organize or support forums which allow early-stage teams to present. Angel investors tend to participate in companies in specific spaces. Most of the groups have websites which list their portfolio companies and outline their investment approach. It is important to make sure that you are presenting to a group or individual that is interested in your space. Angels approach each company as business decision and expect a return on their investment. This tends to be a real challenge to early-stage teams as it may be the first time they will be forced to see their company in that light. A benefit of angel investors is that they will often consider smaller investments.
• Venture Capital Funds: These funds tend to be more organized than angel groups. For the most part, they are investing money provided by institutional investors like pension funds. As fund managers, they are responsible to those institutional sources for generating a substantial return on the money. Because the cost of diligence can be very high, these funds tend to prefer larger investments. That may seem like good news, but the bad news is that they will want a company to be much more advanced in the process of monetizing the value proposition. In addition to a good product or service, you will need a growing, referencable customer base and very good profit margins in order to attract their attention. Venture funds tend to look at a company from an investment perspective and within a fairly short time-line to a future liquidity event. Entrepreneurs who have eschewed venture funding for self-funding do so in order to avoid this pressure. Keep in mind that the venture fund makes its profit when you sell the business, take it public or bring in additional funding. None of these options may have a positive impact on your long-term strategies. Also, venture funds will almost certainly require either a seat on your board of directors or the right to appoint an outside director. They generally push hard for more professional governance and oversight.
• Customer Financing: If you have been successful in getting potential customers to fund your early-stage, you may be in particularly strong position when your company begins to turn a profit. This may be some of the least expensive funding you can access. If you have carefully built a relationship with a range of customers, they may provide additional funding in the form of advance orders or forward-looking commitments. The good news here is that the obligations to them will disappear when you deliver on your commitments.
• Bank Credit Lines: At some point, if you are good at growing your business, your company will become ‘bankable’. That means that it will qualify for a credit line. Initially this line may be used to financing receivables. The bank may loan against purchase orders and give you the working capital necessary to deliver on those orders. If you mange the line well, they may eventually let you use some of it for working capital to make forward investments in expanding the business. A word of caution about bankers; they expect to be paid back on time and with interest. Failure to do so will quickly sour the relationship. So, be careful and prudent when it comes to such credit lines.
• Business Credit Cards: A word of caution first. It is very important to keep business credit separate from personal credit. You may be offered business credit cards rather casually. It is important that you treat them as business credit. Credit cards can be used to fund travel expenses and short-term purchases. It is important to pay them off in a timely fashion. Failure to do so will negatively impact the credit rating of the company and may cause you problems with other sources of credit or funding. A good payment history will improve your access to those other sources.

Prudence, Professionalism and Proportion

The first rule in funding a business is prudence. Do not waste time and energy chasing funding sources that are highly unlikely to fund your business. The second is professionalism. Approach each funding stage in an organized and professional manner. This becomes more important as your company grows but it is essential to take a professional approach from the very beginning. The third rule is proportion. Make sure that you are working to access levels and types of funding that match the stage and condition of your company. Funding a company from start-up through profitability is a major challenge that all founders face. It makes little sense to make the process more difficult by ignoring these simple rules.

© Dr. Earl R. Smith II

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Related Articles:

• Angel Investors to Avoid

• Angel Investors – The Good, Bad and Very Ugly

• Presentations from the Investor’s Perspective

• Protecting Investor Interests: Quick Assessment, the Short List

• Moving the Ball

• Lack of Accountability – The Core of Failure

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Dr. Smith is Managing Partner of The Federal Circle. The Federal Circle partners with teams and existing companies. We help them up their game and win big in the Federal space. We also arrange funding for acquisitions and expansion by acquisition. Our model is based on the belief that, if you select the very best and work with them in a highly professional and focused manner, the results will be truly amazing. He is the author of Amazing Pace: Turbo-charged Business Development – a book that shows how Advisory Boards can dramatically increase revenue. Dr. Smith is also the author of Dream Walk: Parables for the Living – a book of Raven Tales and exploration.

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