The SME’s Guide to Raising Capital: P2 – Who should you raise from?

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This week’s article will look at who to raise money from as you continue your quest of building your own billion-dollar unicorn. If you missed Part 1, you can access it here.

Don’t stress too much about getting “smart money”.

When speaking to entrepreneurs about who they are focusing on raising money from there is often an urge to attract “smart money”; money that will open up doors, connect the dots and help navigate challenges. And why wouldn’t we entrepreneurs want this? We can’t do everything, right?

However, I would say that “smart money” is overplayed and exaggerated. Most entrepreneurs I know get very little from their investors, even the most sophisticated, strategic and well connected among them, apart from cash and a bit of moral support. Investors have their own lives and issues to deal with, and you are nowhere near the top of their priority list. Set your expectations low.

There’s also a common misconception that the holy grail of fundraising is venture capital money. VC money is thought to be the smartest, success-guaranteeing type of funding out there, and entrepreneurs obsess over obtaining it.

Venture capital can certainly open doors and is definitely an indication that your business is on the right track. And there is no doubt that there are many great VC firms backed by really smart people who can help you build your business.

However, even if your business is in a position to receive VC money (no small feat, especially in the MENA region), there are a number of downsides involved with raising money exclusively from VCs.

Think of it this way. When you sign up with a VC, or in fact any “professional” investor, you are effectively signing a contract that you will sell your business within a pre-determined amount of time.  

VCs aren’t investing their own money. They report to the fund’s investors, called limited partners (LPs), who expect to receive returns within the lifetime of the fund. This means a quick, or at least defined, exit path. As such, VCs require a significant amount of control in exchange for their investment so they can try to ensure that an exit occurs within the lifecycle of the fund. Investment comes in and the clock starts ticking. In order to meet this they often have no choice but to throw their weight around — and this is not always in the best interests of the company, but often the best interests of their exit. 

That’s not always a bad thing and may be exactly what you want as a founder. My point is make sure your interests are aligned from day one.

However there is a bigger issue, one which is overlooked by 99% of founders I speak with.

You run a big big risk when getting investment from only one or two investors.

“Why?” you might ask yourself, “I’ve always thought that a small, clean cap table is what I should be after.”

Think about it this way: Say that after using up the funds provided by your own pocket and your friends and family, your business needs to raise to keep growing. You secure investment from two investors who like your business and want to be a part of its growth. Fast forward 18 months, business is good, you’re growing, and you’re ready to take it to the next level. You need to raise again.

Because of pre-emption rights (and probably out of a sense of loyalty as well), you’re going to first approach your initial two investors, who we’ll call Omar and Jessica. Omar says that he would love to reinvest but can’t because his son is off to college this year so he’s cutting back on his investing. Jessica just invested a sizable amount in another business so she doesn’t have the cash to reinvest.

Focusing on professional money only? Then swap Omar and Jessica for VC1 and VC2, who may have changed their investment strategy or provisioned their funds elsewhere

Now you’re stuck with two existing investors who can’t reinvest for reasons not linked to your business’ performance, for reasons beyond your control. Moving forward, the first question you’re going to get from other prospective investors is “why didn’t your current investors reinvest?” Although there are reasons for their decision, which you can attempt to explain away, there will be an instant sensation of delegitimisation in their eyes, an uninspiring feeling of lack of demand, which can make finding investors all the more difficult.

Lesson two: Your primary objective when you raise funds for your business should be getting the cash. “Smart money” or VC funding sound nice but often come with more caveats or less value than you might think. Focus on securing financing as efficiently and conveniently as possible from a broad base of investors so you can refocus your attention on what matters most: building an innovative business.

To learn about the differences between equity and debt financing, and which is more suitable for your business, be sure to check out thethird installment of The SME’s Guide to Raising Capital.

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