Why Capital Raises Fail

Garrett Fisher
June 15, 2013

It is a fact that more capital raises fail than succeed. The advice put out for a successful capital raise is incredibly long – from the cliché to the unique. For example, a rather unique article went something to the effect of “17 Things Not to Say to a Venture Capitalist.” That’s correct – 17. It was not 17 things one should ensure of in the capital raise process – 17 phrases not to say. That is evidence that the school of thought on capital raises has gotten too bloated and oblique. At the end of the day, a capital raise is a sales process – and sales need not be that complicated. Two parties need to agree that it is in their best interests to proceed with the deal.

The bottom line to a successful capital raise is to be realistic. It is that simple. All capital raise advice rides on top of that basic maxim. To make more sense out of this idea, lets consider essential components to the raise process and how realism is beneficial.

    • Product. Is the underlying product that the company will bring to market or expand realistic? Are the assumptions based on reality, clearly defined and well thought out? The biggest factor in a capital raise is what the subject company will be selling to the marketplace. If the product cannot achieve the volume expected, margins promulgated or stay under direct selling costs as forecast, then the entire offering loses confidence. Why invest in a good management team or company if the key driver to profitability is faulty? An essential component to accurate product assumptions is to get in the mind of the customer. Is it realistic that a customer will pay a certain amount or that a certain amount of customers will purchase the product? The only way to know that for certain is to spend time coming at the product pro forma thinking like a customer. Further to that concept is to then articulate the case and connect it to proposed financial performance. Overall projected company performance is the number one place entrepreneurs love to make an impression. Showing a “hockey stick” growth chart or cumulative cash balances is exciting yet fails to consider the key point. A hockey stick is exciting when the specific product and associated revenue is clearly articulated and connected to bottom line numbers.  Investors are smart enough to see if projections are based on faulty assumptions.
    • Ownership Amount. Much like any sales process, the ownership amount being offered to a potential investor is subject to a push-pull between the company and the investor. It is natural that both sides want as much of the deal as possible. However, it is common that founders are unable to step out of their own shoes and consider the perspective of the investor. Emotions get involved and some interesting things come out of the mouths of founders. I have seen companies with no revenue or prototypes state that “this is a billion dollar opportunity” and chafe at giving up more than a minority of a company. Other situations play to the apparent stupidity of the investor – offering a shred of ownership with next to no rights or upside potential for exorbitant investments. The common theme is that the approach taken is not realistic. Investors are partners in an enterprise. To sideline them as ignorant fools best kept out of the picture is a common course of action – and again not realistic. Seeking investment capital is like a romantic relationship – the only way it works for any length of time is to make sure there is a good match. Further, ignoring the business savvy and marketplace connections of a possible investor is tantamount to turning away free labor. Unless the investor has acquired their capital by inheritance or chance, they are probably on the smarter side of businesspersons. To have acquired enough of a capital base to consider investing as an angel or venture investment indicates that the person is of above average intelligence and shrewdness. That being said, I continuously scratch my head at offerings that leave the founder with a significant majority and yet propounds to offer almost all of the risk to the investor for an unrealistic amount of ownership.The issue behind ownership percentages comes down to valuation of the company. Investors look at a company based on what it is worth at the moment they are investing. If there is nothing but some basic intellectual property, then the company is plausibly worth next to nothing. In such a case, a significant angel investment would command a significant majority of the company – except that the investor wishes the founder to be engaged – and if the investor views the founder as critical to the company’s success, he or she will allow a reasonable portion to remain in their hands. Founders prefer to view the company based on what it will be worth after certain conditions are met. Therein lies a significant disparity – which is one of the bigger causes of deal failure in negotiation that I have seen. A founder thinks that their post-achievement valuation is being agreed upon in principle – whereas the investor is really allowing a large portion of ownership to incentivize the founder to perform.
    • Leadership Team. Is the leadership team suited for the task? Realism comes into play. Think about things from the perspective of the investor – he or she is turning over their funds to your control. They need to be able to trust that wise decisions will be made. Consider the illustration of a bank. If a bank had faulty management – would depositors place their funds there? A second point to the leadership team is the matter of compensation. Many deals are thinly veiled attempts by a proposed founder to garner a significant salary raise. Namely, they have not started the business and propose receiving a significant investment along with a very comfortable salary from day one (ironically many times such projected salaries are higher than they have earned in their careers). Such things are simply not realistic. If the deal looks like the founder is willing to take no risk at all, then why would an investor become an employer?
    • The Process. The entire capital raise process – from A to Z has a higher chance of success when considering what things look like from the perspective of the investor. Are the offering documents complete? Do they tell the story? Are the financial projections realistic? Does the company use harsh sales techniques – acting like a used car salesman (“this offering won’t last long”)? To the extent that the company fails to consider what it is like on the receiving end of their capital raise, then the company is left trying to force the investor to see things their way. There are short-term rewards to this sort of behavior – as investors will sometimes continue the conversation to get more information – and yet the company believes the strong-arming is working. Investors will back out of an immature offering when they are being coerced or not understood.

I have seen every shred of incompetence in a capital raise that leaves me scratching my head as to what executives are thinking. The thread to the lack of common sense in these deals is that the founder is emotionally engaged and can only think of himself. In fact, it is admitted to in many cases. A classic retort is “They just don’t understand our business plan” or “They just can’t see how much money we’re going to make.” Interestingly, the disenfranchised founder is uttering these sayings to rationalize to himself why he was rejected and transfer responsibility to the potential investor as an apparent shortcoming of theirs. Unbeknownst to the founder, they are stating the problem openly – the potential investor didn’t understand the business plan or how much money the founder thinks the company will make. Somewhere in the process, that fact was not communicated or poorly thought out; hence, the investor does not agree. As opposed to modifying the approach, note that the founder in this case is simply transferring responsibility to the investor and continuing the same flawed approach.

Entrepreneurs have an egocentric personality type. It is part of the process. Such egocentricity is helpful – providing passion and energy to whatever cause they have attached themselves. It also is a weakness – impairing the ability to view the situation from all sides and make an offering that is not only about the entrepreneur – rather – about the customer, investor and entrepreneur. When all sides are considered and the deal is attractive to all parties, then long-term success is possible.

Motivating factors to most capital raises are the excitement about the possibilities. Growing a company significantly, changing the market (or even the world) and making gobs of cash are certainly exhilarating prospects. In so considering such possibilities, it is natural to come at the deal from self-only perspective – excited about the possibilities that motivate the founder. However, to successfully raise money from an investor, that investor needs to see the deal in the same way. Enter again the concept of self-only perspective. The investor cannot see the deal the same way as the founder for the same reasons. It is fundamentally impossible as the two people are two entirely different creatures. Hence, to get to the excitement of having raised capital, the entrepreneur has a fair amount of work to do – understanding the investor and creating a partnership. Realism is essential to being able to structure such a deal.