I work at a technology-based business incubator, and one of my roles is to help our clients raise capital. Whether these companies are trying to raise capital through debt or equity, the entrepreneurs tend to have some pretty interesting assumptions about the process of raising capital.
I hate to be a “dream-crusher”, but I often have to break the news that the capital raising process just doesn’t work that way. Here are 4 of the most common myths that entrepreneurs believe about raising capital:
1. I Won’t Have to Give Up Equity
Entrepreneurs commonly say, “There must be investors out there willing to give me a loan if I can pay them back with 15% interest, I shouldn’t have to give up any equity in my company.”
The problem is that startups and small businesses are the riskiest investments out there. If an investor wanted to earn 15% interest, there are still much safer ways than investing in a startup. The risk of investing in a startup is too great for a 15% maximum reward. If you need funding, you need to be willing to give up equity.
2. Investors Value a Company Based on Future Potential
This is a myth that you can see every single week if you watch the TV show “Shark Tank.” A common example is an entrepreneur who has created a product that might have a potential market of $100 million, but they have only sold $100,000 worth of product to date.
The entrepreneur might want to value the company at $50 million because the market is huge, but an investor is only going to value the company at a couple hundred thousand. Why? Because investors don’t base the value of your company on how big your market is, they base the value of your company on current results.
Your company still needs to have a huge potential market to attract investors, but you just won’t find a savvy investor who values your company based on a dream.
3. 100% Potential Return is Enough
Entrepreneurs falsely believe that the potential for investors to double their money is enough to attract investment. The problem is that a common rule of thumb for an angel investor might be:
- % of investments are a total loss
- % of investments break even
- % of investments make money
In order to earn a respectable return on their investment, investors need to be looking for businesses with the potential to provide 10x returns.
Let’s say an investor doubles the investment in all 3 of the investments that make money, at the end of the 5 or 7 years that it would take to cash out of all 9 investments, the investor would break even. The 3 investments that provided a 100% return would merely cover the losses of the bottom 3 investments.
A 100% return is good, but entrepreneurs need to understand that investors are looking for companies that have the potential to provide much greater returns.
4. Investors Like Companies With No Competition
When I ask entrepreneurs why someone should invest in their company I often hear this response: “Because we have no competition, no one is doing what we can do.” Then, I have to break the news to them that in 99% of cases this is going to be a major turn-off to investors.
If you have no competition at all, the question is why not? Maybe others have tried to implement this idea and it did not work. Maybe the challenges are too great for you to succeed.
Additionally, competition can actually be really helpful, because it gives management someone to learn from and to compete against. Competition can help keep the management accountable. If customers are choosing your competitor consistently, investors know it is time to change management.
Without a competitor to benchmark against, an investor is left in unknown territory. There are some investors that love to take huge risks in unproven industries and with unproven business models, but those kind of investors are rare. If you don’t have competition, you must be prepared with a really good reason to the question “why not?”
If you can keep these 4 myths in mind as you work to raise capital for your company, you will better understand the mind of a potential investor, and ultimately be able to present a compelling case to an investor.
About the Author: Adam Hoeksema is the Founder of ExecutivePlan which helps entrepreneurs write powerful business plan executive summaries in order to raise capital. Adam is also the creator of the ExecutivePlan Executive Summary Template, which has been downloaded and used by over 5,000 business owners seeking to raise funding.