When is the right time for a company to search for capital? Many companies only look for capital when they are facing major financial challenges, a search that often does not end in success. To increase the chances of obtaining funding on attractive terms, a better strategy is to view capital raising as a continuous process of forming quality relationships with potential financing partners throughout the company’s entire life cycle.
Continuous access to capital is a vital part of building a successful business. In addition to allowing a company to meet its daily operating expenses and pay unexpected costs, capital is necessary for a company to make different types of strategic investments so that it can grow and diversify risk. As I have discussed in another blog post, when the cost of capital is less than the return on investment from that capital, this creates shareholder value. http://businesswarriorsdojo.com/2019/01/22/capital-and-firm-un-value/
Despite the vital importance of money for any firm, many companies look for capital at the last minute or worse yet when they are steps away from financial disaster. Trying to raise capital under these circumstances often means that capital is not raised or is raised on very one-sided terms and conditions that are not in the firm’s best overall commercial and financial interests.
Three Types of Investors
While investors have many different types of objectives and investment strategies, in terms of their general approach to finding and negotiating deals they often fall into three categories: let’s call these three investor types Type A Investors, Type B Investors and Type C Investors.
Investor Type A is an investor looking for one-sided deal terms in their favor that have no real economic relationship with the risks and rewards of the deal itself: if a company is worth $20 MM, this type of investor offers to pay $5 MM for it; if a fair interest rate on a loan to the company given the company’s real credit risk is 5%, this investor offers to lend capital at the rate of 15%. These types of investors tend to comprise a small portion of the total investing universe because many companies understandably will not accept these investment terms unless there is no other choice.
Investor Type C is the opposite of Investor Type A: they offer investment terms and conditions that are much better than market rates. This can happen for several reasons, the most common of which is that the value of the asset to the investor is worth far more than the value of the asset to the market as a whole.
For example, if a company’s entire business depends on obtaining a piece of land, it will often be willing to pay significantly more than what other buyers in the market would pay for that land to make sure that they can get the asset. As with Type A investors, Type C investors tend not to be very common, given that many companies build their businesses in such a way that their commercial survival does not depend on the acquisition of a single asset.
The third type of investor is the Type B Investor. Type B Investors are the most common types of investors that you will come across on the search for capital. These investors are not looking to receive one-sided investment terms or willing to pay high premiums over market rates but rather are interested in striking economically reasonable deals that will not only make sense at the time of investment but also over the entire period of the investment. Given the challenges of finding good deals, many of these investors also try to find deals with companies that will potentially lead to future financing possibilities.
Given the Type B Investor approach, they often take a significant amount of time to analyze a potential deal, the management team and the operations of a company. If the investor is not familiar with the company, the company’s industry or the country where the company is located, they will generally use an extensive due diligence process, supported by external financial, tax and legal advisors, to understand not only the opportunity but also the relevant risks.
This means not only considering deal terms on a piece of paper but getting to know the company and ideally seeing how it responds to different types of positive and negative market conditions. A great deal can be learned about a company by observing how it responds during times of challenge as well as opportunity.
Given these profiles, it should not come as a great surprise that if a company looks for capital at the last minute the chances of convincing a Type B Investor to invest are very low. Further, if a company is under pressure for capital and tries to accelerate the deal negotiation process it often sends the wrong signal to a Type B Investor and reduces the chances of raising capital rather than improving them.
Investor Relationship Building
Given these three investor approaches, companies should try as much as possible to avoid Type A Investors and not count on running across Type C investors. The key question therefore is how to increase the chances of finding Type B investors and negotiating deal terms that are reasonable for both the company as well as the investor.
To begin with, companies should view capital raising not as a one-off exercise but rather as a way to build steady, long-term value for the company. In addition to having capital to support the company’s operational needs and strategic growth, it also means constantly trying to obtain capital at a cost that accurately reflects the company’s risk. Investment risk for many companies tends to fall over time and this means that as the company becomes stronger equity and debt investments can increasingly be obtained on better terms.
Further, as companies grow, it will often be in their interest to diversify their capital base so that they are not dependent on a single investor for all of their capital needs. This means developing relationships with different types of equity and debt investors so that the right investment opportunity can be matched with the right type of investor. When investment opportunities, regardless of how strong they are, are presented to the wrong investor it generally translates into the investor simply not investing or offering investment terms that are not in the company’s best interests.
It is also important to keep in mind that investor investment strategies are not fixed: investor approaches and levels of risk tolerance change in accordance with market conditions, how other investments in the investor’s portfolio are performing, regulatory challenges, how much capital the investor has to invest and the investor’s investment horizon.
Given the dynamic nature of investor investing perspectives, companies should regularly interact with potential financing partners to understand market trends, current investor investment parameters and priorities and how market changes create opportunities to secure funding on better terms or put the company’s overall financing strategy or financial position at risk.
As the company does market research and continually builds its base of investor contacts, it is very useful to develop an investor outreach and relationship program in which the company provides periodic reports so that investors can see how the company is reading the market, follow the company’s progress and see how the company responds to different types of situations.
Finally, investing is a two-way street rather than a dead end: an investor relations program does not only allow investors learn more about companies but allows companies to learn more about investors. This is important, not only to see if a deal makes commercial and economic sense for both parties but also if there is good chemistry between the parties on an operational and personal level. An investment relationship, particularly for private investments, is like a marriage and it is important that the parties are compatible so that the often many years of close contact, discussion and interaction are passed in a climate of mutual support.
Conclusion
Access to capital is vital to build company value. Designing a capital raising strategy that focuses on building long-term relationships with potential financing partners increases the likelihood of raising funds on reasonable terms and forming relationships with partners that can lead to long-term business success.