SME business strategy: Raising money and keeping control

Saturday, 01 December 2001


    With the economy heading down and a diminishing profit outlook making expansion impossible, company executives whether from the big or small end of town are reaching for the downsizing button on the strategy plan.

    Many companies will need to raise extra capital either through increasing debt or selling equity. As Geoff Harrington points out there are ways to do this and still keep control of your business.

    Raising capital to fund growth is an issue that virtually every company will face during the course of its development, and it's an issue that is often critical to the survival of the enterprise. One of the great challenges of capital raising, particularly for companies experiencing rapid growth, is to take in funds without losing control of the business. This is particularly relevant in the case of entrepreneurial businesses where the CEO, who is often founder, inventor and largest shareholder is extremely wary of dilution. Crucial to the success of a capital raising is establishing how much equity in the business the investor's money will buy. The figure ultimately agreed to will be the result of tough negotiation, and an alignment of the interests of the owner and investor. The most important issue to address in raising capital is the potential equity partner. There are as many types of investor as there are opportunities to invest. They can range from high net worth individuals to venture capital companies that specialise in IT and bio-tech, and from private equity funds to funds that invest only in other funds.

    Where you seek capital will depend largely on what stage of development your company has reached. The most easily accessible and most common source of capital for start-ups and companies experiencing very early stage growth is what the investment community often refers to as the three 'Fs' - family, friends or "fools". These sources are attractive because they are usually sympathetic to the entrepreneur's vision, and less intent on supernormal returns. Companies at a slightly later stage of early expansion may seek a "customer aligned" investor. This means that capital is procured from one of the company's most important customers, or perhaps a supplier of strategic importance. These types of equity positions are common in industries such as manufacturing, automotive, telecommunications and some sectors of the service industry - and more often than not they are instigated by the investor. For a rapidly growing young enterprise a customer-aligned investment can be the most effective method of capital raising. In addition to funds, these investors bring with them a range of benefits including industry expertise, new channels to market, R&D support and focus and direction.

    In some cases companies seeking funds look to a trade investor. A trade investor is a company which operates in the same industry and may even be a competitor. The best trade investors for small companies experiencing rapid expansion are those who are capable of making a positive contribution to product development and market rollout. It should be noted however that trade investors often expect to play a dominant role and the ultimate goal will probably be to take control. The pharmaceutical industry, which depends largely on small R&D focussed businesses for innovation, offers a good example of the trade investor model. Interestingly, one of the most favoured sources of capital is the financially aligned investor. This is the group that will exhibit the least patience and the shortest vision when considering investment opportunities. Why? Simply because they are focused only on the return their investment will give them. Financial investors fall into many different categories but their priorities are generally the same. Top priority is to earn the maximum rate of return on funds invested and most aim for upwards of 25 percent compound per annum.

    While this group controls the largest pool of available capital they bring little other than money and the skills of "directing" to the companies in which they invest. For an entrepreneur with a history of successful start-ups a financial investor can be an appropriate equity partner, for the uninitiated however, they can prove difficult to work with. There are many different sources of financial capital available and dependent on the nature and stage of development of the enterprise seeking funds, some will be more appropriate than others. High net worth individuals or business angels invest in businesses they believe will earn them exceptional returns. Typically, the amount invested will be between $1 million and $5 million, and there will be a nominated time at which the investor will want to exit. In Australia there are more than 50 venture capital organisations mostly making investments that range between $5 million and $15 million. Traditionally VCs seek investment opportunities that offer high rates of return and a relatively quick exit. Given the current oversupply of capital, however, there is a trend towards varying this model and some VCs have started to provide both early stage and seed capital, and incubator services.

    Before approaching a VC it is vital to establish which industry sectors they specialise in and what selection criteria they apply to investment opportunities - this information is usually available on request. Private capital, in the context of this article, refers to the half dozen or so private equity investment divisions of large institutional fund managers such as AMP, Catalyst, Deutsche Asset Management, Pacific Equity Partners and Colonial First State Private Capital. The value of investments made usually lies between $15 million and $500 million and each opportunity is approached with a high degree of 'science' and analysis. An IPO or initial public offering is another method of attracting financial capital. However, an IPO should not be considered unless the market capitalisation of the enterprise post listing will be in excess of $500 million. At the very least it should have the potential to achieve this figure short term. In Australia, in particular, the majority of small cap companies suffer from lack of liquidity and rather than retain value in relation to performance, they fall victim to the movement of the market.

    In a recent survey conducted by The Harrington Partnership the share price performance of every company listed on the ASX in the past four years was analysed. The results were sobering to say the least. Of the companies still trading, 62 percent were trading below issue price and a disturbing 30 percent were trading at less than half the issue price. This represents a staggering amount of lost value, a great many disgruntled shareholders and stressed chief executives. When new equity is introduced into a business the original owner must understand that the financial dynamics of his business will change dramatically and irreversibly. What surprises some is that to the new investor the single most important factor is an exit strategy. Regardless of what the owner's vision may be, once capital has been taken in the future of the business will be dependent on one factor: performance. There is simply no argument against the fact that control of the business becomes inextricably linked to return on investment and the investor's exit strategy. Exit strategies can be executed in several different ways, and can vary from an IPO to a trade sale. Often early stage investors are replaced with a customer aligned or trade investor.

    The following diagram illustrates the performance/control dynamic. The good news is that if you can demonstrate and deliver a compound rate of return in excess of 50 percent a year, you will be able to sell down a substantial portion of your business and retain control. If performance begins to slide however, the pressure from investors will increase as will their involvement in management - and that's when control is lost. Important points to consider in any equity raising are:

    • The only way for an enterprise to raise capital and retain control is to continue to grow and perform. Private equity investors are generally not interested in the dream or vision of the entrepreneur, they are simply seeking the maximum rate of return on investment.

    • Be aware of the many different sources of capital available and seek funds from an equity provider that best suits your company's situation

    • When considering an initial public offering bear in mind that success will be dependent on growth and critical mass. Listing a company with a potential market capitalisation of less than $500 million is seriously questionable, and an IPO does not usually represent a viable short term exit.

    Last but not least, let's not forget that entrepreneurs start companies because they have the desire to be in control of their own destiny. It is therefore important to understand that control is not governed by how much of the company is owned or retained, but rather by how well it performs. If you can deliver an investor a return of above 25 percent compound per annum, you will very likely be left firmly in control and able to go to wherever your dream takes you.

    Geoff Harrington is executive chairman The Harrington Partnership. Note: AICD presents courses and seminars on Going Public. For details contact the AICD education manager on 8248 6600


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