If you’ve considered taking on an outside investor at your company, the decision about whether to do so may be keeping you up at night. On one hand, a cash infusion could relieve some pressure on an overstretched entrepreneur or help an established company grow bigger and stronger. It could also mean relinquishing control: an investor will likely want a say in how their investment is used – or at least when and how they get paid back.
So before taking that step, you need to evaluate whether taking cash from an outsider is a smart move for you. Here are four important questions to answer to help you decide:
1. What’s the money for?
How you plan to use the money often dictates the type of cash infusion that would work best for your situation. Keep in mind that when you take on an outside investor, you typically give up some level of control and ownership in the business – and you don’t want to make that decision lightly.
When debt financing, such as a bank loan, is appropriate for the situation, it’s generally preferable because it often costs less and does not require giving up control or equity. For example, if your company has short-term cash needs, such as buying inventory in advance of an expected seasonal sales surge, debt financing is probably the better way to go. Debt financing is also usually preferable for medium- and longer-term investments that will generate a steady or reliable return to the business for several years – such as buying equipment. Whenever taking on debt, however, it’s critical that you are confident your future cash flow will be able to repay the debt principal and interest in accordance with the terms.
Outside equity investments, on the other hand, should typically be reserved for situations where debt financing is not feasible because you need to make investments that cannot be collateralized – such as hiring new employees – and when your business has longer-term cash needs such as growing operations and infrastructure.
That said, Patrick Ungashick, CEO of NAVIX Consultants in Atlanta advises that you should strongly consider raising outside money if such an investment will accelerate your growth consistent with your goals. . “If you’re sitting on a business with a proven game plan and a proven market opportunity, and the only thing holding you back is the lack of something that money can buy, go get that money,” he says.
2. What are your options?
There are multiple ways to structure equity or debt financing, explains Michael Pfeffer, managing director of Post Capital Partners, a private equity firm in New York. Senior debt, mezzanine debt, control equity, growth equity are all potential ways for a company to raise cash – and the list goes on. It’s important to have a clear understanding of both your short-term needs and your long-term goals before determining what type of outside funding you need.
Pfeffer suggests that If you’re not already overleveraged, debt can be a cheaper and potentially easier route to pursue. He notes that you won’t have any outside investors looking over your shoulder as you run your business, but you won’t have the benefit of an investor’s guidance, either. Also, you’ll probably have to sign a personal guarantee, which means you’ll be on the hook for paying off the loan even if the company fails. Then you need to decide between senior and mezzanine debt. Senior debt is typically a straight-out bank loan. Mezzanine debt is a hybrid structure that combines a loan with an equity investment.
On the other hand, if you decide you need an equity partner to help your company achieve its goals, how much control are you willing to relinquish? “There’s a broad misconception in the marketplace that you have to give up control when you take on outside investors,” Ungashick says. “That’s a common barrier for business owners, but there are plenty of investors out there who would prefer to be, or are willing to be, minority investors.”
3. What are you looking for from an investor?
“Money is a commodity, but investors aren’t,” Pfeffer says. “Bringing in a partner is like getting married, so it’s really important that a business owner chooses wisely.” He’s working with one owner who built a successful business based on his technical skills, but now the company needs management expertise. The entrepreneur is looking for an investor and a partner who can help him take the company to the next level. “We take an active, strategic role at the board level,” Pfeffer says. “We only invest if we think we can add value, from helping manage the direction of the business to making introductions that could grow the company.”
Even passive investors come with their own ideas and expectations, so it’s important to do your due diligence before taking their cash. Pfeffer recommends talking to other business owners who have worked with a potential investor to get a better feel for how they operate.
4. What’s your exit strategy?
No investor is looking to ride to the end of the line with you, so you need to make sure their exit strategy and timeline align with yours. Are you hoping to take the company public someday? Are you building your business with an eye toward being acquired by a bigger operation, or passing it on to the next generation? “The key is understanding your objectives, and finding a partner to help you meet them,” Pfeffer says.
Taking on an investor could be just the boost your company needs to move to the next level,but be sure you understand all the potential implications. Talk to your advisors and evaluate your options before making the leap.
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