Recently when speaking with a couple of entrepreneurs with a great startup concept our conversation soon turned to how best to attract investors. After learning more about their business model, target market and their ambitions I suggested they never start something without having a clear focus on the end game. That is, if you want to attract investors, this should be an underlying consideration in all strategic decisions made in the formative stages of establishing and operating any proposed new venture. However, to be able to attract investors requires a reasonable understanding of investor types and the characteristics of the investment opportunities they seek.
Being Able and Ready to Attract Investors is Important
Positioning your small to medium business (SMB) to attract investors is essential for its growth and long-term success. Being able to attract investors allows your SMB to finalise product/service development, launch and commercialise and fast track growth by exploiting new market opportunities.
However, to attract investors your business must investable. That is, it needs to be an attractive proposition for investors. There are many factors that play a role in determining if your business will attract investors, including its structure, competitive position, and management capabilities.
The attractiveness of your business will also vary depending upon the type of investor who is considering an investment. For example, Strategic Investors have different priorities to Financial Investors.
Strategic Investors Vs Financial Investors
Strategic Investors want to invest in businesses that give them an advantage in the marketplace. They are likely to already hold or have considered investments in your ‘space’ so will have a good working knowledge of the industry, competitors, customer preferences, and so will quickly be able to assess the strengths and weaknesses of your business model.
Strategic Investors tend to look for medium-term investments lasting 3-5 years in businesses that can benefit from their expertise, market knowledge and contacts. They expect to make a significant return on their investment by ultimately selling their stake in your business.
Financial Investors invest in businesses with the expectation of a future financial return through cashflows or dividends. Most Financial Investors are larger companies seeking growth opportunities through acquisition and integration with their existing businesses. Typically, Financial Investors tend to look for long-term investments of 10 years or more.
Characteristics of a Strategic Business
The types of businesses that Strategic Investors are interested in have the following characteristics:
i) High competitive advantage
If your business enjoys a significant competitive advantage, it will be an attractive investment opportunity for Strategic Investors. Strategic Investors seek businesses:
- that can produce products at a lower cost than competitors (comparative advantage)
- with unique products or services (differential advantage) usually created through unique manufacturing processes, intellectual property, strong brand identity or superior personnel
- that target a very specific market segment (focus strategy)
- with excellent core competencies such as knowledge, technical skills, manufacturing techniques and customer relationships
- with a unique corporate identity.
ii) Patentable, unique, hard to copy or high level of Intellectual Property
Strategic Investors are attracted to businesses that have intellectual property (IP) in a technical field or market segment they are familiar with. They will typically assist with commercialisation and/or exploitation of such IP for mutual benefit.
iii) Highly scalable assets leveraged by larger company to achieve large revenue
Strategic Investors seek businesses that have assets and infrastructure in place to accommodate growth. For example, if your business has a state-of-the-art process or technical know-how, a strategic investor will happily provide the capital to scale it up to take advantage of growth opportunities.
iv) Not dependent on size or profitability
The size or profitability of your business is less of a concern to Strategic Investors, because they may be interested in other aspects of the business. They will be more interested in your:
- intellectual property
- access to niche or new markets
- business and/or manufacturing processes.
v) Gross profit potential
Strategic Investors will be looking for businesses that have gross profit potential. Your business will need to demonstrate strong gross margins on products or services or high gross margin potential say through economies of scale.
vi) Highly innovative
Being innovative will make your business extremely attractive to Strategic Investors. They prefer to invest in businesses that can produce new and exciting ideas that are capable of transforming industries.
vii) Clear exit strategy
Strategic Investors look for medium-term investments with a clear exit strategy to sell their stake in your business at a significant profit.
viii) Ownership preference
Strategic Investors will take minority shareholdings in the target business, whilst being mindful of dilution in later capital raising rounds. Choosing a business structure that makes it easy for investors to join or leave the business compliments the objectives of the Strategic Investor.
Characteristics of a Financial Business
Businesses that attract Financial Investors have the following characteristics:
i) Low competitive advantage
Financial Investors are less concerned about a business’s competitive advantage. They just want to see that the business is profitable or has a clear profit potential.
ii) Many similar businesses
Your business doesn’t have to be unique for it to be considered investment-worthy by a Financial Investor. In fact, they often seek businesses that are operating in established markets and offering products or services with a proven market demand or customer appeal.
iii) Buyer will likely purchase to consolidate or run as is
Financial Investors often look for businesses to rebrand and consolidate with their existing businesses. They will often implement their systems and management philosophies with the aim of increasing profitability. Alternatively, some may leave the business as is and remain largely hands off, especially whilst results are in line with their expectations.
iv) Little or no high growth potential
A Financial Investor is less focused on high-growth businesses that will require additional infusions of external capital in the short term so as not to dilute their ownership.
v) EBIT focus
Financial Investors typically use historical and projected EBIT (Earnings Before Interest & Tax) and industry earnings multipliers to value your business. Adopting an EBIT maximisation strategy will usually result in a higher valuation of your business by a Financial Investor.
vi) High in capabilities
Your business more likely to be attractive to a financial investor if it is capable, innovative and flexible. That’s because these characteristics help the business deal with change and develop in new ways.
vii) Ownership Preference
Financial Investors will typically prefer to acquire a majority interest (i.e. > 50%) of your business and retain the founder/s for up to two years while integrating with their existing operations. Post-acquisition control of your business is a key aim of some Financial Investors so if you are retained in management be prepared for someone else to be calling the shots.
Stage in Business Life Cycle
Another key consideration for investors is where the business lies in its life cycle.
i) Is the product or service beyond proof of content stage?
It is rare for investors to be interested in products/services that are still at a very early or research and development stage. At a minimum, most investors will require a prototype or minimum viable version of the product/service. However, you may find a Strategic Investor who is attracted by your business’s IP that has yet to be commercialised.
ii) Product/service validated by recurring revenues
Your business will be considered much more investable if it has recurring revenues from a loyal customer base.
iii) Existing or emerging market for product/service
An existing market is one where customers already spend money on products/services like the ones your business is selling. An emerging market is one where the product/service your business is selling is largely untested. Most Financial Investors are interested in businesses selling in existing markets. However, Strategic Investors will often work with businesses targeting emerging markets.
iv) Plan in place to commercialise and grow
Businesses with a 3 to 5 year financial plan or model demonstrating profitability and growth are a much more attractive proposition for investors. Investors like to see a focused and hardworking management team with ambitious but realistic/achievable plans to commercialise their product/service offering and grow the business over the short to medium term.
v) Clear or Demonstrated business potential
Most investors are interested in businesses with a clear or demonstrated business potential including:
vi) Competitive position
Does your business’s competitive position stand out from the crowd? What about your business worries your competitors?
vii) Management capabilities
Does your business have a talented and experienced management team? Investors will prefer managers with experience and a demonstrable track record of success in their fields or endeavours.
viii) Time to market
If not already commercialised or a pre-sales stage, investors will prefer businesses that have detailed plans in place showing the tasks and timing to bring their product/service to market – the shorter the timeframe the better.
ix) Channels to market
Your business’s channels to market are the pathways that you use when bringing your product/service to the market. Some investors will prefer businesses that have established channels to market as it removes some uncertainty about how products or services will be sold.
x) Appropriate business structure
Businesses can be created as a partnership, sole trader, company or trust. It’s important for your business to choose the appropriate business structure for the types of investment you are hoping to attract. For example, if you are interested in obtaining capital from Strategic Investors they will find it easier to interact with a company as it more appropriate for an equity investment. Financial Investors would prefer to buy the assets of the business rather than the entity regardless of how it is structured.
xi) Appropriate governance in place
Investors prefer to work with businesses that are well managed with appropriate governance including internal financial controls, policies and procedures. They look for businesses with:
- A strong board and management team
- Robust workplace policies including workplace health and safety standards, delegation of authority policy, and quality control
- Robust monthly financial reports and budgets
- Strategies for retaining key employees
- Strategies to safeguard and protect intellectual property of and developed by the business.
The characteristics of the Entrepreneur/Founder of the business is another contributing factor to the investability of your business, especially for Strategic Investors. The main characteristics that investors look for in an Entrepreneur/Founder include:
i) Are they mentorable?
Most Strategic Investors prefer to work with Entrepreneurs/Founders who are open to being mentored. They look for business owners who are willing to accept advice and constructive criticism. This allows the investor to make a significant contribution to the business and help it succeed.
ii) Will they listen, or do they know everything?
Some business owners believe they already know everything about running a business. Unfortunately, having this mindset can make investing in the business less attractive. Investors prefer business owners who are open to all suggested tweaks to their business.
iii) Are they capable of making sound business/commercial decisions?
When investors examine your business’s investment potential, they will look at the business owner’s ability to make sound business decisions. If the entrepreneur or founder can demonstrate a history of success in prior or the current business this will be looked upon favourably.
iv) Style of leadership
The management style of the Entrepreneur/Founder will also play a role in determining how investable a business is. Investors prefer to work with a business owner who is calm, logical and strategic rather than say someone who is a fire fighter that randomly moves from one problem to the next.
v) Prior experience in founding/managing high-growth businesses
Strategic Investors seek scalable businesses with growth and profit potential. To manage their risk, business owners who have demonstrable experience starting up and managing high-growth businesses are preferred.
In closing, please keep in mind that the type of investor your business will be most attractive to will vary over time. For example, growth capital for earlier stage business will most likely come from Strategic Investors who in time will be looking for an exit to a financial investor.
Are you considering selling some or all of your business or raising cash to exploit growth opportunities? For a free no obligation discussion about the readiness and investability of your business please email or call me on 0418 697 701.