Identify & overcome hurdles: raising equity for smaller businesses
This article was published in the Private Capital Markets 2017 Spring Conference edition.
According to Statistics Canada, there are over 1.17 mm businesses in Canada of which approximately 98% is comprised of private entities with 99 employees or less. The remaining 2% typically represents larger, more established public and private businesses. This ranges from local and regional entities with employees of at least 100 to nationwide or multinational corporations with employees in the thousands. For dealers, advisors and investors within the private markets sector, one should not discount the remaining 98% of the market given the emergence of new industries, build-out of new technologies and also the potential impact from regulatory changes. However, small to medium-sized businesses may often be faced with particular challenges when trying to raise capital. Working with their dealer, advisory and investor early on and transparently can help manage these.
Many of these smaller businesses in Canada have various options to fund their growth via grants, government subsidies, various debt structures and raising equity via personal funds, family and friends or finding early stage investors such as incubators, angels, venture capital or crowd funding.
According to Statistics Canada, approximately 51% of all small and medium-sized businesses (SMEs) sought external financing. Most private business owners would know to speak to their bank for debt and trade financing, however, some of these businesses may be in certain industries and sectors in which the above alternatives may not be a good fit, or their current size limits the available options. Businesses that are pre-revenue or generating EBITDA of less than $1.0 mm, for many dealers, advisors and investors, may be too small for initial consideration.
Despite the potential lack of clear financial metrics to definitively value the business and its underlying assets, many of these businesses could be in an exciting and up and coming sector which may represent a great opportunity for investors focused in the private markets. More importantly, it could also represent a great opportunity for dealers and advisors willing to work and grow with the company by establishing a relationship during its early stages.
If a great opportunity has been identified, whether it is backed by a strong and enthusiastic management team, a great idea, a growing industry, strong intellectual property or actual purchase orders, there are some typical hurdles when raising capital for smaller businesses which often prove difficult for dealers and advisors to justify investing too much upfront resources. These include:
- Due Diligence: early start-ups or established smaller entities may have limited financial statements or an operating history for the dealer or advisor, and more importantly, the investor, to conduct proper due diligence.
- Limited Assets: many SMEs may have products or services deemed to be proprietary or unique but the products, technology or solutions are typically patent-pending and they may not have sufficient intellectual property or underlying physical assets.
- Valuation and Control: owners/entrepreneurs may have valuation expectations that do not coincide with market/investor expectations. The issue of valuation also ties in with the issues related to maintaining or forgoing control of the business after the capital raise.
The issues identified above are not the only hurdles dealers and advisors may have to contend with when working with SMEs seeking to raise capital. However, having a discussion early and setting realistic expectations should help build a stronger foundation for the relationship whether the eventual capital raise is successful or not. From a dealer and advisors perspective, in an effort to mitigate the impact of some of these uncertainties, (without necessarily dismissing the opportunity due to size), dealers and advisors may try to overcome some of these key issues by:
- Leveraging network: new start-ups or existing SMEs seeking capital may come from new industries with which the dealer or advisor may not be familiar. In these instances, it may be easy to pass on the said opportunity. However, there may be an opportunity to leverage the experience of partners, competitors or investors within your network to get input on general interest in the deal and a better understanding of the opportunity.
- Asking the tough questions: the initial due diligence review conducted by the dealers and advisors should focus on asking the tougher questions which the potential client (business owner) may not fully appreciate. Having the right answers to these type of questions should provide the dealer and advisor additional comfort on the proposed raise as opposed to finding deficiencies after significant time has been invested.
- Setting the right expectations: There should be a clear understanding between the dealer and advisor with the client at the beginning of the relationship. The management team should have a proper understanding and expectation for the potential of success and also be aware of certain alternative sources of financing which could be available. As valuation expectations will not always coincide with the investor, owners should be open to negotiations or alternative financing sources.
- Understanding management team: Consider if the management team is flexible or firm on what they are seeking and determine if the rigidity may impact the potential of success of the transaction. Also consider if the management team is seeking only capital or will they value a strategic partner more so than funds.
Admittedly, not all capital raises will be successful in this segment of the business and a significant amount of time and energy may be expended with little results to show. However, working with a smaller and developing business can be rewarding for the dealer and advisor and result in a long-term relationship as a trusted partner for the company and investors alike.