This post is the second installment of “Laying Down the Law” – a series where our attorney friends at Troxel Fitch give legal advice for budding entrepreneurs. View the first post about Choosing an Entity Type here.
“Should I seek outside investment for my company?” Most, if not all, entrepreneurs ask themselves this question at some point while building their business. Deciding whether to take on outside investment is a major decision for any business owner, and while it can be the start of what turns a small business into a global juggernaut, it is not right for all businesses.
While there are numerous factors to consider when it comes to taking on outside investment, I want to focus on three major questions that all business owners should ask when determining whether outside investment is the best route for their company. First, is my business scalable? Second, when is the right time to start considering taking on outside investment? Finally, what would I do with the money?
Is my business scalable?
When considering whether your business is right for outside investment, you should first consider whether your business is scalable. Investors invest in companies to make money, and many expect returns of at least 5-10x. In order to provide this level of return, a business must be capable of substantial growth.
There are many great businesses that simply do not offer this type of growth potential no matter how well they are run. Many times, this is due to the fact that the business operates in a market that is too limited to produce substantial growth.
For example, a new, revolutionary business that provides products exclusively used in the unicycle market is not scalable. No matter what percent of the unicycle market the company corners, there are simply not enough people who ride unicycles to create a market where major growth can occur. On the other hand, Facebook is a great example of a company that is extremely scalable, because Facebook’s market is basically everyone in the world.
When is the right time to start considering taking on outside investment?
Even if your company is scalable, it may not be the right time in the growth-cycle of the business to consider outside investment. While investors will occasionally invest in businesses pre-revenue, generally outside investors will not invest in a company unless that company can show some initial traction and profitability.
Also, consider how quickly your business is spending money, as investors will consider this “burn-rate” when determining whether to invest or not. Running a lean operation that can absorb cash quickly and utilize it efficiently is attractive to investors.
For some businesses, outside investment can be a way to branch out into new markets or utilize new technology more effectively. If you are considering undertaking a major project that is capital intensive and profitable, but would leave the company with potential cash flow issues, it could be the perfect time to consider outside investment.
What would I do with the money?
Before you take on any outside investment, you should know what you would use the extra money for. While outside investment is a great way to get a cash infusion into your business, it also comes with additional burdens.
For example, taking out a loan for your business obligates you to pay interest and generally gives the lender the right to seize your property if you fail to make these payments. On the other hand, issuing equity in your company creates additional owners that you will likely have to share decision-making authority with. Due to these additional burdens, outside investment should be avoided if your business doesn’t actually need the additional cash.
Therefore, before accepting outside investment, you should spend some time considering exactly where additional money would be used in your company, and develop a strategy to create the greatest return on the money in the shortest period of time.
Seeking outside investment can be a difficult decision, but it is often a major turning point in the life-cycle of most businesses. Therefore, it is critical that you spend time assessing your business and its potential. It may even be wise to contact a business attorney who can learn the ins and outs of your business and provide you with tailored insight into whether your business is one that would benefit from outside investment.
Check back next month as we take a deep dive into the pros and cons of specific types of outside investment.
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