Q & A: Investment: Size Matters

Question: Hello. I, along with a partner, have 20+ years combined experience in the carpet cleaning industry. After investing over 10k of our own money, we will still need an additional 30k for start-up of our own business. We are in the middle of writing a business plan for possible private investors or an SBA loan. I was wondering, on average, what sort of ROI or security is offered to the potential investor. Such as: A straight loan with repay plus interest? A percent of ownership? A percent of annual income? Or, is an initial offer usually propositioned by the investor? Also, what sort of numbers or percentages might be ‘entertained’ as an offer to possible investors looking at our 30k request? I’m sure it can vary quite a bit, but we’re just looking for an average to negotiate around. Any advice will be much appreciated.

Start by forgetting the idea of some arms-length investor you don’t already know. There are lots of reason. First is that it’s illegal, forbidden by the SEC except for “sophisticated investors.” Second, the $30K amount is peanuts in that context, it won’t happen, they won’t take you seriously. third, the legal costs on an arms-length investment are a lot more of that. One of the problems angel investors deal with is that it costs as much to invest $100,000 as to invest $2,000,000. Outside investment isn’t practical at those low levels. You need to be looking for a few hundred thousand at least, and have a plan that shows the need.

Furthermore, whatever the range of returns that private investors want, they don’t get any return at all until you sell your company. That’s what “exit strategy” is all about. Are you building this carpet cleaning business to sell it? I doubt it. Take a moment to consider the investors’ point of view. They spend the money to invest in your company and they get nothing back from that investment at all until they sell their shares.  Who do they sell them to?

One of the worst deals in the world is a minority share in a privately held small company without an exit strategy. The return on that is zero.

And, realistically, do you have an exit strategy when you start a carpet cleaning business? No, of course not. You want in, not out. That’s perfectly normal. Don’t apologize for that, but realize that investors aren’t interested.

You could legally get that kind of investment from close friends or family, but that’s still not a good idea. Somebody who invests $30K to your $10K is going to expect to own a substantial portion of your business. Ultimately, the $30K isn’t that hard to get, and if you get it as investment you won’t have to pay it back but you will have to sell a substantial share of your company, and you will have to live with one or more partners, and manage another relationship like a marriage. Do you and your partner want another partner? Are you ready to get into a close relationship equivalent to a marriage? Are you ready to have an investor who will essentially be the boss of you? I doubt it. I wouldn’t.

And, by the way, I do speak from personal experience. My wife and I built our business, Palo Alto Software, without outside investment. It wasn’t easy — at one point we had three mortgages and $65K in credit-card debt — but the good side is that we have 35 employees now and healthy cash flow and 80% market share in retail, as I write this, and we own it outright. It was worth it.

if you borrow what you need instead of getting investment, you have several options:

  • If you want friends and family involved, do it as a loan and write it up with the correct legal documentation so that your lender has legal recourse and you have to repay the loan and therefore there is no confusion that he or she is an owner. I recommend you use one of the family lending websites, or a lawyer, to give you the right paperwork. Search also for person-to-person lending.
  • The SBA has some programs for smaller-size loans. Generally they loan you no more than 70% of total investment required, which would mean you’d have to put in $13K to borrow $30K, but it’s a loan not an investment, so you still own your business. You can follow up on that by going to a local bank; SBA loans are managed by local banks.
  • Not that I recommend credit card debt as start-up financing, but it does happen a lot. The interest rates are very stiff, but people use credit card financing anyhow because it’s easy to get.
  • You might also be able to get a personal loan from your local bank, assuming you have assets you can afford to risk, so you can borrow $30K from the bank.

Remember of course that borrowed money is a risk because you will have to pay it back. Still, if you needed $200K to start that business we might talk about investors, but with only $30K, like it or not, the best practical answer is to borrow.

By the way, just so it doesn’t seem like I’m dodging your question, private investors generally want very high returns. They need to believe that every $30K put into your business will pay them back $1 million or so in 3 years and $3 million or so in 5-10 years. They know that only 1 of every 10 investments (or so) will be successful, so they need to believe each one has a chance to return 100 times or more the initial investment.

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3 thoughts on “Q & A: Investment: Size Matters

  1. Tim,
    thank you for your blog, I am learning a great deal from it.

    In the last paragraph talking about very high returns, it seems to me that the expectations are shall we say a little too high. Here is my thinking/understanding/back of the envelope calculations. I agree that the rule of thumb is 1 out of 10 winning investments. ( Say ~4 or 5 are complete failures and the investors does not see a dime, and the other 4 or 5 are living dead companies and the investor has no real chance to get their money out, so we can view them also as investment loses. )

    Say an investor invests $30K into 10 companies, for a total of $300K. Now ( I am about to use some nice round numbers ) because of the risks, significant returns are needed say ~24% or using the rule of 72 the money doubled every 3 years. Since CD rates ( They say CDs are risk free, but what is risk free? ) are now in the low (low ) single digits interest rates, a 24% return is a great, or what I would call a “very high return.” But that takes the $300K to $600K in 3 years, not ~$1,000K. To reach $1,000K an expected returns of ~72% per year is needed, e.g. $1,200K in 3 years. 24% is very high, but 72% seems to me off the scale high.

    I suspect that the response to my ‘rant’ above is likely to be something like, that is how life is.

    In theory if someone came to an investor with an investment request and all agreed that the idea, plan, team, market etc, was a good and looked like it would return 24% per year the investor would not invest because the return was not 72%? (Yes I know there are different investors, I’m using the hypothetical typical private investor.)

    Maybe again that is just how things are and I am getting more of an education. Makes me pause as I plan my own startup and consider the need for outside funding.

    1. Thanks Anthony. My response to your co-called rant — I think of it as a thoughtful comment, myself, a welcome addition to the discussion, not a rant — is the impact of uncertainty. The investors know that the odds are stacked against them, that even though they only invest in what seem to be very good opportunities, there will still be mostly failures; so we want to believe that every single one could be a huge win.

      If we end up getting the returns you suggest, yes, we’re happy with that. It’s just that it seems like the best way to end up with acceptable returns is to aim for the sky on every one.

      In your hypothetical case that everybody agreed it would return 24% per year, it’s all in a world of uncertainty. Every deal any angel investor makes fits your description, the everybody agrees part, when the deal is made. But only a very small percentage actually succeed. So if there is finite money (and there always is) and another deal that everybody agrees will return 72%, then the everybody agrees 24% doesn’t win. And only a small percentage of those everybody-agrees-72% deals ever get to the even everybody-agrees-24% level.

      And then, before we leave this fascinating subject, there’s this one: I’d always invest first in an everybody-agrees-24% deal than in a supposedly-72%-but-I-don’t-believe-it deal. Sometimes founders and entrepreneurs are frustrated and unhappy because investors prefer a credible projection to a much larger but also not credible projection. It’s hard to generalize, but I know I’m never going to go for the latest numbers unless they are every bit as believable as the other plan’s not-so-large numbers.

      Thanks, I appreciate the addition. Tim

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