Small Business Advice

Raising Money: What do investors look for in SMEs?

23 Jan 2020

Looking into options for raising money? When investors sit for pitches, they expect to be told about an exit strategy. This includes a tale of future acquisition or initial public offering (IPO).

As a small business accountant, our opinion is if you wake up one morning and decide you want to sell up, the reality is you should have started planning your exit strategy at least 3 years earlier.

Doing so helps small businesses avoid potentially reducing the value they could receive for what may be their biggest asset.

Small businesses have played an important role in Britain’s economy across the generations, comprising the backbone of the country’s economy.

However, with 58% of SME owners lacking an exit strategy, they are completely unprepared for the transfer of ownership from one party to the next and are missing out on unlocking the true value of the business they created.

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Modern contingency plans

Nowadays, contingency plans have become more creative.

For example, some businesses opt to divide their business into two or more verticals. For the purpose of illustrating this, let’s assume the these verticals are Franchising and Banking. This move would allow the firm in question to begin to isolate the value of each respective channel and package it for a potential sale.

The next step could be to expand the business through acquisition so that the business has the necessary cash flow to support the company independently. At this point, a business is in the position to do two things that boost their value to investors.

Firstly, the banking channel could be sold as-is at a valuation that made sense for more buyers. Second, the firm could retain the franchising segment of the business, and focus on making it profitable.

This would allow a business to offer investors an outsized and, far more confident, return.

But there’s far more to attracting investors than originality.

Building ambition on good foundations

A lot of investors will look at each company on its merits as businesses will have different drivers in their respective markets. But one important matter is whether there are any obvious vulnerabilities, namely issues out of their control such as forthcoming legislation changes.

These are a no-go for many investors, as it’s a variable you cannot control.

Beyond this, the business must provide something worthwhile for customers, as this leads to decent margins and that’s crucial. A diversified customer base is equally as important, since over-reliance can be risky.

If investors see a rhythm of profitable growth backed by a solid management team, they are more likely to take a closer look. They usually want strong net margins of, say 15-20%, and robust growth, but don’t look for specific sectors or types of business.

There must also be an element of continuity, whether it’s the founder or someone else who knows the business intimately and is able to manage change.

The attraction of high valuations

A possible high business valuation is also a factor in deciding which business to go with. So profits are important, as well as how they’ve been maximised.

Investors will look at the predictability of earnings and rates of growth, making recurring revenues particularly attractive.

Valuation is an art rather than a science, so investors can weigh-up the potential of a business – where can it go, and is management sufficiently motivated to drive this?

Ultimately, investors are usually only the temporary owners so they will tend to think about the eventual exit and how to get there. Could it be an IPO or sale to a strategic trade buyer, for example?

At the end of the day, the business has to be happy with the investor as well. Beyond capital, what do companies usually they want from an investor?

Beware of the knowledge trap

One of the most common mistakes founders make is failing to tap into an investor’s knowledge.

Part of an investor’s role is to help founders understand the range of options available to them. While they do provide capital, they can also introduce lawyers, accountants, and corporate financiers to help make more informed decisions.

Another mistake is not thinking through succession planning. Founders can get caught up crystallising value and getting the deal done without thinking about who will take the business forward after they step away.

Succession planning comes hand-in-hand with an exit strategy. At least, it should.

Research repeatedly coughs up the fact that too few companies think of succession planning as important, and this is particularly common among family-run businesses in the UK.

If you want to exit within five years, that is a great time to bring on board a backer who can help you get out with two bites of the cherry.

A key point is the founder’s willingness to remain involved for a period of time – if the founder wants a speedy exit, trade is a better option than private equity.

Overall, adopting an exit strategy will help your business ultimately become more valuable to investors, should the company ever be sold.

Talk to our MBA-qualified small business consultant about your own business’ value and getting your exit strategy in place for investors.