Why You Need To State Risks When Raising Capital

Raising capital for any new venture is challenging.  During fluctuating economic cycles it takes even more creativity to even attract investors. Add a restaurant to that equation and the obstacles can become insurmountable. Hoping to avoid disappointment, entrepreneurs attempting to raise money frequently sidestep one of the most important topics in the process: The risks involved with invest in their venture.

I know, many supremely confident, pie-in-the-sky entrepreneurs simply don't believe that investing in them might present risks. The facts are, however, that it is imperative to state that an investment in your venture is a high-risk proposition. It is also required by law if you're raising substantial capital.

In current economic times the risks involved in private investments are more complex than ever before. And, unfortunately, new owners are often blind to future obstacles while boasting about the stratospheric potential of their ventures. This is a monumental mistake made when hunting for capital, and it can leads long-term aggravation and serious legal troubles.

Last week a friend was discussing his new venture. He already owns one retail clothing store and is now working on a wine cafe. I was astonished at the numbers he was projecting for a first-year operation and asked what type of proposal and prospectus he was developing. He didn't have either, although he had been working on the project for more than a year and had already signed a lease. The first mistake: Not having a prospectus and proposal done a full year into the project.

He's attempting to raise $400,000 from four investors. Each investor would receive 5 percent of the cafe for a $100,000 investment. When I asked about the projected first-year sales, profit, and loss, he said the volume would be minimal as the space was small, but the profit would be hefty, hovering between $350,000 and $500,000. He claimed the risks were also minimal.

The projections were puzzling. The space is around the corner from three failed restaurants. That's a risk. But my friend spouted numbers with the confidence of a hedge fund manger who'd just received his bonus. Why would anyone put themselves in a position of failure before they even began the game? If he fails to reach his projections his investors will be disappointed in the investment and his performance. That's pressure nobody needs when running a business.

There are a variety of  rules to keep in mind when raising capital for a private venture. Four that I find important are:

1. You can either sell on history or mystery. With history you'll need performance numbers supported by data, records, P&L statements, and their supporting documents. Few start-ups have these. It's the mystery that works. Paint the picture. Create an impressive document and a presentation setting the stage for the venture. Have a strong prospectus doc and don't forget to state that the risks are high.
2. Under promise and over deliver. Simply do not ever boast about what a great profit you are going to make the first, second or third year. Turning a profit in business is difficult anytime. To be able to immediately accomplish the goal is almost too golden to believe. Be realistic. Set your sights on breaking even. Savvy investors will understand that. And then, if you are a wizard and make a profit, everyone is happy.
3. State the risks in the investment. What may not seem like a risk is usually a big one. The fact you have never owned a restaurant before – a risk. The fact you have signed a long-term lease, for a substantial amount of money in a previously failed space – a risk. The fact you have never managed a restaurant – a risk. And, the risk list goes on and on and on. Don't be afraid to state the risks. Knowing them before hand gives you the ability to overcome them.
4. Find an investment banker or a lawyer with a strong knowledge of securities to help you with the documentation and prospectus presentation.

Each of these rules are important. But stating the risks and finding a good advisor or lawyer will save you aggravation, grief and court time if the deal goes bad and you have nothing to boast about.