Whatever the exit strategy, a company has to be a prospect that outsiders want to invest in or acquire in the first place. Companies at the lower end—start-ups and businesses doing under $1 million—usually rely on internal funding sources from the entrepreneur’s network of family and friends. In the middle is what Klaas Baks, associate professor in the practice of finance, calls the “donut hole,” where it’s difficult for moderate-sized businesses to raise new money. The reason, he says, is the economics of return on investment.
The availability and cost of capital all depends on the company’s size in terms of revenues and profits, notes Baks. Companies worth around $5 to $10 million in annual revenues may turn to the equity markets and other professional investors, but professional investors aren’t exactly beating the doors down to hand cash to smaller firms. Small investments are simply bad economics; they require the same skill and effort in research as a large investment but have a limited upside in terms of return.
Many a small business and start-up have fallen through the donut hole, never to recover. Getting through the funding crunch isn’t easy, but it’s not impossible either, Baks notes. That’s where organic growth is critical to getting to the next level. “Instead of looking for external financing, these companies should focus on internal financing through sales—by trying to push their product or service,” he says. “It allows them to generate capital through revenues in an organic way.”