University of Tennessee Research tells us that more than half of all new businesses fail by the end of year four but only 37 per cent of technology businesses remain operable by that same time. Despite this fact, new technology firms are sprouting up constantly and that’s good.
Entrepreneurship drives our future. The competitiveness and fate of our country hinges upon our skill as entrepreneurs. But most startups will eventually need to complete a capital raise and that will require that a value is attributed to the company. Attributing value is a source of countless rolled eyes, smacked foreheads, arguments and sometimes business failure.
Here’s a few quotes from entrepreneurs defending a stratospheric valuation:
‘We just don’t want to give up 30 per cent of the company.’
‘This is conservative.’
‘But Facebook . . ..’
Two entrepreneurs were recently pitching their deal. Their technology was unquestionably phenomenal and several large companies had already expressed interest in the products offered by the pre-revenue company. It had taken a few years and two capital raises totalling $3 million to get the technology right. Now they had reached commercialization and valued the company at $40 million. The meeting was over. The company was still pre-revenue and would require a lot to go right before this thing turned into a success. The technology risk may have diminished, but there was still a lot of execution risk remaining. Pre-revenue investors need a 10 times target return and it was not possible that this firm would reach a $400 million value over the next five years. Not even close.
Investors in a pre-revenue company are still in scratch-and-win land and fewer than one in 10 will turn out to be a good investment. As a result, pre-revenue investors seek that 10 times returns to make up for all the other deals that didn’t go well.
By the way, if you are investing in very early stage deals, study this business for several years before you jump in. Most early stage investors lose enormous amounts of money before they learn how to invest properly. Then, if you’re going to do one deal, be prepared to invest more than three times that amount in order to hold your percentage ownership position as each follow-on round is completed. Then be prepared to go into at least a dozen deals in order to give yourself a chance that you might hit the 10 times winner which will ease the pain of the other losses.
Most Merger and Acquisition transactions occur in territory under $30 million. Let’s say your tech start-up has proven itself in the market with $1 million in sales and you just sold 50 per cent share of the company for $1 million. It’s still losing money but everyone can see the traction and you have many years of patent-protected market differentiation in front of you.
Two years later another $2 million round of financing buys 50 per cent share as profitability has been achieved and sales continue to escalate rapidly. This equates to a $2 million value at the first round and a $4 million value at the second. The founder still holds 25 per cent of the company which is now valued at $4 million.
From here the plan is not to raise any further cash, but to continue to grow the company to an exit within 48 months in the busy acquisition territory of $25 to 30 million. There is a detailed implementation plan that everyone understands and has agreed to. Everyone’s interests are aligned and hopefully it will all work out.
Obviously, every company’s path and pattern is unique, but it is very important to detail your own before asking others for capital. Get the right financial advice and find mentors who have built similar companies before. The decision in the end is your own, but in this case it’s always better to hear others opinion and rationale before forming your own.
Get as far as you safely can without taking on capital in order to build value. But first, build out your plan, identifying how much capital will be needed at each stage of development. Start with the exit and come back from there. If you have found similar companies building out to a specific revenue and EBITDA (earnings before interest, taxes, depreciation, and amortization) level and exiting within a certain value range, you have justification for exit value expectations.
Now work backwards and make sure that each round of investment gets enough of the company to make a good investment. You may find that this exercise will erode your ownership position down to a percentage that you find surprising. However, there are a lot of entrepreneurs that have done very well making others rich.
It is far better to own 10 per cent of something incredible than 100 per cent of nothing.
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