How Much Equity Is Enough
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Over my entrepreneurial
life, I have started dozens of businesses, some needed cash from an outside
investor or bank and some did not.
For the ones that did need an investor or bank, being a new start-up usually
meant an investor. Many of those have been private informal investors but some
have been angel investors. I don't think it really matters what type of investor
you bring on, they all want some piece of your business and usually in the form
of common shares.
So, here is the tricky part. Most entrepreneurs over-value their companies in
the start-up stage and either ask for more than they need, can afford or offer
less shares than what is reasonable and based on real world numbers and facts.
To complicate matters worse, most informal investors are new at this game and
when an entrepreneur throws out a value for their company and shares, many will
accept this because they too lack the understanding and knowledge to question
this.
Then you have the sweat equity factor thrown into the equation and when an
entrepreneur says they have just spent the last so many months or years
developing their business project and worked this many hours, how do you verify
this? How dare you tell an entrepreneur their time is not worth what they say it
is!
These are tricky waters but you know what, as Donald Trump says:
'It's not personal, it's just business!'
Regardless of anything else, it is just business and you need to keep reminding
yourself of this. However, I am not so sure "The Donald" is the best person at
trying to find the correct understanding and balance between how much someone is
offering vs. what they are willing to invest.
So, is there an answer? Absolutely not. BUT, a BIG BUT, understanding business
valuation is the foundation for both entrepreneurs and informal investors.
A pre-money start up or early stage valuation is definitely the most difficult
to value (vs. an establish business) but there are some rules. For example, at
the very minimum, a business is worth at least 100% of the invested capital.
£100,000 cash invested = 100%.
You can dilute from there keeping the same percentages as post money starts to
come in. On the other extreme, one can make an argument that a business is worth
what it "should" generate through future earnings. For example, if an
entrepreneur makes the argument that their business will generate £1 million in
sales and £250,000 in profit each year over the next 3 years (or any number of
years), and an investor comes in at £250,000 for 50%, they will see a return of
50% per year based on their investment.
Will it happen? That's the tough part, maybe and maybe not but that is
speculation and all part of the game. In the middle of all this is some estimate
of cash invested, future earnings, sweat equity, future rounds of finance, etc,
etc. It can get very complicated and subjective.
My rule is to look at and base things on the initial cash investment from the
entrepreneur (plus anything they have personally guaranteed because they are on
the hook for this as well), allow them 20% of this for their sweat equity, be
VERY cautious about future earnings because if they happen, they happen because
of your investment and if you are taking common stock in the company just like
the founder, you both go up and down as things move along. If you can bring
other things to the equation such as physical involvement, industry contacts and
leads, overhead infrastructure, etc. start deducting this from their proposed
equity offering.
As we are all learning, sometimes we win, sometimes we lose but if we learn a
little each time and have some basic foundation rules, the losing will become
less and the winning will become more!
By
Rishi Anand
Written for and
behalf of Venture Giant Enterprises Ltd.
About the Author
Venture Giant
is a premier UK business Angel investment network and small to mid sized
business networking portal that matches active business angel investors with
entrepreneurs' seeking investment capital and business funding.
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Article Published/Sorted/Amended on Scopulus 2009-01-30 12:25:29 in Business Articles
