Editor's Note: Learn from a panel of experts and entrepreneurs who have successfully financed their own ventures and are helping others do it at the Thought Leaders Live 2013 event May 29, in Long Beach, Calif. Event and ticket information can be found here.
How many times have you contemplated the $100,000 from outside investors who want a 40 percent equity stake in your business? Simple math shows that if $100,000 is 40 percent of the firm's value, then the firm must be worth $250,000. The situation is made worse if no one has a clear rationale for why the firm is worth $250,000. So if the deal negotiations simply pick a random percentage, the business gets valued due to that percentage and the dollars invested. But that does not define the underlying reasons for the company value, and that is a major problem for entrepreneurs to avoid.
The key to this issue has two distinct parts, both of which come under a basic rule. First, take the time and spend the money to have a formal business valuation provided by an independent third party. Too often, business owners either don't bother to set a definitive value on the company or they work with a value that was loosely generated using a simple rule of thumb. Worse yet is when they pursue either of these two plans, the party providing the funds ends up in the driver's seat in setting the value for the company, which establishes the percentage ownership stake for the investment made. For example, if an owner sits down with a potential investor and does not have a value set forth in advance of that meeting, the investor gains the upper hand and is in a position to offer a value to begin the discussions. Not having a solid value prepared also makes the owner appear relatively unsophisticated in understanding the basic issues of business dealings. Think of it: What kind of confidence does an investor have in an entrepreneur who doesn't even know the value of her company? So the first priority should be to open the dialogue based on a starting value provided by the firm owner.
In the other case, some owners come into the investment discussions with a value that is merely based on a simple formula such as "three times annual sales," "four times net assets" or "six times earnings." But those multiples are not the basis for the firm's value. Instead, they are typically reported as the quick summary after obtaining a detailed valuation. For example, once a formal, comprehensive valuation is completed, it turns out that the value is a certain multiple of the firm's sales, assets or earnings, so that gets quoted when people say, "We're doing the deal at four times sales." But starting with a simple multiple does not provide the broad review of cash flows, industry analysis and business risks needed to establish a firm value.
Entrepreneurs must also make a strong effort to accumulate a solid file of supporting evidence about the company's tangible risk exposure and positioning. When the issue of the firm's value (and the percentage stake the investment represents) becomes the heart of the discussions with the funding source, the entrepreneur is in a much more advantageous situation when he has several files packed with tangible and credible data to support the valuation. Reports from trade publications about the market, articles from magazines about the competition and state of product technologies, or government studies about the labor and capital issues affecting the industry are all examples of such third party evidence. Other items could include a listing of all competitors and suppliers, some recent figures on sales of comparable firms, market values for similar publicly traded companies or a university research study about local business trends and impacts. The key focus here is that the entrepreneur needs to be the one educating the investors about the risks and company position, rather than having the investors come to the table with all the pertinent data to show the owner why the firm should have a certain valuation.
Finally, don't neglect this basic rule: Negotiate everything. Just because an investor quotes "35 percent" as the targeted equity stake doesn't mean that's the final figure. A well-prepared entrepreneur who has a formal independent valuation and a few folders worth of third party supporting documentation about the company's risks and market status is in a great position to offer the starting figure for what stake the potential investment represents. If the investors try to start the discussions with their own figure, it is very reasonable to expect that the firm owner will counter that offer and provide a solid basis for that lower percentage. If entrepreneurs go into the deal unprepared, then there is no one to blame for getting stuck at a high percentage equity stake. So negotiate everything until the funding deal reflects a sound model and good supporting evidence for the value.
David Newton is a professor of entrepreneurial finance and head of the entrepreneurship program, which he founded in 1990, at Westmont College in Santa Barbara, California. The author of four books on both entrepreneurship and finance investments, David was formerly a contributing editor on growth capital for Industry Week Growing Companies magazine and has contributed to such publications as Entrepreneur, Your Money, Success, Red Herring, Business Week, Inc. and Solutions. He's also consulted to nearly 100 emerging, fast-growth entrepreneurial ventures since 1984.
The opinions expressed in this column are those of the author, not of Entrepreneur.com. All answers are intended to be general in nature, without regard to specific geographical areas or circumstances, and should only be relied upon after consulting an appropriate expert, such as an attorney or accountant.