One of the most difficult tasks for startup entrepreneurs who seek early investment is determining the value of their company.
Face it, when you ask Aunt Nellie to be a silent partner, the stake you exchange in your business is based on how you both value it. Armed with an understanding of early-stage investments, you can greatly reduce the stress of reaching an agreed upon value.
Through my experience at Startup.SC, I have learned that the true goal of early-stage investment is to delay actual valuation until later stage fundraising, when a more accurate valuation can be made. With that said, you still need to have an agreed upon value with your early investors. More important, how you value your company at these early stages is crucial for long-term success (not to mention peace of mind for you and your investors), so it should not be taken lightly.
Related: Understanding a Business Valuation
Here are a few tips for novice startup entrepreneurs to consider.
Know your 18-month runway.
How much working capital will you need to get your idea developed and launched within 18 months? This includes the cost of development, hiring (and retaining) key talent and acquiring customers (marketing). This runway can vary from 12 to 18 months, but the latter is widely accepted by most angel investors. Also, remember the number-one rule of investors: do more with less. Do not be frivolous with your estimates and be certain that every dollar you raise goes to launching your business.
Remember the 20 percent threshold.
In startup rounds of fundraising, you should avoid giving up too much equity. The amount will vary between 15 percent and 25 percent, depending on the source, but in general, the idea is that in later fundraising rounds (series A and beyond), new investors will also want a cut of the equity, so if you have given away too much in the beginning, there will be very little of the pie left to share.
Calculate your value.
So you have determined that you need to raise $200,000 to get your company launched over the next 18 months. If you target a maximum of 20 percent of your business in exchange for this startup capital, then you have valued your company at $1,000,000.
Now this will be difficult for many novice entrepreneurs to swallow. How do you ask early investors to invest in a startup company that you have valued at $1 million? Assuming you have validated your startup idea, most sophisticated angel investors will understand how you determined this valuation and the reasoning behind it. Whether they agree with it or not is another story.
For other investors, such as your Aunt Nellie, who may not understand the reasoning, it is important to explain that the goal is to delay the valuation until later rounds of funding, at which time your startup company will have (hopefully) launched and had some success. Saving equity for later investors only helps to increase the value long term.
Consider this scenario:
- After you have successfully met your 18-month runway plan, you might look to an experienced venture capital (VC) firm to raise another round of capital to grow and scale. At that point, determining your company's valuation will be much easier and more accurate.
- If you have protected your startup investors with an agreement (convertible or safe debt) and a market cap (a maximum valuation of the company that all investors agree upon, in this example, $1,000,000), then their 20 percent investment is secure.
- If the VC firm decides to invest $1,000,000 in exchange for 20 percent of your business at that time, which comes out of the entrepreneur's equity, they have just valued your business at $5,000,000. Your startup investors have just made five times their money.
The biggest concern for all investors, and to a great extent the entrepreneur, is equity dilution. If you dilute the equity too much and too early, then later investors have no incentive to invest. Early investors need to understand and appreciate that later round investors are key to growing a business, increasing the value of the company and, hence, the value of early investments.
Of course, all of this is an oversimplification of the sensitive process of valuing a startup company, but it can serve as a guideline for new entrepreneurs with little experience. Additionally, startup entrepreneurs should:
Leverage entrepreneurship centers.
Find experienced entrepreneurs to help and advise you through the process. Use them as a sounding board for your concerns and ideas.
Do not get desperate.
Not every early investor is sophisticated enough to understand the importance of protecting against dilution. You may find yourself faced with an investor who is willing to invest a large sum of money but has unreasonable demands. As tempting as it may be, do not sacrifice to the point where it hurts your long-term goals.
Remember that everything is negotiable.
There are always creative ways to structure deals that will make all parties comfortable. Be willing and flexible to entertain ideas, as long as they do not compromise these early-stage fundraising tips.
In the end, remember that raising startup capital is a long and difficult process. Put yourself in the shoes of investors, and remember that patience, honesty and determination will ultimately help you meet your fundraising goals.
Your Aunt Nellie will appreciate it too.
Do you have any other advice for startup entrepreneurs who are looking to raise capital? Please share your valuable thoughts and experiences with others in the comments section below.