Q: I need to establish a profit percentage to present to prospective investors. Where do I begin?
A: Your question assumes the profit percentage is something that gets figured out. In fact, the profit percentage is the subject of your negotiations with prospective investors. Don't analyze your business hoping to find a profit percentage; rather, establish a percentage and then ask yourself how you can pull it off.
The return you're offering investors drives your fund-raising strategy. When you raise money, you're giving investors a chance to invest in your company instead of putting their money into another investment. You're just one choice among many for investors, so you need to compete against other investment vehicles for investors' money. Here's how:
- You can compete on the profit you'll offer. You'll usually have to promise investors a better return on their money than they could get elsewhere. In many cases, because new businesses are very risky propositions, you must offer a return high enough to compensate investors for taking a bet on you. It's common for angel investors to want a return on their money that's anywhere from 40 to 60 percent per year. Venture capitalists may expect even higher returns. Because most start-ups fail, investors need very high returns from the survivors to recoup the money they've put into less profitable companies.
Investors don't necessarily believe you'll return 40 to 60 percent, but they need to be convinced such high returns are plausible. Your business planning must create a company valuable enough to give that level of return.
- You can compete on risk. Investors have a risk tolerance. Warren Buffett, for example, will only invest in well-established companies with lots of cash and high earnings potential. He's not a big fan of risk. Other investors will toss in huge sums of money on a rumor. You can present your opportunity as either or less risky depending on the investor's risk tolerance. They will generally expect a greater return if they perceive a greater risk. U.S. Treasury Bills are considered risk-free investments, and the long-term T-Bill rate sets the minimum rate of return you must offer an investor. (Otherwise, they can just invest in risk-free T-bills.)
There are many forms of risk. Bio-tech companies risk not making it through the FDA approval process. Many dotcoms use unprecedented business models, which risk not being feasible given customer behavior. Years ago, Microsoft risked standardizing its office suite on Windows 3.1 before the market had accepted Windows. Your business plan should outline the risks you're taking and the return you believe you can promise.
- You can compete on the payback schedule. Investors can put their money in a bank account and get interest paid monthly. By investing in a U.S. Savings Bond, they can get interest several years later when the bond matures. If an investor writes a loan, he or she often receives monthly interest plus a little bit of principal repaid at the same time.
Investors needing ongoing income may prefer investments that generate monthly income over those that pay out at the end of several years. Such investors may be willing to accept lower interest rates in return for the favorable payback schedule.
- Finally, you can compete on the kind of investment. Banks invest by offering loans; venture capitalists invest by taking stock in companies. You can structure your investment offering as a loan or as stock, making it fit different investors' profiles. For high-growth companies that anticipate several rounds of funding, the deal structure may have profound effects on the company's ability to raise later rounds. Both loans and stock come in many forms with different legal and payback implications.
Since I believe that if something's worth doing, it's worth getting help with, I'd find someone who has done several venture deals before and ask for their help thinking through the way the payback will be structured. I find that lawyers who specialize in small-business creation have often seen just about everything in the book and can be a great resource. Start asking around, and you're sure to find someone who could help.
As an entrepreneur, technologist, advisor and coach, Stever Robbins seeks out and identifies high-potential start-ups to help them develop the skills, attitudes and capabilities they need to succeed. He has been involved with start-up companies since 1978 and is currently an investor or advisor to several technology and Internet companies including ZEFER Corp., University Access Inc., RenalTech, Crimson Soutions and PrimeSource. He has been using the Internet since 1977, was a co-founder of FTP Software in 1986, and worked on the design team of Harvard Business School's "Foundations" program. Stever holds an MBA from Harvard Business School and a computer science degree from MIT. His Web site is a http://www.venturecoach.com.
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.