Prepare to be Diluted

Posted by Trevor on 27 March 2012 | Post a Comment

With your mind on survival and your feet firmly planted on the ground, we’re ready to talk valuation. Many entrepreneurs have a hard time understanding the valuation of a company. There are three ways to finance an idea and each has consequences. Whichever way you go, prepare to be diluted.

The riskiest option is to put 100% of your own money behind the company. This is the Texas hold ‘em style of doing business. You’re all in. The problem is that a business can fail through no fault of your own. If it’s your life savings invested, failure will hurt more than it should. Backing my own idea was a high-risk game. I subsidized myself by working about three days a week for someone else until my company had enough money to pay me a wage.

Debt financing makes sense for a small business. The lender wants to be paid back in a set time while making a profit off of the interest. They take a back seat when things are going well, and are all over you when things aren’t well. You still have to put some of your own funds in, about 10%, but the lenders often give you a grace period so you have enough time to get revenue flowing. There’s pressure to pay back the loan and doing so adds more stress to life, but there’s no better feeling than the day you pay it off.

Your third financing option is to exchange ownership of a portion of the company for a cash investment. Capital financers want to have a say in how the company is run, which means board meetings. The challenge is that startups often have no revenue in the beginning so there’s no value to exchange. Entrepreneurs also have inflated ideas of the value of their company. If you want to borrow $100,000 in exchange for 20% of your company, you’re valuing your business at $500,000 today. These numbers must be backed up with tangible support of where the revenue and profit is coming from, like contracts in hand or customers lined up.

One of the smartest financing structures I’ve experienced is hybrid capital financing. Investors owned 70% of my company in the beginning and I owned 30%. By paying back their initial investment within a set period of time the ownership reverted back to my favor. I then owned 70% and they retained 30%. This got us over the hurdle of trying to assign a valuation to a new company.

It’s a hard thing for a budding entrepreneur to give up a large piece of their pie for an investment, but this is the way the world works. A 2009 Tufts University survey found that the average equity ownership entrepreneurs with capital financing had was under 10%. I started my first company with nothing and sold it a few years later for over $100 million. When people hear that, they expect to get a go in my private jet. No. I made a lot of capital investors very happy and occasionally get to fly in their jets. That is how the real world works.

Remember that capital investors bring much more than funds to the table. They have access to a network of experts, and to new and bigger opportunities. In truth, I prefer to give up some ownership in exchange for the non-monetary value they bring.

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