If you have been a smart entrepreneur, you will have built your start-up to the point of outgrowing organic growth opportunities and will be looking for an investor to take you to the next level. Or, you have a revolutionary idea, but it needs more capital than you have available.
With the arrival of an investor on your horizon comes the tough decision of what percentage of the business will they get in return. And to achieve this, you need to know the value of your company. While most business owners have an emotional value of their businesses, due to the blood, sweat and tears they have gone through, there is ultimately only one value that will stand up to the test of the market. Once you have reached a figure that you, and the market, are happy with, you can then move on to the stage of deciding the equity amount available to trade with investors.
This equity figure will not be only one figure. You will need to conclude investor equity amounts for the initial investment as well as investor equity amounts for future rounds. The value per ‘share’ is usually higher at that point. Therefore, less is given away for the same amount of capital being invested.
If this is your first rodeo with venture capitalists and investors, then here are some insights and tips to help you strategise your approach and contingency plans so that you stay the investor pony for longer. We have included some gems from one of the current, favoured, global thought leaders, viz. Anthony Rose of SeedLegals.
Evaluating your business and choosing investor equity amounts
As we said above, the blood, sweat and tears that you invested might carry enormous value. The stress, the sleepless nights, the tested marriage and, perhaps, the patience of your angelic children are priceless. These factors do not make a business evaluation easy. Seed funding companies are very astute at it, as they should be after hundreds of rounds of evaluating hopeful companies. They also lack the emotional baggage so they can give professional, clear, market-related advice or values that can be easily justified to investors that are potentially interested.
Let’s look at what an angel investor, venture capitalist or financier would expect you to have worked through before creating your pitch deck:
1) How much money do you need to raise?
2) To obtain that amount of capital, how much of the company are you prepared to sell?
3) To work out the percentage of the company (from the total value), what type of company valuation should you use?
There are immediately two approaches that you can use to answer these three questions, but ultimately, market value will be the hardest restraint on your calculations. The two approaches are:
a) First, decide on the amount of money you need for your next phase of growth or your launch and proceed from there, or
b) Then, decide on the total amount of the company that you are willing to part with, now and in future rounds, and then proceed backwards from there.
Let’s look at the first option in point a). You will first decide on the amount of money you need.
There are different schools of thought among investors on the setting of targets for how much money to raise. There is no perfect answer as each entrepreneur, product, and business is unique. The one school of thought within the investor sector proposes that when seeking to raise funds, you should raise as much as you can. Another school of thought from venture capitalists and investors is to aim for a target amount that covers the next 12–18 months, at which point you will go into another round of fundraising. Yes, you need stamina.
To be successful at fundraising, or raising investor capital, is not for the fainthearted. You need tenacity, and you need to hit your KPIs, so don’t shoot yourself in the foot. Consider what would create leeway in terms of breathing space around KPIs. We recommend that you don’t be idealistic and overshoot your capital needs. To keep things realistic regarding the investment amount, consider what would be suitable for the aims of the company’s current phase. Then consider if that amount is going to put excessive pressure on your ability to deliver against the KPIs. Also, consider whether that capital amount and your ability to manage KPI deliverables are going to make investor expectations and relationship management a nightmare – or not.
The time period of twelve months to eighteen months includes a presumed period of six months that will be needed by you for your fundraising dog and pony show before funds arrive in the business bank account. If you have a second round of investment pitches before a twelve-month period, it will be incredibly hard to deliver on important KPIs. It will also, arguably, be difficult to show substantial amounts of business growth in that period. Your focus will also be divided between growing the business, which is critical, and preparing for investor pitches. The latter takes time, and it is time away from your core aim – a stronger, more valuable business.
Having said that, this might not be possible for you based on the amount of capital needed and the speed at which the company is growing. You, therefore, will do smaller, more frequent rounds of fundraising. We discuss this in option b) below.
Investors call the twelve months to eighteen months time period a ‘runway’. At the end of that runway, they want your business plane to take off – or it crashes.
So, to get to the calculation part – to work out how much capital you need to pitch for, start with looking at your monthly expenses. This is called a monthly burn rate by investors. Calculate how much headcount you need to take on during the runway period to meet the new business demands. Calculate your marketing spend, your development costs, new premises costs, and all other costs from your business plan. Now, relook at your new total monthly expenses versus the original monthly expenses amount. It is always prudent to add in a buffer for anomalies. Then multiply this monthly amount but the twelve or eighteen runway months.
The funding of the total burn rate is not what the investors want to hear about. They want to hear why £X will get you to each KPI, milestone and new growth point. They don’t like to hear about survival tactics as that is a defensive approach. They want you to attack the opportunities. They want to know what success you are going to achieve and how long you need in order to achieve it.
Let’s look at the second option in point b). You will first decide on the total amount of the company that you are willing to part with.
Have you ever watched Dragons’ Den? Did you take lots of notes? Unfortunately, you can throw those notes away because it is a far cry from equity investment reality.
Firstly, to help guide you in the right direction, it would be prudent to note that if you are targeting Angel Investors or seed funding, then a ten per cent to twenty per cent portion of the company is expected by the investors. This is not a thumbsuck that the industry thought was a good idea. The amount of between ten per cent and twenty per cent is the return on investment that the equity investor expects to get back on their released funds. They are not only investing in your business but have spread their risk over a number of startups, knowing that the majority of their bets will deliver a zero result. It is a high stakes game they are playing, so the returns need to be high to justify the risk ratio. The size of their stake within the company will give them a potentially, meaningful return and it also gives them a level of influence over key company decisions.
Looking across general market data, the indicators show that company owners are releasing fifteen per cent of their businesses in the first funding rounds. If you, therefore, have an investor banging down your door for thirty per cent, then we would recommend a cautious approach to this deal and, perhaps, looking elsewhere. Perhaps, in your unique scenario, there is a perfectly good explanation for this, but it is usually an indication that you have undervalued your company or, perhaps, you are going too big too soon, i.e. trying to raise too much too soon.
If it is not possible to raise an amount that matches your twelves to eighteen months of burn rate, then you can choose an option that is gaining popularity in the industry, viz. Choosing a process that involves more frequent but smaller funding rounds that give away between two and six per cent. This is done every few months.
Historically, this methodology was strongly discouraged for the following reasons:
As mentioned above, funding preparation takes time, and your eye is off the business ball.
Each round of funding needs lawyers involved, and their costs are high, which increases the cost of money.
Traditionally, investors saw this approach as a company’s failure to be attractive or not being able to put together a well thought through pitch.
New, agile seeding companies and venture capitalists are changing the views of the latter. In a bid to get a share of ‘hot products’, they are making it easier to raise money at any time. They are replacing the long runways and the ‘go big’ approach with timing that suits the business growth cycle; hence funding happens at a logical, business-relevant time.
Now that we have looked at ‘slicing up’ your business, let’s look at the size of the pie.
How to calculate the value of your company?
Unfortunately, we do not have a straightforward answer for you as the answers are as unique as the investors. Some say ‘pitch a number, and if you can impress us, you get it’, others are more scientific in their approach, others are a combination of the two, and so the list goes on.
As we mentioned in the beginning, the hardest restraint on your business is the market opinion. The market forces can include the differences between the supply and demand of money, the timing of exits, the size of exits, the premium quality of the product on offer, or the desperation of the business owner.
If your competitors have pitched for investment, consider using their valuation as a guideline. You can also use the investment amount you want as a factor multiplied by three or four to reach the company valuation total.
Investors are human beings and some are influenced by their head whilst others are led by their head but having your data carefully calculated and all your values solidly justified is still vital.
Company valuation estimator in the UK
To give more tangible examples of funding-investor business valuations, here is an analysis of UK data of business values at time of pitching for funding:
Pitch Phase: Service or product idea
Business valuation amount: £300,000 – £500,000
At this stage, you will probably be pitching for £50,000 to £100,000. A fair charge for legal fees relating to this should be about £700.