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How Much of My Business Do I Have to Give to an Investor?

By: Dave Berkus

 

How Much of My Business Do I Have to Give to an Investor?

If you’re looking for growth capital, this one’s for you. We’ll cover what information you’ll expect to provide, your range of expected values and amounts of investment to expect. All to help you set your expectations. OK?

Financial History and Projections

Let’s start with the basics. If you are a growing business with a track record of revenues, then the importance of accurate current financial statements cannot be overstated. If there is no record of revenues, see the “The Berkus Method” available with any search query for valuing the business before revenues.

And you should “know your numbers and be able to defend them” during early meetings with candidate investors. At the least, historical numbers must include the latest income statement and balance sheet, showing activity through the latest period. If the business is not a startup, expect to supply income statements for the past several years as well, to emphasize trends in revenue and costs.

Projections for your future

You should expect to present detailed projections for the next 12 months as a basic minimum. Beyond that, plan to prepare projections for two additional years, but not necessarily in account-by-account detailed format. Sophisticated businesses will also create a cash flow projection for the same period, showing cash used and remaining at the end of each period. And note that projections showing “unbelievable” rapid growth are always suspect. Careful about “hockey stick” forecasts.

How much money can you get?

Well, here is a question with a circular answer. To grow your business to a size that will be attractive to a VC or angel making an investment now, you’ve got to show that the business will be large enough at the time of the investor’s liquidity event (cashing out) to make the investment attractive at all.

Most VC’s look for a 10x opportunity—that is, a ten times increase in the valuation from investment to liquidity event. Later stage investors sometimes look for less, since the business has already proven its capability to stay in the game and has already completed its product development cycle, eliminating more risk for the investor.

So, you’ve got to play with the numbers to determine your level of comfort. The more you ask for, the more equity you give up. Completing this exercise often leads you to lower your expectations about the amount of money to be raised.

It is also a factor that early stage investors don’t want a controlling interest in your company. It is a disincentive to you and a burden to them. “Engineer” your needs if possible so that you give 20-35% to investors on the first professional investor round.

Here’s a valuation example for you based on amount to be raised

Try this example: You want to raise $2,000,000 today. Your projections and the analysis we’ll undertake below lead to a possible valuation of $40,000,000 in five years, assuming that you meet your plan, and allowing for a 50% discount to your projected numbers during the investor’s evaluation. That means—using the investor’s 10x expectation for return—making the business worth $2,000,000 today at best. To raise $2,000,000, you must give up 50% of the post-investment equity (the current value of $2,000,000 plus the investment of $2,000,000). The post-investment value would be $4,000,000. When multiplied by 10x, the target valuation at exit would be the $40,000,000 quoted above. It is a fact that very few businesses reach the $40,000,000 valuation hurdle. And it is probable that you’ll need more money to reach that target, muddying the calculation and reducing your equity percentage.

Remember your employee option allocation

Your potential investor will include the full number of shares reserved for your present or future option plan—usually 15-20% of total equity—making your personal equity 20% less when calculated as “fully diluted,” or including a reserve for options. Therefore, in the example above, you would control less than 50% of the company at funding if you received $2,000,000.

Given your strong desire to keep controlling interest in the early stages of growth, the amount that can be raised must be lower than $2,000,000 in order to accomplish this goal.

So, the circular reasoning exercise returns. Raise your projections (and sell your investor on the increased projections as a result) or lower the amount of capital you raise in this round. Your future rounds should be at higher valuations if you meet your plan, making dilution of your equity less onerous at that time.

Published: April 12, 2019
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Source: Berkonomics

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Dave Berkus

Dave Berkus is a noted speaker, author and early stage private equity investor. He is acknowledged as one of the most active angel investors in the country, having made and actively participated in over 87 technology investments during the past decade. He currently manages two angel VC funds (Berkus Technology Ventures, LLC and Kodiak Ventures, L.P.) Dave is past Chairman of the Tech Coast Angels, one of the largest angel networks in the United States. Dave is author of “Basic Berkonomics,” “Berkonomics,” “Advanced Berkonomics,” “Extending the Runway,” and the Small Business Success Collection. Find out more at Berkus.com or contact Dave at dberkus@berkus.com

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