How Much Equity Is Enough?
By Rishi Anand
Over my entrepreneurial life, I have started dozens of businesses, some needed cash from an outside angel investor or bank and some did not.
For the ones that did need an angel investor or bank, being a new start-up usually meant an angel investor. Many of those have been private informal individuals that are high net worth but some have been through professional angel investors. I don't think it really matters what type of investor you bring on; they will all want some piece of your business and usually in the form of common shares.
So, here is the tricky part. Most entrepreneurs over-value their companies in the start-up stage and either ask for more than they need, can afford or offer less shares than what is reasonable and based on real world numbers and facts. To complicate matters worse, most informal angel investors are new at this game and when an entrepreneur throws out a value for their company and shares, many will accept this because they too lack the understanding and knowledge to question this.
Then you have the sweat equity factor thrown into the equation and when an entrepreneur says they have just spent the last so many months or years developing their business project and worked this many hours, how will an angel investor verify this?
How dare someone tell an entrepreneur their time is not worth what they say it is! These are tricky waters but you know what, as Donald Trump says:
'It's not personal, it's just business!'
Regardless of anything else, it is just business and you need to keep reminding yourself of this. However, I am not so sure "The Donald" is the best person at trying to find the correct understanding and balance between how much someone is offering vs. what they are willing to invest.
So, is there an answer? Absolutely not. BUT, a BIG BUT, understanding business valuation is the foundation for both entrepreneurs and informal angel investors.
A pre-money start up or early stage valuation is definitely the most difficult to value (vs. an establish business) but there are some rules. For example, at the very minimum, a business is worth at least 100% of the invested capital.
£100,000 cash invested = 100%.
You can dilute from there keeping the same percentages as post money starts to come in. On the other extreme, one can make an argument that a business is worth what it "should" generate through future earnings. For example, if an entrepreneur makes the argument that their business will generate £1 million in sales and £250,000 in profit each year over the next 3 years (or any number of years), and an angel investor comes in at £250,000 for 50%, they will see a return of 50% per year based on their investment.
Will it happen? That's the tough part, maybe and maybe not but that is speculation and all part of the game. In the middle of all this is some estimate of cash invested, future earnings, sweat equity, future rounds of finance, etc, etc. It can get very complicated and subjective.
My rule is to look at and base things on the initial cash investment from the entrepreneur (plus anything they have personally guaranteed because they are on the hook for this as well), allow them 20% of this for their sweat equity, be VERY cautious about future earnings because if they happen, they happen because of your investment and if you are taking common stock in the company just like the founder, you both go up and down as things move along. If you can bring other things to the equation such as physical involvement, industry contacts and leads, overhead infrastructure, etc. start deducting this from their proposed equity offering.
As we are all learning, sometimes we win, sometimes we lose but if we learn a little each time and have some basic foundation rules, the losing will become less and the winning will become more!
By Rishi Anand
For Venture Giants
Venture Giants is a premier UK business Angel investment network and small to mid sized business networking portal that matches active business angel investors with entrepreneurs' seeking investment capital and business funding.
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Written for and behalf of Venture Giants Enterprises Ltd.