Before you approach an investor to fund your growth strategy, make sure you are able to articulate what they will receive in return.
Every business at some point needs to rely on growth investment. In some cases funding comes from the entrepreneur's own pocket, but in many cases business builders need outside access to growth capital--through venture capitalists, individuals, angel investors, or our parent company.
We recently wrote about the 10 questions investors will ask to help them decide whether to invest in or pass on your company. One question in particular puzzled some of our readers:
What am I buying for my investment? In other words, what will I "own" when you are finished spending my money?
This prompted a question from Arvey Guihama, CEO of Solevariety: "How do I assign an equity stake based on the investment?"
There are a couple of ways to think about this.
First, in a theoretical sense, your company has a value today. Let's say it's $100,000. This is usually called the "pre-money" valuation, since it's the value of the business prior to any funding. If you are asking an investor for $300,000 to build the company, then the company will be worth $400,000 "post-money," or after funding. This is because it has assets and capabilities that are worth $100,000, plus $300,000 in the bank. In this case, the investor would get 75% of the company.
The trick here is that it's often difficult to agree on a "pre-money" valuation. If the company has specific assets that can be sold, that becomes the base, or floor, for a valuation, and intangibles like talent and expertise could be added on top of that.
The second approach is more practical, especially among venture funds. In this methodology the investor targets a specific rate of return, or IRR, which is typically 30% to 40%. VCs need to target a high return since successful investments must cover the losses on failed investments.
If the investment is $300,000, the VC may estimate that it needs to net $1.5 million in five years. If the VC estimates the value of the company in a successful future scenario will be $2 million, and they need $1.5 million in proceeds to hit their target, they will require 75% of the company in return for their $300,000 investment.
The problem that many entrepreneurs have is that they haven't built enough "value" prior to approaching an investor. Put another way, their pre-money valuation is not high, given that they are not bringing many unique assets or capabilities to the table.
If you approach an investor with close to nothing, you aren't giving them much to "buy" for their investment. In this case they will take most of the equity in the business, since their capital is the most valuable asset the business possesses. More likely, they will pass on the investment or potentially take their capital to someone else who is a more appropriate or "valuable" choice to build the business.
KARL STARK AND BILL STEWART are managing directors and co-founders of Avondale, a strategic advisory firm focused on growing companies. Avondale, based in Chicago, is a high-growth company itself and is a two-time Inc. 500 honoree. @karlstark