It's the classic conundrum for small business owners when meeting with investors: How much equity should they offer potential backers? Further, how do they calculate this figure based on business valuation?
For startups that lack profit margins or a set revenue model, this can be a formidable challenge. The problem here, says Panu Keski-Pukkila, CEO and co-founder of Caktus, a startup that recently netted $200,000 in seed funding, is determining a fair market valuation of a business that's still early-stage.
"It's more like an art form than a by-the-book process," explains Keski-Pukkila whose business provides solutions to help people drink enough water. “Neither startups nor investors often have a solid, fact-based number for the valuation. Investors who have done several seed investments have a gut feeling as they compare the startup to the ones they have invested in. Early-stage startups often have no customers or revenue, and that is why much of the evaluation is based on the team, idea and market opportunity.”
Establishing the equity stake might boil down to simple mathematics, notes Ben Hertzog, president and CEO of Procyrion, a Houston-based medical device startup that recently received $2.9 million in funding.
"What's the valuation that's going to support attractive returns for that investor?" he asks. "And how long is it going to take to do that?"
How then can small business owners meeting with investors decide how much equity to offer that would be worthwhile to both parties? Below are some tips.
Decide on how much you need
Before you phone a potential backer asking for a meeting, determine how much capital you need and for what purpose. Whether it's for product development, personnel hiring or any other incentive, it's imperative that you settle on a figure that will help you achieve these critical milestones. Scrutinize your expenses and your cash flow and then set your funding target. That should give you an idea of the percentage stake to offer investors.
“If the valuation is $2 million and I need $400,000 to build the product, then I need to give out 20 percent of the company,” he explains. “It might sound like a big chunk, but I need to make it clear that usually the first round investors get the biggest bang for their buck. If things start going well, the valuation will be higher in the next round and I don't need to give out that much equity to get the same or even bigger amount of funding.”
For entrepreneurs worried about giving away too much equity early on, Keski-Pukkila has a caveat.
“Entrepreneurs need to accept the fact that they will get diluted, no matter what,” he says.
Hertzog concurs, adding that entrepreneurs need to be realistic about their options when negotiating equity stakes with investors.
“Put yourselves in the shoes of the investor and think about the risks,” he urges. “What are the returns that make sense? In our world, for instance, the venture investor has a portfolio and I think a lot of them subscribe to the belief that a third of their deals are going to fail outright—they won't get any money back; a third of their deals they may get their money back but little return and the last third of their deals they'll make a good return.”
Don't inflate your business valuation
When meeting with potential investors, it might be tempting for anxious small business owners to inflate figures to help score funding. That would be a mistake with far-reaching consequences, insists Keski-Pukkila.
“If the company does not perform up to the expectations the valuation demands, it will have problems raising the next round,” he cautions. “If the company is valued at $2 million in the seed round but during the next funding round, seasoned investors value it below that amount, it means the company will have to settle for a "down-round,” [which is when businesses receive investments at a lower valuation than previous funding rounds]. That's why pushing inflated valuation figures will come back to haunt the entrepreneur eventually.”
To avoid this strategic error, Keski-Pukkila advises business owners to listen to interested investors.
“Start negotiations from the number they state,” he says. “Often investors try to ask a valuation figure from the entrepreneur first. This is because they'd like to get an idea of whether the entrepreneur is in the ballpark with his figures. Also, it's a nice opportunity for the investor if the entrepreneur significantly undervalues their startup.” Still, good investors don't typically try to undervalue a company since they want to provide incentive for the entrepreneurs as well and make a fair deal, he adds.
Determine if you really need the funding
Do an appraisal of your company's fiscal health. Is your business in a state where you feel comfortable offering investors a significant stake in it?
Also, determine if an equity stake is really the proper way to raise money. If the need for significant cash is urgent, then perhaps offering equity to investors is a viable proposition. But be careful. If your business is doing well, you might not want to surrender equity so easily.
“I heard an investor once say that when startups have a sufficient amount of money, equity should be treated as really valuable,” recounts Keski-Pukkila. “It's the last thing they want to give out.
Disclaimer: Since the details of your situation are unique, you should always seek the services of a qualified professional for advice specific to your business.