Many entrepreneurs continue to ask about the difficult decision
of establishing ownership stakes for investors in the earliest
rounds of business development. The concern is always that a few
friends, family and close associates will provide some seed funds,
but in exchange for this needed capital, the entrepreneur often
ends up giving away far too large of an ownership percentage in the
venture's equity allotment. Then later on, when the pre-launch
activities are completed, the entrepreneur finds it difficult to
raise additional investment dollars because a disproportionate
amount of the company's stock has already been given away to
these early-round capital providers. The key issue is to get the
venture valued as soon as possible.
The pre-launch stage is typically characterized by activities
that have no immediate direct connection to generating revenues.
For example, the company's legal form must be
organized and put into place (partnership, LLC, corporation, Sub-S
corporation and so on). Key members of the proposed management
structure must be approached about joining the team. Preliminary
work is normally done on the product concept, various levels of
R&D might need to be completed, and key suppliers have to be
contracted and readied for the launch.
A formal business
plan will need to completed, both as a roadmap for the founding
team in implementing operations and overall strategy, and as a
document used in raising capital from investors. A certain physical
site (a building, a strategically positioned plot of land, an
access way to a key distribution channel) might have to be secured
in order for the venture to move forward in preparation for the
launch. Also, an environmental impact report might have to be
completed. The entrepreneur may have to complete a comprehensive
market test using various focus groups, or an industry analysis and
market feasibility study might have to be completed before the
venture can open its doors for business.
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Every one of these pre-launch activities requires time and money
to get them finished and integrated into the venture's
operations and strategic planning. Often times, entrepreneurs are
perhaps too quick to grant certain ownership stakes to early-stage
investors. Entrepreneurs are also often too quick to give away
equity in exchange for legal, consulting, accounting and other
services when they don't have a lot of cash on hand to pay for
these professionals.
Two items come into play here. First, pre-launch investors
understand that there really is no business to speak of at the time
they bring their funding to the table. This leverages their
investment position and allows them to ask for a sizeable equity
stake because they perceive the venture is not yet operational and
still quite a way from generating revenues. So for this increased
risk, they want an increased stake. Second, entrepreneurs in this
pre-launch early-round funding are generally desperate for funding,
because they know they have to get these funds secured in order for
their great idea to move forward. The combination of the
investor's perception of risk and the entrepreneur's need
for funds strongly favors the investor in requesting a somewhat
large equity stake because there's really not yet any solid or
tangible value, and the entrepreneur really needs the money.
The key component to balancing the relative positions of the
investors and the entrepreneur is to get the venture valued as soon
as possible. A reputable valuator with a solid and lengthy track
record of successfully completed valuation projects can help the
entrepreneur put a baseline value on the enterprise, even when
it's still in the pre-launch stage and there are no revenues.
The business model can be evaluated relative to conservative
estimates about the market, competition, pricing, costs, margins,
overhead and traffic, and projected future after-tax cash flows can
be generated to support a baseline valuation. With this in hand,
the entrepreneur then has a basis upon which to parcel out equity
stakes in exchange for seed capital.
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Take the example of the entrepreneur who gave up 20 percent of
the company to some friends and close associates for $50,000 at a
very early pre-launch stage. That money ran out in just three
months, paying for an initial market study, lease negotiations and
corporate formation. But there was still a feasibility study to
complete and suppliers to secure, as well as personnel to get for
the management team and other development costs to complete. So he
got another $25,000 together, but had to give up 10 percent in
equity (the same proportion as the initial funding). At that point,
nearly a third of the venture had been opted out to investors for
just $75,000. That placed an implied value on the firm of
only $250,000 ($75,000 divided by 30 percent). And this severely
limited the entrepreneur in the launch round of funding to go after
revenues because there was less than 20 percent equity remaining to
offer to investors if the entrepreneur wanted to maintain a
majority equity stake. And then when the next round needed $500,000
to do the launch, the implied value from the initial $75,000 raised
was quite a sticking point because the launch round by itself
represented twice the entire implied value for the entire firm from
early round. This put the entrepreneur in a very awkward position
in trying to negotiate reasonable stakes with new potential equity
investors.
Having a solid value established is the most important item to
check off the planning list when raising capital, especially during
the earliest rounds of funding. It should help the entrepreneur
give up smaller stakes for smaller investments in the pre-launch
rounds and save sizeable equity stakes for later rounds.
David Newton is a professor of entrepreneurial finance and
head of the entrepreneurship program, which he founded in 1990, at
Westmont College in Santa Barbara, California. The author of four
books on both entrepreneurship and finance investments, David was
formerly a contributing editor on growth capital for Industry
Week Growing Companies magazine and has contributed to such
publications as Entrepreneur, Your Money,
Success, Red Herring, Business Week, Inc.
and Solutions. He's also consulted to nearly 100
emerging, fast-growth entrepreneurial ventures since 1984.
The opinions expressed in this column are those
of the author, not of Entrepreneur.com. All answers are intended to
be general in nature, without regard to specific geographical areas
or circumstances, and should only be relied upon after consulting
an appropriate expert, such as an attorney or
accountant.