I had a really enjoyable time in Miami earlier this week as a guest speaker for the Entrepreneur Magazine/UPS Growth 2.0 Conference. You may have seen my 10 Practical Tips for Starting Fast here Tuesday, taken from my talk there.
There was one question I didn’t answer well because it would have taken too long and would not have applied to a lot of the audience. Time was limited.
An audience member asked me how to establish the right percentages when asking for investment. He said he’s done his business plan, he’s been to talk with the local SBDC and SCORE organizations, but he still doesn’t know how to calculate the right percentage. How much of his company does he have to give away? He said he didn’t know if it was 1 percent, 10 percent or 50 percent.
Of course that’s impossible to answer well without going into the details of the specific case, but generally you have to understand that investors’ best weapon, as they look at a deal, is the simple word “no.” As in “No, I don’t want to do this deal.” And I also asked him to consider the needs of the investor, which are more about getting cash out in a reasonable time than just about having a share in a healthy company.
So, thinking about this on the plane back to Oregon, here are some general thoughts (in no particular order). Warning: these are all general rules; there are exceptions to every one:
- While it is true that you can occasionally get naive people with money, often friends and family, to write big checks for small pieces of ownership (say 1 percent to 5 percent), those are often bad deals. They’re bad for the investors because the return is likely to be very low or nothing at all. They’re bad deals for the company because you end up with unsophisticated investors who get in the way of real growth prospects later, if there are any, by interfering with professional investors.
- Do you want to start your company with naive investors? Consider this previous post of mine, about the wisdom of looking for stupid investors.
- Investment by outsiders is for scalable, defensible, high-profile startups with proven management teams. Unscalable services don’t attract professional investors. And there has to be a real commitment to a credible exit strategy in three to five years. If you don’t like these criteria, rewrite your business plan to need less investment.
- Investors want to have enough clout to make sure you don’t decide later that you don’t want to sell the company. That doesn’t mean that every investor is going to want more than 50 percent, but he or she will almost always want to see that the outside investors, when their holdings are combined, hold more than 50 percent. They don’t make money when you do. They only make money when you sell.
- Don’t give equity to anybody you don’t want permanently involved in your business. Those 1 percent-5 percent-10 percent pieces that startup entrepreneurs give to professional advisers, relatives the kid that did the website? Those are going to drive you crazy later. If you grow and prosper, you’ll need those shares for employees. If you fail to grow, those people will be bugging you over the long term, pressuring you to give them money where there is none.
- Remember the math of equity and valuation: You calculate how much money investors give for how much ownership by managing valuation, meaning how much you say your company is worth. So if you want to give 10 percent equity for $250,000, you’re saying your company is worth $2.5 million. Is it? Can you argue that with investors? Will they agree?