Entrepreneurs are, by nature, visionary and optimistic. Their company valuations are high and prospects are rosy. Perhaps as a result, many may be wooed by pie-in-the sky investment discussions that never result in bona fide term sheets while discouraging realistic but less complimentary offers, which, in their estimation, undervalue the business and their management skills.
For these reasons, I recommend that the entrepreneurial management teams discuss the following five tough questions amongst themselves and update a file of written answers for their eyes only as the company fortunes wax or wane. This “reality check” will help them ask investors and investment bankers discerning questions earlier than they might otherwise do, and will enable them to determine in advance the value of particular offering terms at various points in the company’s future.
Question 1: If the company has no other clients or revenue sources other than those currently active, how long can it sustain its burn-rate?
Analysis: Entrepreneurs may project fantastic valuations after “this” or “that” milestone, but investors and other financial sources also evaluate the present, so entrepreneurs should, too. The more immediate a company’s need for money, the less sense it makes to spend time and effort seeking private equity and the more sense it makes for the company to spend time hawking its widgets to paying customers, increasing its profit margin, and cutting costs. Due diligence by investors will ALWAYS take longer than a financially strapped company wants, and its financial vulnerability will be obvious to the investor, who will either regard that deal as risky enough to (a) abandon or (b) offer less than the entrepreneur needs or (c) propose terms that the entrepreneur may regard as onerous.
To Do: Figure out how long the company can remain in business with no investment and nothing other than organic growth. Calculate the cost of the number of months required to turn a profit and repay debt. This is the amount of money the company needs (vs. wants). How much of the company would you sell to an investor or how much interest would pay on a loan that carried you through this time period?
Question 2: How time sensitive is your financial need?
Analysis: Some companies face seasonal or cyclical highs or once-in-a-blue-moon marketing or sales opportunities they must hit or they are doomed. Others enjoy a short term competitive advantage that is significant, so they could make more money expanding rapidly now than growing organically later. In such cases, money invested or loaned now is worth much more than money invested or loaned later. Calculate a bonus value for the money.
To Do: Look at a calendar and identify a date before which investment is highly valued and after which it is valued less. Determine what you are willing to give up or pay to get an offer by that date.
Question 3: Under what investment terms are you willing to sell 51% of the company, step aside from a management role, or give up a Board seat?
Analysis: Many investors have a clear and public preference for roles, such as majority or minority control, a Board seat, their own management team in place. Many investing firms identify this on their websites or will let you know in a timely manner so no one wastes time.
Know their preferences. Know what you will accept. Also, smart money is worth more than “dumb” money – that is to say that investors who know the industry, and have sales, merger, or vendor contracts can bring terrific value in addition to needed dollars. So the value of the money may vary according to the source.
To Do: Think about all the RESOURCES your company needs to grow – not just money. Calculate the time/cost to achieve goals on your own vs. inheriting professional resources with investment dollars. What is that worth to you – what percentage of the company or what management role?
Question 4: What upcoming milestones will make the company cash flow positive? How much time and money are required to meet the minimums?
Analysis: Most private equity sources will not invest all promised funds up front. Rather, they will release a portion to be followed by later tranches if the company meets identified milestones, usually in sales revenue or development. These increments and goals should be negotiated in the contract.
To Do: Figure out various fast and cheap tracks to profitability. Calculate the bare bones cost to each and add some pertinent allowance for extra time and costs. Read the term sheet carefully. If accepting less money in a first tranche decreases the likelihood of meeting the milestone, you could lose your company to that investor. Some unsavory characters have written contracts in such a way that they can acquire control of your company for the cost of that first tranche from non-detailed entrepreneurs who were starry eyed about the big number at the end of milestones they were ill equipped to meet.
Question 5: If all goes well and the company grows, at what point will expansion exceed the competency of current management?
Analysis: Many entrepreneurs are great at starting companies but weaker at maintaining or growing them. The success of the company may depend on recognizing management’s strengths and weaknesses. For example, running a public company is different than running a private one or merging with a competitor.
To Do: Develop a graceful transition and departure plan based on realistic self and company-assessment.
You will notice that several of these questions approach the same question from different perspectives. The gist is this, “if you cannot achieve your goals without investors or additional capital/skill resources, then the most important valuation to acknowledge is not how much the market will value your company when it is successful, but rather, how much you value the early money that takes you the first, steep step to get there.