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Articles:: The Art of Funding and What Investors Will Never Tell You
This article is based on real funding scenarios with real money by real people. There is a caveat, though: The content is relevant only in the present economic climate - one which is challenging but without the economic extremities characterised by the dot-com craze or a global recession. To illustrate, if a second wave of the dot.com craze were to hit, my valuation of your company could be pathetically low, but should there be a new global recession the valuation would be meaninglessly high.
VCs have a penchant for mocking the naivety of entrepreneurs. This article hopes to stop the VCs from making a mockery of you.
How much are they willing to invest?
The funding community has differing views, but on average, VCs and angel investors are currently willing to invest 4 to 5 times the net earnings of a company. For instance, if your company makes S$100,000 net profits a year, your company is valued at about S$500,000. This is different from IPO valuation, which is valued at about 8 to 10 times the company's net earnings at present market conditions.
What about a company that earns revenue but make losses? Well, the current market rate is to pay 2 to 3 times of real revenue. Meaning if your company earns S$100,000 revenue a year, it is likely to be valued at S$300,000.
A new start-up with no revenue, let alone profits, should not have high expectations unless it has a world stunning patented technology or a fantastic business model with low risk of failure. After all, most VCs are now claiming to be 'steady state' investors or post seed-round investors after the dot-com crash. This literally means they are taking less risk and are willing to put their bets on surer things. Being able to get S$50,000 to $100,000 as a technology bet to build a prototype and to test some plausible ideas is good enough.
For those who have heard of friends who got million of dollars seed funding for some proprietary technology, think again. The only profession that sees millions and millions is an astronomer, not an entrepreneur. The late astronomer Dr. Carl Sagan is fondly remembered for uttering 'millions and billions' in his brown professorial turtleneck. Unfortunately, the millions and billions are stars not funding dollars!
Friend or Foe?
Many VCs seem to be our adversary, dissecting our business plans to shreds. But, should they be helping us to get rich? Firstly, most VCs are employees too. They have deadlines and targets to meet and at the end of the month they take home a salary which is no different from many others. If they can invest in a company at a lower price, they are performing in the eyes of their employer. I have not heard of a VC who gets a bonus overpaying his investments. Therefore, a VC's purpose in life is to make his employer rich, not you.
Overvaluation is bad
Overvaluing your company is bad. To illustrate, you have a brilliant idea to manufacture manual typewriters and by some fluke, some crazy VCs valued your company at S$10 million and you are over the moon. To your horror, the VC only takes a 1 percent stake in your company and pays you S$100,000. You will end up bragging to the whole world that you own a S$10 million company but in reality, you won't even have enough money to pay your staff a decent salary. Unfortunately, this is not the end of your misery. You will quickly run out of the S$100,000 and will soon find yourself frantically searching for the next round of investment. The next VC will gasp in horror at your previous high valuation, and ask for a 'down round', which means you are actually valued less! Having given the first VC the first right of refusal, you will then have to beg him to accept a down round, locking yourself in a downward spiral.
Undervaluation is also bad
Many entrepreneurs, on the other hand, play start-up heroes by saying, "I need very little money." They imagined that by asking for very little money, the VC and investors will respect their integrity and financial prudence. These entrepreneurs will show accelerated project timelines and quick return to profitability. They will have development teams that will meet every deadline and sales targets in China, Cambodia and California all at the same time.
But what is wrong with that? Firstly, 99% of projects in human history tend to stretch beyond the targeted deadlines. Projects that are completed before deadlines usually involve world class project managers who have inserted enough buffer time to make the projects look good. In short, you need to plan for contingencies where funding is concerned. Ask yourself: "What if your team gets hit against a brick wall?" "What if your targeted customers change their preference?" "What if Asian Duck flu hits?"
Secondly, the amount of due diligence checks by VCs is roughly the same whether it is a S$1 million deal or S$5 million deal. You are not making life any easier by asking for less money. Regardless of the size of the deal, the VCs will still have to go thru your patent filing, the profile of your management and technical teams, your accounts and projections. Thirdly, most funds have a minimum investment limit set on the fund disbursement as much as they have a limit set on the highest level of usage.
Remember, Dr Evil in the Austin Powers movie? Do not threaten the entire world and ask for a ransom of a mere $1 million dollars. Ask exactly what you really need.
Ownership - How much to dilute?
Giving out too little share of your company may not be good. Referred to as micro equity, it is roughly between 1% to 5% of total ownership. Similar to the above 'asking-for-too-little-money' mistake, a VC exercises the same due diligence be it a 1 percent investment or a 20 percent investment. Since a VC does the same amount of work, it makes economic sense for him to spend time on deals that his firm can own substantially. More importantly, if the VC's share of equity is low, it could mean other VCs and investors jumping in and taking a stake as well. Having to co-exist with other competitors could complicate matters.
However, entrepreneurs should also not lose majority control. The joy of being an entrepreneur is to take decisions into your own hands and pull the trigger exactly how and when you want it. The trick is to give up enough equity and yet have sufficient say in your business. Perhaps, Depeche Mode sums it up nicely, "Get the Balance Right!"
Plan for Exit
While many business plans are beautiful with fantastic financial projections, they fail to address how the investors can exit. At best, they will have some vague ideas like IPO listing or sell out to the MNCs. Even though you may not get the exit valuation right, it is nevertheless important that you consider some form of exit mechanisms for your investors to realise capital gains. The fact that you have taken time to think about how much they can benefit from their investment in your company, will send out the right signals. That is also why some seasoned entrepreneurs are able to get a stream of funding.
Last but not least, entrepreneurs must be mindful of the 'IPO exit window'. The capital market is often seasonal and unpredictable. The window of opportunity for listing may be as short as nine months to a year. When the market conditions are favourable for listing, go all out for it. As one of my investment banking friends put it eloquently, "Ask money when the market conditions are right not when you need it." Many an entrepreneur have made the cardinal sin of believing that their companies are worth 'millions and millions' more when they are courted by bankers to list; only to find their valuations plunge when the conditions turn sour. If Warren Buffet does not pretend to be able to predict the future, lesser mortals like us should not even try.
All the best to your funding.
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