EQUITY - Often called "the most expensive way to fund a business"

After doing quite a bit of research my brother and I are considering offering the intrepid first investors in our company an equity stake.

THE BIG QUESTIONS.......How much value should be placed on company equity early on? This is for the purpose of raising necessary funds to make your business profitable.

 Say we would like to raise $250,000?  How much equity should that represent? I know that there are formulas designed for valuation of a private stock but I would love to hear from somebody what they feel should be the typical first offering for an equity stake in a company.

I would love to hear what different people here feel should be the actual dollar amount used to purchase a representative 1% stake in a company? (I realize this differs per business of course)   Assume for the purpose of this exercise that in 10 years, we expect an annual gross income near $1 million. Also consider that without the initial investors we are nowhere near that figure. What is fair? What is too generous? 

Break out your calculators and put on your thinking caps!

~Eric

Anyone?............. Anyone?........... Bueller?............... Bueller?

There are no wrong answers on this one. Only opinions..........Anyone?

Eric,

Placing a valuation on an idea stage business is very challenging. We advise our clients to delay this process until the business is more established – if possible.

Without more info, it’s difficult – but for the sake of discussion – let me assume the following:

The company will generate $200,000 of earnings (profits) in year 10.

The company can be “sold” for 5 times earnings

Given the above, if the investor is going to achieve a 20% annual return on their investment – they will need to own 75% of the company.

Remember - this answer is fraught with assumption on assumption and should not be used anything other than an indication that more detailed effort should be done.

All the best,

Robert Johnson

Ok Mr Johnson,

Keeping the assumptions alive,  (you may call it daring but you'd probably be more likey ill-advised or even dumb) are you saying that investors would seek an annual rate of return in the 20percent range? 

If so that is a frightening proposition. But I am also assuming that what you are saying is that such is the cost of an unestablished company.

Of course you are talking about relinquishing ownership when you speak of 75 percent and that just cannot be considered. We would see that as a monumental failure.

I'm hoping that you are presenting the extreme scenario from a V.C. point of view. Fortunately we are far more prepared than that to even let such a scenario enter our minds. V.C. funding is a last resort.

Thanks for the response Mr Johnson, I was getting lonely there for a minute! 

Please don't be afraid to make some assumptions here as I was asking for such. As Startups, we all assume from the beginning that we will succeed with our efforts in a big way. It's almost required.

 Of course, don't let that also be an assumption that we throw all caution to the wind and go running madly down the Yellow Brick Road toward the Emerald City oblivious of the need for a plan to breach the gates upon our arrival. .........................Ok maybe we are a just a little nuts.

~Eric

Eric,

First, the ROI an investor would expect is directly related to the risk they perceive they are taking. For a idea startup – I’d say 20% would be on the low side. Venture Capital firms typcially look for 30% plus as the opportunity and usually in 5 years as the limit. While the calculations are rough, I wanted to give you an idea of how an investor will “view” your opportunity.

Given that this scenario isn’t appealing – you need to refine (or re-define) your deal so it will make good business sense to both parties. Just remember, if you create a higher valuation – you still need to consider the investors side of the deal.

There are several approaches to this issue – more if this capital will be the first and only equity round you will need.

Robert Johnson

Thanks for the clarification. I realize that I didn't really give you much in the way of detail. As a professional I asked you to make a broad statement without any understanding of the business being funded. Your answer was a fine example of  a very careful and professional approach. I really can't ask anything more of you than your professional understanding allows.

 I've heard of some V.C.'s looking for a 100 percent return on debt financing over time with a forfeiture of equity upon default. A desparate move for sure but your example definitely shed some light on what one could be faced with.  

I suppose that as soon as I get my ducks nicely aligned, sorted by color, size, weight, gender and quacking ability, I'll be afforded the ability to assign a more concrete value to the lot.

Thanks again!

Eric

Eric,

Thanks for your compliment. I’m glad to hear that you found my comments helpful.

There are Venture firms with people who believe their job is to “drive a hard bargain” with the entrepreneur and we do see some forfeiture terms being included- but I wouldn’t say it was the “norm”.

As to your ducks – it is true that capital is attracted to things that are organized (and repelled from that which is disorganized) – don’t overdo it. You may be better served to concentrate on adding value to your enterprise - which increases the valuation.

Let me know if we can help.

Robert Johnson