Every year, entrepreneurs spend countless hours planning and preparing for the perfect investor pitch. They research, practice, and pick apart every piece of their idea and/or business to find success in the form of an investment to propel them to the next level. However, all of this time spent preparing and practicing can be futile if there is not a strong foundation first; namely, “Is the business built on an idea worth investing in?”
This is not always an easy question to answer with so much personal time, attention, and energy focused on developing that idea. Saying there is a little bias may be a rather large understatement. That’s where gaining further perspective allows you to assess whether it is, in fact, a “good idea” or not. And even if it is a good idea, exactly how good is it?
To decide, you have to consider not only if it is a “good idea,” but if it is a profitable one—two very different matters. Profitability depends on many internal and external factors, only one of which is how good the actual idea is in the first place. And it can only truly be evaluated by looking at it from different perspectives. Understanding these factors from various perspectives, and how they influence profitability, will give your idea a stronger leg to stand on when under the certain scrutiny you’ll face in that investor meeting.
Seven Questions and Perspectives to Evaluate Your Idea … Before the Pitch
What do you think makes your idea unique?
Think about you as your own customer, not as an inventor and/or entrepreneur who spent months or years perfecting a product or service. Consider what specifically makes your idea unique and interesting. Why would you choose what you offer? Once you’ve identified your value proposition, use that as a baseline when considering other perspectives.
What do others think make your idea unique?
Now that you have your baseline, start asking others the same questions—family members, friends, strangers, fellow entrepreneurs. Record their answers and analyze where they fall according to your baseline. Look for any patterns or weaknesses and think about how to address them. Take the time to consider the results of your research and how they affect your baseline.
What is your competition doing?
Once you have a better understanding of your customer perspective, take a thorough look at your competition. What are they doing differently? What are they doing the same? Similarly, look at trends in the market and your specific industry. Where does your business fit in? What pain point does it solve that your competitors are missing? What are your differentiators?
If you’re not already in the market, how will your competition react when you enter it?
Getting your idea to market is one thing, but keeping it there is entirely another. Consider the impact your idea could have on the market and how competitors might respond. This is an extremely valuable perspective to have when preparing for a pitch.
What will critics say?
This is often overlooked. Why? Because it’s unpleasant! We don’t want to hear the bad feedback. It’s so much better to relish in the compliments. But this is crucial. Think about the perspective of those who have negative opinions of your idea or business. Is there any validity to them? If so, how can they be addressed? Taking in the thoughts of critics is incredibly important for ensuring you are not missing the mark. If you don’t address them, your investors will.
Do the numbers make sense?
Numbers don’t lie. There is no gray area. Either your business can be profitable or not. If the numbers aren’t there, there is no hiding it. Consider the following:
Are there holes in your research?
Was there an error in the data?
Is there any way to lower costs without affecting quality?
Is there any way to increase distribution?
Numbers are a massive factor in any investment. Ensuring yours make sense will go a long way with investors.
How much sentiment is attached to your idea?
Now that you’ve examined the perspectives of others, it’s time to reexamine your own perspective again, especially its weaknesses. One of the biggest mistakes someone can make when pitching an idea is getting too sentimental. Don’t get me wrong—you want to tell your story. It makes the most impact. But emotions and sentiment will never take the place of profitability. And if you are too sentimental, it may appear that you are trying to cover something up. It’s crucial that you are able to separate your sentimentality to the project from your logical stance on the viability of it as a profitable enterprise.
Barker Associates provides strategic guidance and outsourced CFO services to companies of all sizes. We can provide the higher level of strategy your company needs to grow, including helping to prepare for that ever-important pitch. If you need assistance, or have any other questions, please click here to schedule a 30-minute consultation at a rate of $100.
Equity Makes the World (or at least Businesses) Go Round Know What You Have Before It Stops Turning
You’re an entrepreneur. You wake up one day with a brilliant idea on how to make people’s lives easier and/or make the world a better place – and you cannot wait to get started. Congratulations! On that day, you own 100% of the equity in that idea. But as that idea solidifies into something tangible, equity becomes a bit more convoluted.
Most likely, you will not be able to transform that idea into a product or service on your own. You will need some help. And unless you have boatloads of cash laying around (that would be nice), you will have to figure out another way to compensate others for their expertise. Many times, that exchange agent is equity. But before you rush off and give it away, risking devastating consequences, up to and including, losing any interest in your own idea at all, there are some important issues to consider.
All in the Family Equity
Oftentimes, you are not dealing with an angel investor or capital venture firm right off the bat. It is far more likely that your first experience with equity discussions will happen with friends and family who “want to you help you” with your new venture. Now, my quotes do not mean they don’t actually want to help – of course they do. But when it comes to money and the idea of making a lot more of it because of someone else’s brilliant idea, situations tend to get very sticky, no matter how close you are to the other person.
The best advice I can give when it comes to giving equity to family and friends is to think before you act. I mean really think before you act. You cannot afford to be impulsive here – literally cannot afford it. Don’t just think about the highs you will experience together. In fact, try not to think much about them at all (counterintuitive, right?). It’s far better, albeit unpleasant, to think about the extreme lows and what they would look like with the equity distribution you’re considering.
What About Employee Equity?
If your business has employees and you are considering an Employee Stock Option Plan (ESOP), you should start with your equity allocation to principal management. The rule of thumb for the allocation of equity to senior management and advisors is 15 – 20%, but as always, it depends on several factors and even timing. For example, perhaps you plan on hiring a CEO/President in the near future. In that case, you will want to reserve some equity for that person.
Employees in technology and financial positions are critical in most companies, especially as they are in a growth phase. As such, the majority of the allocation should go to these positions. In contrast, when you think about sales executives, you should take into account their commissions (that most management won’t receive) when considering a lower allocation of equity.
Another consideration is vesting equity ownership as an employee incentive to perform well and stick with it while the company evolves from start-up to success. My advice is to keep these agreements simple and the terms the same for each group.
But Wait … There’s More Other equity considerations include:
Equal split of equity and decision-making with a Partner(s). Proceed with caution and have everything laid out in your agreement. Remember clear leadership for the team and company is crucial for progress.
Conduct proper due diligence and background checks before giving equity to anyone. Otherwise, you not only risk losing equity, you also risk damaging the company’s reputation. Due diligence should include speaking with other entrepreneurs with whom they have invested. The right investment partner will offer invaluable wisdom and advice.
Maintain accurate records. Every transaction should be documented – whether you are a one-woman company or a Fortune 500 company. Document everything, including initial capitalization.
Refusal to part with any equity. Some entrepreneurs refuse to give away any equity, which is not usually ideal either. Sadly, many end up owning 100% of nothing in the end.
If, after all of these considerations, you decide that giving some equity away is in your (and your business’s) best interests, then the allocation should be clearly documented in a Stock Option Agreement. This will spell out the terms of vesting and all criteria, and can be a very simple document, as long as it clearly lays out expectations and terms.
Remember, entrepreneurship is an emotional roller coaster that you have to continue to ride – there simply is no getting off when you need a break. And after that sky-high feeling of things going great, you often plummet back to earth – those are usually the times when you don’t have enough cash, start to jeopardize your own personal finances, and make quick judgments that have long-term effects. So, think through your equity considerations carefully and do your due diligence to keep your business going round.
Barker Associates has extensive experience in equity allocation and agreements. If you need assistance, or have any other questions, please click here to schedule a 30-minute consultation at a rate of $100.
How would you respond if someone made a legitimate offer for your business? Would you know if the amount is what the market would pay? Even if the offer sounds like more, or less than you imagined, you want to respond from a position of knowledge, not sticker shock.
Valuation is the value an investor would place on your company if you were to seek investment funding. From a negotiating standpoint, it’s better for the prospective buyer to say a number first so you have an indicator of how serious they are. Prepare yourself – arm yourself with the knowledge of a realistic valuation so you can effectively negotiate.
One measure of the value of your business is what someone will pay for it. Enterprise Value is a real number that investors calculate using your historical financial statements to arrive at a multiple of revenue, or EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). Other factors influence the value that could actually be paid for the business.
For example, are you loading your books with personal expenses and other tactics to avoid paying taxes? When investors value your business, such expenses can lower your EBITDA and affect the sale of your company.
On the other hand, EBITDA can be higher when you keep personal and business expenses and bank accounts separate and run your business as a true entrepreneur. Large and small organizations alike are guilty of combining personal and business expenses. C Suite executives in large organizations without governance over their expense account can significantly impact the value of the business by deflating the run rate of profit. Smaller businesses sometimes pay their family members a salary without the family member ever doing any work for the organization. Neither of these examples are proper stewardship over the financial governance of the organization.
Then there is the value that the market will bear. Factors that can influence the actual value paid for your business include how scalable your infrastructure is – the people, processes, and technology. If a new owner wants to focus on growth, is the right infrastructure in place to support that or will the new owner have to invest in infrastructure first? How much debt are you carrying? Someone has to pay off debt when the business changes owners.
On the other hand, your approach to acquiring new capabilities – buy, versus build, versus lease – in some cases can raise the value that the market is willing to pay.
Your role as an entrepreneurial leader can also influence the market value of your business. Employing a strong team who lead and run your company with an eye to the future is much more attractive than a business operating with old, inefficient processes and no new product launches.
My goal with this post is to help you understand the importance of knowing the value of your business. You never know when someone is going to reach out to you with an offer you cannot refuse. Be ready by knowing the valuation of your company so you can speak intelligently – before you get on the emotional roller coaster of discussing a transaction.
Part 2 of the Equity series. In Part 1 of the Equity series I laid the groundwork for equity allocation by discussing the impulsive entrepreneur who gives away the business to friend and family just to have them involved in the new venture.
Part 2 focuses on equity allocation to key roles in your organization. Unless your entrepreneurial idea is to start a new kind of venture capital firm or become an attorney who specializes in IPOs, discussing employee stock option plan (ESOP) allocations and agreements with potential staff members may seem intimidating.
That’s why I am sharing some key considerations for you to be aware of when you are ready to start that conversation. My perspective is that of a former principal and chief financial officer of a private equity firm.
Equity allocation to Principal Management. The rule of thumb for the allocation of equity to senior management and advisors is 15 – 20%.
The allocation to individuals depends on several factors and even timing. For example, if the founder(s) know they need to hire a CEO/President after they get the entity to a certain level, they should reserve some equity for this position.
Sales executives typically will earn more through commission than most of the management team, therefore should have the lowest allocation of equity of the C-Suite.
Technology and Financial positions are critical in most companies, which means the majority of the allocation should go to these positions.
Equity to advisors is another factor when divvying up equity, and discussed in more detail in Part 3 of this series.
Finally, there is vesting equity ownership as an employee incentive to perform well and stick with it while the company evolves from start-up to success. My advice is to keep it simple – don’t have one-off vesting arrangements for each person – keep it straightforward, make all terms and conditions with all option arrangements pari passu (on equal footing) with everyone – this makes it easy.
Part 3 concludes the Equity series with other key considerations for entrepreneurs considering equity allocation for their startup.
Mindy Barker & Associates (firstname.lastname@example.org) works with entrepreneurial growth companies to help maneuver the many questions of funding, employee compensation and other decisions and is available to discuss your questions on equity.
Part 1 of the Equity series.
Virginity and equity have a lot in common: human beings do not spend enough time thinking through how to give away either of them, but once they do, the results have the potential to be rewarding or devastating.
This article focuses on giving away equity – virginity is a topic for another time, maybe even under a pseudonym!
As an entrepreneur, the day you think of an idea, you own 100% of the equity and intellectual property (IP). The power to give the equity to others in exchange for their time and money is one of the most important decisions you will make. The devastating consequences of misappropriating equity can ruin even the best of ideas.
Giving equity or IP away may start with a conversation over drinks with a friend. When you start to tell friends and family about your entrepreneurial venture, be prepared to hear their version of your great ideas, along with their advice.
The conversation goes something like:
Friend: “That is a great idea and I have been thinking about doing something like that for a long time. You are great at technical development and I can help you with sales and operations. I can quit my job and help you with this company.”
You: “Wow, I am so flattered you think so much of my idea that you would quit your job and help me!”
What you are thinking: “You are absolutely right, I hate to sell and it would be great to have someone help with that. After all, I do need a team to help me launch this idea.”
So your friend then says, “For only 10% in options and a salary of $100,000 a year, which is a lot less than what I make now, I will be part of your team.”
You are thinking, “You are a great sales person at ABC Large Company ABC selling to other huge companies – you will be great at helping me with getting my company off the ground.”
The two of you toast to the future with visions of a wonderful partnership dancing in your head – this is exactly what you need to launch the business.
Stop Right There!
You have just given away 10% of your equity with almost no forethought of the consequences.
Think of starting a business as a real-life personal development plan where you learn quickly how to deal with the ultimate emotional highs and the down deep lows. Most of the down deep lows result from lack of cash. Your friend sounded very generous when they offered to take a lower salary and accept $100,000 per year. However, when cash is tight and you are fighting to find the money to make payroll, it may not feel so generous. In order to pay them you make sacrifices. Paying their salary keeps you from paying yourself, which means your personal finances are in jeopardy, which causes you stress. This stress may turn to resentment toward your friend and cause tension, especially when the sales are not coming in at the rate you expect them to.
You can see where this is going, right?
According to Fortune magazine, 9 out of 10 startups will fail. The exuberant valuation and success realized by Jet.com. Amazon, Airbnb and Uber are clearly the exception, not the rule. If you have boot strapped this Company, not taken a salary for 5 years because you haven’t realized the success you once dreamed of, you are not going to want to pay your friend 10% of the $500,000 proceeds you may be offered for your company after Year 5.
Here is the advice I give to enthusiastic entrepreneurs who are eager to cut their friends and family in on a share of their big idea – think before you give it away.
The allocation of equity should be properly documented early on in a Stock Option Agreement that lays out the terms of vesting and other criteria that work for all. Even simple agreements should be undertaken by a business attorney who can prepare you for scenarios you currently could never imagine.
To help you start a conversation with your attorney about a stock option agreement, read Part 2 of my series on Equity, Considerations for Equity Allocation Agreements.”
Until then – remember that barroom conversation, and think before you give it away.
Mindy Barker & Associates (email:email@example.com) works with entrepreneurial growth companies to help maneuver the many questions of funding, employee compensation and other decisions and is available to discuss your questions on equity.