Category Archives: Business Financing

Sticky Questions on Startup Ownership and Buy-Sell

Advice, Business Ethics, Business Stories, Starting a Business, Valuation,

I received this interesting detailed question from the ask me form on my website. I’ve decided to answer it here. I think my answer might be useful for others with similar questions. I’m putting the question in quotes, paragraph by paragraph, and adding my response directly where it comes in the question. 

It starts like this:

A person ‘X’ owns 15% stake in a startup company – not by investing money but purely by virtue of having dedicating hours for building a product for the company. No salary was to be paid as per an initial agreement. The 15% stake was deduced by a simple calculation: (value of company) / (number of hours worked) x (dollars per hour).

Was it clear in the initial agreement that the formula here was to be used in future buy-sell transactions? Was that agreed to by all? 

The question continues: 

The value of company is therefore, sum of [(number of hours worked) x (dollars per hour)] and [hard cash invested by a person ‘Y’, also taking into consideration year-on-year appreciation of this hard cash]. Lets call that VC.

No, it’s not. The value of the company is what somebody pays for it when they buy it. And if nobody is buying it, then the value of the company is an estimated value. There are lots of formulas for estimating it, and estimates will vary widely. I’ve got more on that below, in my specific recommendations. 

However, it could be valued like you propose, for purposes of a buy-back transaction, if there was a buy-sell agreement that set that formula in the beginning. That’s if and only if. Issues like these are the reason experts recommend that partners and cofounders talk about the eventualities and agree, before the business starts, on how they’ll be handled. You have to agree beforehand or you’re stuck with arguing and negotiating the valuation afterwards. And when you try to pull it apart afterwards, without the benefit of an agreed-upono buy-sell formula, then many formulas might apply. 

And here’s the heart of the question: 

The company is not profitable yet. Person ‘X’ decides to give up his 15% stake of the company. My questions:

– How much is ‘X’ entitled to receive as the value for 15% stake? 
– Calculating backward, would X receive as much as [(number of hours worked) x (dollars per hour)]? 
– How does this change if the only buyers of the 15% stake are also two other stake-holders within this company, one of them by virtue of cash invested in the company, and the other by virtue of hours spent working for the company?

Normally, unless otherwise specified, owning 15 percent of a company means you own some shares that amounted to 15 percent of the total shares issued when they were issued. Ownership privileges are defined in company documents. You might have a seat on a board of directors, or not. You might get dividends when that’s relevant. And you’ll be able to sell those shares subject to securities and exchange regulations. 

Just hypothetically, as an example, say you agreed two years ago that you got 15% because you had put $15,000 worth of work on it for free and the founders agreed then that it was worth $100,000. If it’s launched and very successful now, with sales of $1 million annually, then it’s worth something like one or two times revenues, less a discount for debts, less a discount for not being liquid. In that case your 15% is worth something like $100,000. On the other hand, if it launched, has no sales, no profits, and has spent all its money, then your 15% is worth about zero. Companies are almost never worth a formula based on hours worked. 

So unless you have that buy-sell agreement stipulating the formula you’re using, then it doesn’t apply. Here’s what I recommend. 

  1. Agree on an estimated valuation. The formula you’re suggesting seems like it might be one-sided and self-serving. Good luck with it because it’s going to be hard. Expect disagreements. Depending on how much money is at stake and how severe the disagreement, you might need to work with an attorney and a valuation expert you can agree on. Here are some posts on this blog about valuation. This one is particularly relevant: 5 things business owners need to know about valuation. Sales, sales growth, profitability, and scalability and defensibility make it worth more. Debt, and not being liquid shares, low growth, and losses make it worth less. 
  2. Take 15% of that valuation and negotiate with your cofounders based on that value. I hope for your sake and the sake of your cofounders that things are going well for this business and they’re happy to buy you out. If they aren’t, then you’ll have to keep discounting until you get to an amount they’ll pay you. Or just keep your 15% of the shares, stop working for the company, and hope that someday they’ll be worth something. 

The moral of the story: please, the vast majority of business marriages (partnerships, startups with founders, etc.) end in divorce. Do a business pre-nuptial agreement, which is what they call a buy-sell agreement. 

 

 

Greatly appreciate your response and all your help!

Q&A: How Do I Finance My Company Without Losing Control?

Advice, Angel investment, Q&A, Starting a Business,

Question:

I need $250,000 to get my business started, but from what I see on the web, I’m going to have to give away the business, practically, to get that money from investors. And I don’t want to borrow the money because it’s a startup and I can’t be sure I’ll succeed.

cash ball and chain

My answer:

  1. You may be worrying about the wrong thing entirely because investors want know part of you or your business. Don’t even try to get angel investors unless you can convince them that there’s a reasonable chance that the money they give you today will give them ownership in a company that they’ll be able to sell to somebody else for 5, 10, or more times that amount of money in 3-5 years. “Reasonable chance” is just that, a decent shot at it, we know you can’t be certain. But can you convince people that it’s worth spending money on your business for their chance of return?   Ask yourself: do you have what investors want? If you don’t, then don’t waste time on this.
  2. Investors write checks. They expect something back in return. If they they write checks for your business instead of to buy a fancy car or second home, that’s because they expect to own something for a while and make money on it when they sell it. Don’t complain about giving them ownership.
  3. Real investors want control for good reasons. Good investors end up as partners. Don’t give up control if you don’t have to, but depending on how good your business looks, and how much startup experience you have, sharing control might be the only way to go. Or the best way. 
  4. I’ve written it many times, although this isn’t mine originally: choose an investor like you would choose a spouse. Find somebody compatible, who can offer help and advice, and ad to your team.
  5. If you manage to convince friends and family to invest in your business and give them a bad deal, you’re going to have to live with that problem for a long time.
  6. 10 good reasons not to seek investors for your startup.
  7. You don’t want to borrow the money because there’s too much risk? But it’s your startup, right? Why should anybody else take the risk you don’t want to take. Banks aren’t supposed to take risks either; it’s against the banking laws.
  8. Not that you should borrow the money, even if you can because you have house equity or something to pledge as collateral. Weigh your own risks and returns.
  9. If you want peace of mind, scale that business plan back to a size you can manage with your own resources. It’s possible for some businesses.
  10. Look for alternative financing like early prepaid sales, or share of future revenues, etc. Read 5 non-traditional ways to get startup money.

(Image: cash chained, bigstockphoto.com.)

3 Incredibly Common Credibility Killers in Business Plan Numbers

Business Financing, Business Mistakes, , ,

Business plans are about business decisions. When I read them — and I read hundreds of them every Spring — I’m looking for the concrete specifics, like dates and deadlines and tasks and milestones, that point towards execution. But part of that is reasonable, credible projections. And I am way too familiar, way more than I’d like to be, with these three very common mistakes. 

Credibility killer #1: unbelievable profits

Face it: startups aren’t normally profitable. Existing businesses, once they’re established, rarely make more than 10 or so percent profits on sales (that’s profits divided by sales). Some of the best businesses make 15 or 20 percent. 

Therefore, when you project 30, 40, 50 or more percent profits on sales, you’ve lost all credibility. That doesn’t make anybody think you’ve actually going to generate that kind of profitability. It does make people think you don’t know the real costs. 

Additional tip: nine times out of 10, you’ve underestimated the marketing costs. 

Credibility killer #2: ignoring sales on credit

Businesses that sell to other businesses don’t normally get paid immediately. They send invoices for products and services. They wait. Weeks or months later, they get paid. Sales accompanied by an invoice like that are called sales on credit. They count as a sale, but instead of adding to cash they add to accounts receivable, and then they get into the bank account later, when the receivables are paid off. 

If you don’t allow for sales on credit in your projections, you kill your credibility. So plan your cash to include the additional working capital it takes to support waiting to get paid.

Credibility killer #3: expenses vs. assets

We all use the word asset to refer to something good to have, like a friend, a second language, and a college degree. More to the point, we often refer to business advantages such as a product design, software code, a prototype, brand awareness and so on as assets. 

In financial terms, however, assets are specific. They are entries in a balance sheet. Assets are equal to capital plus liabilities. Cash, inventory, accounts receivable, equipment, office furniture, vehicles … those are assets. 

The most common problem with this is what happens when you pay salaries or project fees for software or web development. That’s an expense. It reduces your profits and lowers your taxes. So it’s a loss. Way too often people show those expenses as if they were buying an asset. Sorry, we hope that your programming expenses generate something good for your business; but they are expenses, not purchase of assets. 

Oh, and that land and those buildings your business owns? Those are assets, yes, but they should be on your books for what you paid for them, not what you think they’re worth. 

Summary: 

Finance and accounting have this annoying thing about them: things have to mean what the standard principles say they mean. You don’t get to redefine them back into what you think they ought to mean. 

(Image: shutterstock.com)

7 Steps to Practical Business Stories

Business Pitch, Business Stories, Personal Productivity,

Remember, stories aren’t just stories. They’re truth and promise and relationships established. They’re vital to business. There’s more truth in stories than in all the statistics ever published. 

Geoffrey James posted How to Tell a Great Story on Inc.com last month, quoting Mike Bosworth of Solution Selling, and Ben Zoldan, one of his top trainers. So this is how to tell a memorable business anecdote:

1. “Decide on the takeaway first.” There’s a business goal. Yes you want to make conversation, but also make a business point. If you’re selling shoes, tell a story about a shoe disaster, or a shoe rescue. 

2. “Pick the ending ahead of time.” Get the ending that supports the takeaway. 

3. “Begin with who, where, when, and a hint of direction.” He adds:

Every great story–and indeed, every great movie, novel, or TV show–starts with a person (who is going to do something), a place (where things are going to happen), a time (so people can relate “then” to “now”), and just a hint of direction, indicating where the anecdote is headed.

4. “Intensify human interest by adding context.” Details, done right, make it a story. Try to put your people there, caring about the people and the situation. 

5. “Describe the goals and the obstacles.” They call that plot. What was the problem, and how was it solved. 

6. “Describe the decision that made achievement possible.” 

It’s important not to confuse the decision (or turning point) with the ending of the story.  The turning point is not “what happened”–it’s the decision that caused what happened to happen.

7. “Provide the ending and highlight the takeaway.” Don’t assume your listener figured it out. Make sure to say it, out loud. Tell everybody what happened and why it’s important. 

Nice post, good recommendations; thanks Geoff, Mike, and Ben. 

Do You Have What Investors Want?

Angel investment, Starting a Business, Venture Capital, , , ,

What do investors want? I’ve read more than 100 business plans in the last two months. Entrepreneurs are overwhelmingly predictable on this point. Investors want disruptive. Investors want game changing. 

But not just saying it. Being able to believe it. Two of every three plans says it. Only a very few make it actually believable. 

And believable, in this context, is still a matter of huge uncertainty. Nothing in startups is fully believable. The closest you get is an interesting market story about solving a real problem and doing something important differently, and a team that seems to have experience and background that indicates it can execute the idea. 

The best thing I’ve seen in a while on what investors want — at the high end of venture capital — is this one on The Anatomy of a Successful Entrepreneur, that appeared on TechCrunch about a week ago. Post author Rip Empson digs into the recent Kaufmann data on venture capital, adds some analysis by Fred Wilson, Chris Dixon, and others, and comes out with the short list shown here. 

 

 

Interesting Idea for a Hybrid Crowdfunding Solution

Angel investment, , ,

This is interesting: what if some crowdfunding sites limit the investing to so-called “accredited investors” as defined by the SEC. I just read David Rose’s take on this at Quora.

David mentions two sites, his own gust.com and angelist, that already group accredited investors. Up to now they work as platforms for getting investors together to look at deals, submitting deals to investors, and managing communications, research, and so on. But they could also register under the JOBS act, as he suggests: 

… fully registered Broker/Dealers and actively facilitate financings for a percentage of the raise.

Why not? No good reason why not. 

Why? The JOBS act loosened restrictions on who is allowed to invest in startups, and it is now waiting for regulations to make it real. In the meantime, though, there are hundreds of thousands of accredited angel investors. Using the change coming in crowdfunding but starting with accredited investors could get somebody started quickly, without (in theory at least) violating the existing regulations. 

 

Is Venture Capital Gone Forever

Angel investment, Venture Capital, , , ,

I completely agree with Steve King of Small Business Labs, in Is the Venture Capital Industry Broken? He says:

The news here isn’t that the VC industry is broken. This has been actively discussed for years. The news is who’s saying it’s broken.

Which is, in the flap this month, the Kauffman Foundation.

The Kauffman Foundation has long been a close friend of the VC industry.  In addition to investing many millions of dollars with VCs, Kauffman’s mission of supporting entrepreneurs and high growth companies has resulted in them closely collaborating with the VC industry.

The foundation recently published We Have Met the Enemy and He is Us, a blistering critique of venture capital and its role in startups.

Here’s the problem in one simple business line chart (why I like business charts). It shows how the rate of return on venture capital looked great during the first big Internet boom. It’s not a pretty picture.

On the other hand, those low points in the last few years aren’t uncommon, are they? How is your industry doing since the great recession? The chart shows pretty much what Steve summarizes as follows:

Kauffman has many reasons why the industry is broken.  But the quick summary is the industry simply hasn’t performed well.  Only 38% of the funds Kauffman invested in over the last couple of decades beat public market small cap indexes.  This is primary due to the expensive fees VC firms charge.

So does this mean hard times for startups? I doubt it. I see is a shift towards smaller seed rounds and more angel investment as a web and software technology have reduced the capital needed by the average high-end web startup to get from nowhere to proof of concept and validation. In an oversimplified general sense, what took $2.5 million in 1998 takes probably $250,000 today.

Business comes in cycles. Suppose the huge camelback hump in returns in the late 1990s (the boom) were a temporary aberration. The hard times afterwards (the crash) are probably a temporary aberration too.

Steve recommends this story in GigaOm and this one by Fred Wilson of AVC for further reflections on the Kauffman findings.

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3 Essential Truths About Startups and Investment

Advice, Angel investment, Back to Fundamentals, Starting a Business, , , , ,

Today I’m answering, with this post, a lot of similar questions I get often in email, where somebody is asking me how to get connected to or hooked up with or recommended properly for angel investment. Here are some unpleasant and unpopular facts about startups and investment.

  1. Only friends and family believe in you and invest in you because you’re you. And that’s if your friends and family do believe in you; that’s not true for everybody. Outside investors, in sharp contrast to friends and family, either believe in your business prospects, your market, and your team, or they don’t invest. They’re doing it to make themselves money. (back story: I get a lot of emails from people asking how they can get investment for their business when they have pretty much nothing to offer investors. The answer is: You can’t.)  Or not at all.
  2. About that great idea you have that’s worth $5 billion for which you need $500 million to get started: unless you’re already a startup star, or an oil prince, or family wealth princess, just forget it. Mark Andreesen or Mark Cuban or Paul Allen could maybe get $500 million for a new idea. You can’t. (If it makes you feel better, neither can I). Give it up or scale it down to a $5 million idea that takes $5,000 to get started; or just forget it.
  3. All of you newbies – new to entrepreneurship, no successful startups, no traction — asking how you start your business with no money: Please, get real. Once in a blue moon a foundation or government agency will grant some money, and usually that’s just a low-interest loan, to some proposal that has social and economic value that fits government priorities. We see this in special development zones, some scientific or defense-related research areas, and occasionally with private money committed to social good. But it’s rare. If you aren’t one of those special cases, forget it. And if you are, do your homework, find out what really happens with grants and such.

If you’re still interested in a startup, stop looking for some pie-in-the-sky solution. Get a job in the business area that interests you, and learn the business. Partner up with people who’ve been there already. And do your homework, look up all those web pages full of good advice about startups, including this one, bplans.com, which is full of information about what you can and can’t do. If you’re in the U.S., connect with your local Small Business Development Center, or Women’s Business Center, or Small Business Administration (SBA) office. If not, find the equivalent in your country. Get some real info, and then do the work: do some research, develop a realistic plan, take real steps.

Starting a business isn’t a right. The government doesn’t owe you your startup. You have to make it happen. 

Disrupt Education … Please!

Angel investment, Business Plan Contest, Venture Capital, Venture Contests, , , , ,

I wonder if we as a society are ever going to figure out how technology can disrupt our antiquated systems for educating our children.

Think about what’s happened to information, social interaction, research, and business over the web — not to mention mobile technology — and then think about education. Preschool, K-12, and higher education.

Would anybody disagree that the institutions we depended on as kids are now embattled and crumbling as a result of political and economic factors? Higher ed has had the worst inflation of any industry I can think of over the last two generations. And the K-12 still depends on the old model of the teacher and two or three dozen students in a single classroom.

Innovation, yes, all over the place … but has it really changed anything yet?

And why not? Last week Shelley Palmer‘s email update tipped me off to Harvard and M.I.T. Offer Free Online Courses on YTimes.com, and a new Stanford-related venture called Coursera, a Web portal to distribute a broad array of interactive courses in the humanities, social sciences, physical sciences and engineering.

Also last week I received this in email…

(The innovative minds at TED have brought a new educational video website to the head of the class. Today, TED-Ed launched http://ed.ted.com a site that features TED-Ed’s original K-12 animated videos with accompanying lessons and quizzes. On top of that, the site allows educators to create original lessons for any YouTube video, rendering the video on a new link where teachers can monitor student progress.

And I’ve subscribed to several and offer several courses at udemy.com myself. And by this time we’ve all heard of Kahn Academy, another compilation of online courses.

How many universities are offering online courses? How many of those are simply free to users? How many at very attractive prices?

But what about attendance, homework, kids doing things they don’t want to do, people growing up, validation, certification, leverage, consistency?

My angel investment group is looking in detail at EdCaliber, which offers online tools for K-12 teachers. And I saw two additional education business plans over the last three weeks at business plan competitions at Rice and the University of Texas.

I’m hoping something really changes public education for the better. I haven’t seen it yet.

(Image: bigstockphoto.com)

What Kickstarter Means to You — Maybe

Angel investment, Crowdfunding, Venture Capital, , , ,

I’ve had several visits to Kickstarter.com in the last week. First because some friends of mine are looking to launch a project there. Second, because I’m getting so interested in crowdfunding. Third, because of the Three Years of Kickstarter Projects infographic on NYTimes.com.

At kickstarter, I saw the Pebble project that’s raised more than $8 million for an epaper watch. It was at $6.6 million when I first saw it last week. This morning it’s at $8.3 million.

While I was at Kickstarter, I preordered my Phonesoap unit there for $39. I saw Phonesoap at the Rice Business Plan Competition two weeks ago. It didn’t win that contest, but it has now won $63K of the best kind of financing, without question, which is sales.

Every entrepreneur has to go look at what’s happened with that project. Take a step back, exhale, and think of this as the best possible kind of financing: prepaid sales. The people who’ve contributed to Kickstarter don’t get a share of ownership. They get future product, not yet built. And they have to fit into one of the standard kickstarter.com categories. You can get that with the NYTimes infographic.

Need I say more? Go look at it.

So what’s going on at Kickstarter? The best possible financing, sales as pre-sales or pre-order sales. It’s not technically crowdfunding, but it’s better than that, because it doesn’t dilute ownership.

By the way, speaking of crowdfunding, Myventurepad.com this week released a free ebook called The Revolution in Venture Funding, which covers the topic pretty well . Disclosure: I’m one of the authors.