THE LOGO DESIGN PROFESSIONALS

What I Learned on the Inside. Part 2

Editor’s Note: The most difficult hurdle for most new businesses to overcome is financing: you have the idea, but how do you get it off the ground? Should you borrow from friends and family, seek private angel investors, try to attract a professional venture capital investor, or eschew outside investment completely and pursue a slower, self-funded strategy? Jeff Kearl, head of sales and marketing here at LogoWorks, came to work with us from the heart of the dark and mysterious world of start-up financing, the venture capital firm. Since his intimate knowledge of this important subject is regularly sought, we have asked him share some of his insights with you in a series of articles. The first installment was "Sources of Capital." (July Issue) In this issue, Jeff tackles the issue of valuation in "How Much Do I Give Up?" Next month, he’ll ask the question "To Raise, or not to Raise." We wish you success in growing your business.

To some degree, the best way to raise a lot of money at a high valuation and favorable terms is to get your business to profitability by bootstrapping. I discussed this at length in last month’s article. This gives you flexibility in your fundraising and allows you to be picky about when and how much you raise. Alas, I concede that some businesses are not good bootstrapping candidates and will need to raise money before they have revenue or are profitable.

Sophisticated investors such as professional venture capitalists and experienced angel investors know that ownership percentage is the biggest driver of investment returns. Thus, they will generally seek as much ownership as possible with some considerations. Most venture-backed companies go through at least two, and often many more fundraising events, each one with a different valuation, terms, and investment amount. Since many of LogoWorks customers are new businesses in the midst of evaluation all financing options, I’ll focus on the first round of funding, usually called the Series A.

The first consideration is the distribution of equity among founders, management, employees, and investors. Smart investors know that the alignment of self-interest is critical for success. In one of the investments I was involved with, we actually purchased a company with $5 million in annual revenues from the founder. In turn, we created an incentive stock option pool as a vehicle to allow the employees to earn equity. However, the pool was less than 15% of the total equity of the company. Not long after the transaction closed, the company decided to open a credit line for inventory financing. The bank wanted a personal guarantor. We knew the equity incentives were too small when the CEO called and said, “You do it, it’s your company”. I’ve heard equity compared to manure. If it piles up in one place then it really stinks, but if you distribute it across a large area then the smell goes away and things start growing. Even if you never raise capital you should always keep this principle in mind.

The second consideration is the number of investors in your investment syndicate. Angel investors and venture capitalists usually prefer to invest alongside other similar like-minded investors. This distributes the risk and hopefully provides the company with access to the other firms networks and experience. However, each new firm that invests will seek to own a reasonable stake in the company.

As a general rule, early stage investors target an ownership percentage of at least 20%. The average venture capital partner can only manage four to six investments at a time. Each company requires a significant amount of time and attention. Thus, a venture capitalist can’t afford to invest in a company, spend considerable time building value, and then end up with a small stake. This also means that if you have more than two firms investing that you will be giving up at least 40% of your company in the first round. Plan on the investors requiring another 20% to be set aside for a stock option pool, leaving about 40% for the founders. This 40/40/20 split is a very common post first round ownership distribution. While it does seem like the entrepreneur is giving up a lot, remember that you’ve already made the decision to build a large, high growth company and that is hard to do without help. Intel, Cisco, Microsoft, FedEx, and Starbucks all went through a financing event similar to this.

Thus, the answer to the first question is that you should plan on giving up 40-60% of your company in the first round including the employee option pool.

Now for the second question:

Many entrepreneurs are under the impression that if they ask for a small amount of money, they’ll be more likely to receive an investment. Makes sense… less money at risk should equate to a more comfortable wager. While this may be the case with an individual angel investor or when you’re gambling in Las Vegas, a sophisticated venture investor is not focused on the investment amount, but as we discussed above, their ownership percentage. Again, this is because investor returns are a function of a high ownership percentage in a successful outcome. Therefore, a savvy investor wants to give the company enough money to be successful and get a moderately high equity stake in the company.

Thus, focus on how much capital you need to win, not what you think the investor wants to give you. Many entrepreneurs try to raise all the capital they need in the first round. Since this is often not possible, plan to raise at least enough for all to give your company at least 18 months of operations in between financing events. This is so you can put your head down and focus on your business without worrying about making the next payroll.

Another approach an entrepreneur can use to predict an investors appetite is to study their fund. As I mentioned above, the average VC partner can only handle 4-6 deals per fund effectively. So if the fund has six partners and each partner does 4-6 deals, that means that fund will complete 24-36 deals which happens to be the average number of deals in an average VC portfolio. Now let’s assume they have $250 million under management in their current fund. This means each partner has $41.6 million to invest or $6.9-10.4 million per company. The bottom line is that venture fund metrics play a very important role in determining the investment appetite an investor will have for a given company.

In summary, all things being equal, a wise entrepreneur will:

• Make sure that all the important stakeholders self-interests are aligned.
• Insist that the investors invest enough money to properly execute the business plan.
• Make sure to raise enough capital to get to profitability or at least enough for 18 months of operating runway.
• Study the potential investors fund and make deductions about their average deal size.
• Realize that giving up equity to qualified investors will allow your company to grow and increase in value more quickly than it would have on its natural course.

«  Part 1  |  Part 3  »

Jeff can be reached at jeff@logoworks.com

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