By the end of this week, you should understand:
Why investors invest and what they are looking for in a venture investment
How the rate of return of an investment is calculated
The tradeoff between risk, liquidity, and potential return in investments
The return requirements for venture investing
The theoretical and practical ways for determining a company’s value
The mechanics of start-up investment
The main types of investment structures
Advice for fundraising
You know your customer and understand their problems. You have a clever solution. You have modelled out the financial return and impact of delivering on your solution and you are convinced that you have something big. You have started to think through how you will design your product to deliver the most value and are engaging with your customers to iterate on this. Now all you need is some capital to get things going. With such a great plan, this will be easy. Right?
Wrong. Fundraising seems to be the one thing that consistently surprises first-time founders in its complexity and difficulty. As much as you love your business, and as much as your customers may love your solution, the simple fact is that investors see literally hundreds of companies making claims similar to yours. Competition for investment is fierce, and the bar for a successful venture investment is so high that ‘no’ is almost always the response when pitching for investment. Successful fundraising requires a killer business, a sophisticated CEO, and a lot of time and effort. There are, of course, exceptions. Some businesses are so good and so aligned with a widely recognized trend that investors chase them to invest. But looking to them as a comparison is kind of like trying to learn tips from dating by examining the love life of a famous celebrity - the rules that apply to them almost certainly don’t apply to you.
You could fill a library with advice for successful fundraising. At least half of it would be contradictory. As such, the goal of this module is not to teach you how to fundraise successfully. The goal of this module is to provide a bit of the background required for you to understand the world of start-up investing. Like almost all of the other skills that are fundamental to being a founder, this is something that you will constantly develop.
Venture Investors: Why Do They Do It?
Investors, in general, are looking to grow the value of their savings. Because money loses value over time due to inflation, people with large amounts of savings have to invest to protect their wealth. Obviously, most people with large amounts of savings want to increase their wealth through clever investments.
In general, investors care most about how the value of their savings increase. This is called the return and is generally expressed as a percentage. If I invested $100 today and received $110 in 1 year, my return would be 10%. If I invested $100 today and received $200 in 3 years, my money has grown by 100%. However, returns are often expressed in annual terms. Doubling in 3 years is equivalent to a number growing by 1.26 every year for 3 years, so the annualized rate of return is 26%.
Almost all investors are trying to maximize their return. In investment markets that are liquid (i.e. large amount of investment options that are very easy to buy and sell), the average return of each investment should come to equal the same number. This is because any investment that offers a better expected return than the average will be in very high demand and therefore the people selling that investment will demand a higher price. This will cause the return to decrease.
There is a tradeoff between how much money an investment can earn, how long money is tied up in that investment, and how risky that investment is. For example, a savings account where you can withdraw the money at any time and there is practically no chance of the money disappearing (especially in countries where bank deposits are insured by the government), one can expect to earn only a few percentage points of interest. If one invests in real estate, where the money is tied up for a long time and the price that you can sell a building for is unclear, the rate of return is often closer to 10%.
It’s important to understand this background to know how investments in start-ups (also referred to as venture investment in this module) fits in the context. Most start-ups fail. Because most start-ups fail, buying stocks in a start-up requires you to lose access to your money until the company is acquired, is listed on a stock exchange, or is mature enough to organize a private sale of stock. Compared to other investments available to investors, start-ups suck. The reason they attract capital is because they can offer crazy returns. In 2004, legendary investor Peter Thiel invested $500,000 in a start-up called Facebook. He has since sold all of his stock to earn over $1,000,000,000. He grew his investment by 2,000x, or an annualized return of ~50%. For investors motivated purely by profit, start-ups need to offer potential returns greater than 30% to justify the risk.This is part of what makes attracting start-up investment so difficult. Most new companies do not have a credible pathway for earning this rate of return. In fact, entire sectors have been deemed unsuitable for traditional venture investing for this reason (e.g. clean technology). The result of this is that most companies need to pivot their business plan to be able to promise higher growth or find alternative sources of financing (e.g. grants) to decrease the risk profile of their business.
Sometimes investors have motivations other than a pure financial return. When large companies invest, they are often looking for innovations that they can incorporate into their business that they do not want to develop in house. A good recent example of this is Ford Motor Company’s recent investment in the electric truck company Rivian. By helping Rivian succeed, Ford can quickly catch up to its competitors in the electric vehicle business. There are also some impact driven investors who are investing their money to see some sort of non-monetary impact. Lastly, there are individual investors called Angel Investors. The investors are appropriately named - they are often people with tons of money who are the first money into a start-up and are the reason most first-time founders are able to get their business started. They are still looking for a great return, but they sometimes are willing to part with large sums of money to simply support a founder they believe in even if they could get a better return elsewhere.
Determining the Value of Your Business
There is a concept in financial mathematics called the time value of money. It refers to the idea that, since savings can earn a return, money in the future is worth less than it is today. For example, assume that the government sells bonds for $100 that will pay me back $110 in 1 year. This means that $100 today is equivalent to $110 in a year.
If a friend wants to borrow money from me for a year, he would have to pay me back at least $110 in a year so that I have not lost out on any opportunity to earn money. If he wanted to borrow $100 for five years, then he would need to pay me back at least $100x(1.1)x(1.1)x(1.1)x(1.1)x(1.1)=$100x(1.61)=$161. This is because for every year that he’s been holding on to my money, I could have reinvested the return from the previous year into a new bond and earned interest on top of the interest I earned.
Converting future values of money into a present value of money is called discounting. If my friend promises to pay me $161 in 5 years, and the rate of return I could earn on my money is 10%, then I need to divide $161 by 1.1 5 times to determine the present value of that money. To find the present value of a business, one needs to add up the present value of future profits. The rate that you divide future payments by to find the present value is called the discount rate. In this example, we have been using a discount rate of 10%. Theoretically, the discount rate is the sum of the risk-free rate of return and a premium. The risk-free rate of return is the interest on an investment with no risk. 3 month US treasury bills are often used as the benchmark (approximately 2%). The premium is a number meant to represent the investors preference for liquidity and to avoid risk. This premium represents investor preferences, and so it is specific to different industries and is prone to fluctuate as the difference between supply and demand of risky investments fluctuate.
It is impossible to determine the ‘actual’ value of a start-up using this method because future cash flows are practically impossible to predict and there is no good data on appropriate premiums for start-ups in a specific industry. However, it is still a good practice to check if the story you are telling about your start-up (e.g. how much money you can make and when) is compelling from a financial perspective. Some investors may also require it of you.
Exercise: Determining Company Value
Please note that you are not required to submit this task as we are past the core program delivery.
For early stage companies without any sales or proven out business model, the imprecision of this approach makes it functionally equivalent to answering a few simple questions: 1) Does the company have a compelling and defensible value proposition so that it can dominate its market? 2) Is the market a multi-billion dollar market?, and 3) Does the team have a reasonable plan that they can execute them so that will have substantial market penetration in 5 years? More sophisticated investors will focus on the answer to these questions than complicated financial models that are practically useless.
Working through this process, you may find that your company’s value is very low. If the number is low because your revenue is low, then the opportunity you are pursuing is simply not big enough to attract venture investment. You will need to find a way to finance your business to the point where it is de-risked enough to attract more traditional forms of investment.
Mechanics of Start-Up Investment
If you successfully convince an investor that your business is worth investing in, then you will need to agree with the investor what the value of the business is prior to their investment. This is what is called the pre-money valuation. Despite all of the work done in the previous section, determining the pre-money valuation ends up being the result of a negotiation between you and the investor. For early stage companies, this seems to depend more than anything else on the local market for start-up investing and how in demand you are as a start-up. For example, the same company pitching for investment in Waterloo, Canada and San Francisco, USA can expect a valuation that is 2x - 4x in San Francisco. As long as the pre-money valuation is reasonable, do not spend too much time worrying about maximizing it. As a first time founder, your focus should be more on actually succeeding with your business then trying to hold on to as much of your business as you can.
With the pre-money valuation defined, you will divide the pre-money valuation by the outstanding shares on what is called a fully diluted basis. Fully diluted is industry jargon that refers to the practice of treating everything that can be converted into shares as shares. This is relevant because most companies create an employee option pool at the time of founding, where they will set aside a substantial amount of equity to give out to their employees through stock options. So, for a company where the founders have 9,000,000 shares and 1,000,000 shares have been set aside for employees, and for which the pre-money valuation has been set at $4,000,000, the investor will be able to buy shares at $0.40 per share. If the investor invests $1,000,000 dollars, then they will be issued 2,500,000 new shares. This means that there will now be 12,500,000 shares outstanding on a fully diluted basis. The investor will own 20% of the company. This is summarized in the table below:
Sometimes investments are done with convertible instruments instead of an equity purchase. With convertible instruments, the investor gives you money today in exchange for equity at the time of the next equity sale. The amount of equity they get is determined by the pre-money valuation used in that equity sale. Often, these convertible instruments define both a discount and a valuation cap. This means that the investment will convert at whichever price per share is preferential: 1) the price per share paid at the future investment round multiplied by the discount or 2) the price per share calculated as if the valuation cap was used as the pre-money valuation.
Raising investment requires you to reduce the amount of the company you own. This is called dilution. Everytime you raise money, you and the other shareholders will own proportionally less of the company. For shareholders to be happy about this, it requires that the valuation used in subsequent rounds of financing is significantly higher than that used when the investor bought it. The valuation at a round of financing is used to determine the value of the company. If you sell enough stock that an investors ownership decreases from 20% to 10%, they will be happy as long as the company valuation increase enough to make it so that 10% of the new valuation is a higher number than 20% of the old valuation. Of course, since the investor is expecting rapid growth, they are expecting the value of their holdings (percent ownership multiplied by company value) to be increasing by approximately 30% every year.
Advice for Fundraising
If the result of the above activity is that your company is practically valueless when you use a 30% discount rate, then simply do not plan on raising venture finance to fund your business. If all you need is one round of financing and the amount you need is very small, then you may be able to raise the funds you need by giving up a large chunk of ownership to an angel investor. However, if you need a large amount of money through multiple rounds of fundraising, then you simply need to be able to demonstrate a very high rate of return to be able to do this. If you cannot reasonably generate this return, then the likelihood of your fundraising-dependent business plan succeeding is practically zero.
In this case, you can look for grants and awards to fund your business. Try to get to the point of profitability as soon as possible so that your business can sustain itself on sales. You can use reinvested profits to grow your business. You will not be able to grow as quickly as if you took outside capital, but this is still a very viable way to grow a successful business. Even if you can generate the returns required to attract venture finance, if you think that you can fund your growth through profits you should definitely consider this. Taking on outside investment can be very time consuming, stressful, and may result in you losing control of your company.
If you think growing your business through venture funding is viable for your business, then you need to plan to spend approximately 6-12 months on each round of fundraising. Plan to raise enough money to fund at least 18 months of operation so that the company CEO does not spend the entirety of their time fundraising. One of the best ways to find investors is to ask for introductions from other founders. If these founders like you and like your business, the investor will be grateful to receive the introduction because they are constantly on the hunt for exciting opportunities. Expect to be bad at fundraising when you start, e.g. awkward at presenting, ineffective at answering questions etc. So you should try to practice a lot on other founders before you start meeting potential investors.
Strategies for fundraising vary across region, company stage, and company industry. There is no clear playbook. Your best resource is to network with other founders who are in your region and industry who have had success fundraising so that you can learn from them. In general, the more you have proven out the value of your business through building your product and gaining sales, the more exciting of an opportunity you will be able to present to investors. So never lose focus on building a great business!