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Entrepreneurs often make deep, personal investments in their firms, devoting years of exertions to bringing their ideas to life. However, this emotional attachment can cloud their judgment and make it difficult to objectively assess the value of their enterprise. They may find themselves trying to translate personal effort, time and sacrifice into financial value, which might be problematic in the current environment.
While Series A investment activity has been stable recently, there has been an uptick in declining rounds. According to PitchBook and JP MorganDown rounds increased from 8% in 2022 to 20% in 2023. This means there is less money coming in than usual, which suggests more venture-backed startups are looking for capital.
The matter is further complicated by the valuation process itself. Many latest firms incorrectly base their value on competitors, using the similarity of goods or services to estimate value. This type of comparison ignores differentiating aspects equivalent to operational, financial or performance risks. Failure to account for milestones you have not yet achieved can lead to the false belief that each one things are equal.
It’s necessary to keep in mind that your competitor’s current valuation is the result of their unique journey, and yours will likely be something completely different. The challenge is separating personal bias from an objective assessment, because to get an accurate and realistic quote you wish a clear view of what your organization has to offer.
Preparing for a funding round
Just because you have a great business doesn’t mechanically mean it’s ready for investment. The basic economic principle behind raising capital is that an injection of external funds should drive growth and increase the value of the company, creating the potential for investors to see a return on their investment. It’s not like investors invest out of the goodness of their hearts (at least most don’t). They want to see a clear path to profitability. So the query stays: How exactly do you prepare for these inevitable funding rounds? Here are some suggestions to get you began:
1. Show “why”
It is rarely, if ever, enough to simply offer part of the business to potential investors. When applying for funds, it is necessary to fastidiously present the advantages of supporting your enterprise. This is particularly necessary in the light of the above 30% decrease in startup financing in 2023– reports Reuters. You should find a way to answer at least these questions: Why would someone invest in what you are promoting? What is the economic justification for this investment? How will an investor make money?
Whether it’s an ambitious technology innovation or a lofty goal, go beyond your organization’s vision or mission and lay out a plan that clearly shows how you plan to use capital to achieve specific milestones. This means focusing on practical financial results, which increases the probabilities that potential investors will see a path to profitability. They also gain a higher understanding of existing mechanisms for monitoring progress and achieving exit. This visibility into the potential for financial return might be the difference between securing much-needed funding versus not meeting at all.
2. Understand the story behind the numbers
In the context of enterprise capital and private equity, a compelling pitch will only get you so far. Securing financing is more about what the specific numbers say about the viability of your enterprise. Profit margin, for example, provides insight into your organization’s financial health and growth potential. The same might be said about customer lifetime value, cost structure and revenue.
For example, when my firm is evaluating a company, it is crucial to understand the cost of capital in the current market – much more so if we encounter a startup with unclear capital distribution or without significant personal financial investment. The problem arises when such a company claims to be value a significant amount, say $1 billion, without a defensible justification. In other words, at all times provide tangible evidence that the exertions you place into building what you are promoting translates into something of real value.
3. Be careful about investment conditions
One aspect that entrepreneurs often overlook is the concept of “toxic minority control,” which refers to the disproportionate influence or power held by minority shareholders. If a disruptive investor purchases enough shares to secure a seat on the board, this might potentially lead to adversarial consequences for the enterprise and other investors. This is necessary to remember when raising capital, as investment terms can have far-reaching consequences beyond the immediate inflow of funds.
Take Alphabet Inc. for example. Although Larry Page and Sergey Brin own only 5.7% and 5.5% of the company respectively, each Google co-founders owns class B sharesor “super voting” shares, giving them 10 times control – or a total of 51% of the votes. Meta and Walmart are other examples of firms whose founders (or heirs of the founders) who proceed to control the company even after the initial public offering.
4. Never underestimate (or overestimate) market trends
While it needs to be obvious, the direction the market is heading can significantly impact the valuation of your startup. Just look at last yr, which saw the emergence of generative AI and AI-related startups almost $50 billion in enterprise capital, according to Crunchbase reports. But don’t make the mistake of comparing yourself to publicly traded corporations.
While market trends definitely make one startup more attractive than one other, being in the same industry does not equate to having the same value. Consider the nuances of your organization’s stage, market position and operating history compared to firms operating in the same space. Both PitchBook and Y Combinator are great resources because they recurrently publish statistics on average valuations of amounts raised in various funding rounds. Understand where your organization really stands in terms of where the market is heading, in addition to your scope and market status, to get a realistic valuation of your enterprise.
Entrepreneurs often start with an idea and imagine that the idea itself equates to realized potential. They look at the end goal, which may lead to unrealistic valuations. What really matters, at least in the eyes of investors, is the feasibility of this concept, which comes down to numbers. Explain your situation, then let that information guide your conversations with potential investors.