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Don’t offer equity 6 times dearer than you just got from Startmate, and other ways founders can get real on investment

The best way to fund your business is from your customers – to get out and sell. This has the side effect of proving your product is something people are willing to pay for. It will also help answer one of the first questions an investor will ask you.

Investment is best used to pour petrol on the fire, to accelerate your plans. But if you’re just doing it for status in the startup blogs, or are trying to create buzz around your business – please quit while you’re ahead.

Getting investment should be about setting a goal, having a plan to work towards that goal, finding the capital needed to fund the cash shortfall due to the plan, and then executing the plan. If the plan starts to work, the value of your business will grow, allowing you to raise money at a higher valuation.

On last night’s episode of TEN’s Shark Tank we saw some great examples of how tough it can be to win investors over, no matter how good your idea or pitch is.

ANSWER THE HARD QUESTIONS BEFORE THEY’RE ASKED

Entrepreneurs need to have a strategy for every investor pitch meeting they enter, and a big part of that is tackling the hard questions upfront, preferably before they are even asked. Hugh and Richard from Nexus Notes entered dangerous territory when they came to the table asking for $300,000 for 7.5 per cent equity, weeks after they had been accepted into leading Aussie accelerator Startmate, requiring them to sell 7.5 per cent for just $50,000.

There is no denying that Nexus Notes delivered an excellent pitch. They had a strong team and their business has already started to see traction. But what Nexus Notes offered the Sharks was a day one loss of epic proportion, and they tried to hide that fact rather than put it right on the table.

Getting into Startmate is a fantastic achievement; it is a great program that is helping companies find global success. But to put any investor into a down round, and then show a wilful lack of understanding about what you have done, demonstrates a massive lack of business maturity – something I know Startmate will fix.

Entrepreneurs need to understand how investors value startups and know the risk of locking investors in at an early stage at an inflated valuation. This can mean entering the scary world of the down round – when you need to raise more cash later, and your valuation is lower than for previous rounds. Many investors have anti-dilution clauses to ensure that their shareholding stays the same in the down round or if targets are missed. This means that the math for founders is scary. Somebody has to lose out, and it will be invariably be the founders’ shareholding that takes a hit.

My offer to Hugh and Richard was serious, even though it came from the annoyed part of my brain. It is a great business, so I offered them the exact valuation they had already agreed with another investor.

DON’T OVERCOOK YOUR VALUATION EARLY ON

Early stage investors are used to seeing startups pull a valuation number from thin air using a justification that they have a massive market or a “world first product”.

But when Hani and Meray of Charli Chair announced their baby-shower chair business was worth $4 million, despite the fact they had only produced and shipped 500 units – I have to admit I was shocked.

If you want to get investors over the line you need to be able to validate your valuation. Silence when an investor pushes you on why you’re worth $4 million will never be met with a ‘there, there’ pat on the back and a blank cheque.

When I was part of the founding team at PIPE Networks, we brought our first external investors on at a $550,000 investment at a valuation of $5.5 million. At the time, we had a net profit of almost $900,000. Sure, we could have pushed for a higher valuation but we knew that the investment was critical for our growth plans. We knew it would bring on the right investors for long-term capital needs, and most importantly set us up to play the big game. The business later floated on the ASX, and then sold for over $370 million.

Sydney’s “The Dinner Ladies” came to the Shark Tank with a strong, established business and plans for an exciting new project. The catch was that they didn’t want to include the whole business in their investment. This is a rookie error. No investors want to see their entrepreneurs distracted and a subsidiary’s ability to take focus from the main game is a recipe for an unhealthy business arrangement.

An entrepreneur’s long-term plan should include diluting equity to bring the right investors on board – not splitting up the business to gamble on new ventures and only offering investors the riskier part.

This article first appeared on Business Review Weekly. View the original here.

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