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Shark Tank’s Steve Baxter shares five lessons for valuing a start-up

There’s an old saying that “5 per cent of something is better than 100 per cent of nothing” and it’s an important factor to keep in mind when it comes to giving up equity in your firstborn start-up. At the same time, that 5 per cent can equal vastly different amounts of money, depending on the stage and size of a business.

Understanding how the different equity possibilities can play out is fundamental to good deal making.

Take Kim Huynh from online marketplace WeTeachMe who pitched on TEN’s Shark Tank last Sunday night. Still in its early stages, WeTeachMe has turned over $400,000 in revenue to date, but this did not stop Kim from giving the business an exorbitant valuation of $8 million.

Calling Kim out on his unrealistic offer of $200,000 cash in exchange for 2.5 per cent equity, Shark Andrew Banks made Kim a counter-offer of $200,000 for a 45 per cent stake. Andrew warned Kim that he wouldn’t be impressed by the offer but this still didn’t prepare Kim for the much larger equity percentage Andrew was after.

Standing in front of an investor with substantial revenue and an improving balance sheet puts an entrepreneur at a big advantage. But coming to the table with a more educated view of valuation and when to give up equity and how much to give up will help more entrepreneurs walk away with a deal they know they can be pleased with.

Here are a few guidelines around you valuation process and understanding your equity position:

1. BACK UP YOUR VALUATION: Help an investor understand why you think you are worth what you say you are. You need to believe your valuation number so be prepared to defend it and explain it. Don’t pull a number from thin air – there is always a methodical way of getting to a reasonable valuation. For example, if you are a tech start-up without a track record of revenue you may dispense with financial metrics and instead look at traction – how many users and how fast you are getting them, what it costs you to acquire and retain users, the size of market etc. You need to demonstrate this with solid numbers. A claim about your traction without evidence of numbers is a hypothetical few investors will be interested in.

2. FOUNDERS ARE FUNDAMENTAL: The “founder risk premium” factors into the way I value a majority of my potential investments. Founders matter to me – if I don’t like you then you don’t even get in the door. If you can’t demonstrate impressive skills in your space then the conversation ends. If you fail to articulate the problem and get me excited about the space, then I am out as well. As the entrepreneur you are the face of the business, if I’m not sold on you, I’m not interested in what you’re selling.

3. THINK THROUGH YOUR FUTURE CAPITAL REQUIREMENT: Investors want to understand where start-up founders want to take their business before collaborating with them on a potential future requirement for capital. This is where a well mapped business plan is key. You need to ensure subsequent capital raisings do not jeopardise the future of your business. A smart investor needs to know you’ll be in the business until it has its feet – so if future investment dilutes you past the point of caring, that’s a huge risk to the business.

The biggest rookie error an entrepreneur can make during the negotiation process with a potential investor is to offer to lower their cash requirement in order to maintain a certain level of equity for themselves. This is misguided. Your business timeline is dependent on your funding from the outset. Sacrificing your initial investment request only signals to an investor that you’ve failed to account for every step in your business plan and have not considered the bigger picture.

4. SWEAT FOR EQUITY? When you are starting out, one of the fastest and most obvious ways to grow your team is to offer people an equity position in your business. Whilst this can seem like cheap labour in the early stages of a start up, if not managed appropriately, it can quickly cause confusion and distress amongst the early-stage team – leading to walk-outs, legal battles and in extreme cases the collapse of the company. If you do go down the sweat-for-equity path, take advice on the appropriate amount to give away (usually in the 0.5-1.0 per cent range), and have a vesting scheme that ensures the work happens satisfactorily before the person walks away with their shares. Places like River City Labs in Brisbane or Fishburners in Sydney hold events around these sorts of topics all the time. Have a look around your city and see if you can attend a session that may offer some free advice on a rather thorny issue.

5. MAINTAIN CONTROL – BUT HOW MUCH? There’s no hard and fast rule for determining how much of the company you should retain. For me, it is basically about ensuring you as an entrepreneur have enough skin in the game to make the sacrifices worthwhile. I get nervous any time I see an entrepreneur within their first few rounds of funding with a less than 50 per cent equity holding. By the time founders are ready for an exit (when things have gone really well) you want them in for a collective equity percentage of between 20 per cent and 40 per cent. (Note to founders – fund your business from customers and you get to keep a lot more equity). Control does not have to be asserted via an equity holding but can be agreed as part of a shareholders agreement. Whilst under the Corporations Act there are some things you can’t do there are lots of things you can. Retaining effective control by agreement can be a way around an otherwise daunting dilution.

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

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