Business finance runs along a continuum where the lowest cost of capital is a loan and the highest cost of capital is equity. Everyone knows that loans must be paid back regularly from the cash flow of a business. On the other side of the continuum, you have equity, where there is no legal obligation to pay investors, and investors are taking a chance that the business will be sold someday or that their shares will be bought out. In between those two points, there are varying forms of capital such as leasing or subordinated debt, which cost less than equity and significantly more than borrowed money.
To me, there is a misconception in business financing that equity is free because there is no legal obligation to pay it back. Especially in technology, this opens the door for entrepreneurs who may not be frauds, but who are irresponsible about raising money. This is especially true during periods of economic expansion where people are predictably too buoyant and less than careful in their investment decisions. For example, the amount of equity capital raised by private companies grew by more than 200 percent in the five-year period from 2009 through 2014. Just recently, Snapchat was rumored to be raising another $200 million at a valuation of about $20 billion. Similarly, late last year, Uber sought to raise more than $2 billion in a financing round that would value the company at over $62 billion. On the surface this growth in capital raised by private companies would be good if all of those companies deserved capital or were worthy investments. Unfortunately, time has taught us that a lot of these companies are not worthy of investments.
What does this mean to us as entrepreneurs? It means that we have to be responsible acquirers of investment capital and to know when our businesses are truly ready for investments. This requires discipline and a sober approach to knowing our businesses. I am often astounded by the values that entrepreneurs place on their businesses given how far the businesses have (or haven’t) progressed.
I remember talking to one entrepreneur who was trying to start an upscale horse photography business for show horses. She did have revenue, although the business was losing money, and she was seeking $2 million in investment capital and valuing her business at $10 million. Although there was some revenue in the business, it was nominal. So how might a sharp investor or even entrepreneur look at that? If the business is valued at $10 million, this entrepreneur was asking someone to write a $2 million check to get a minority position in a private company with no regular source of return and no liquidity for the stock. What investor would do this?
I have seen so many of these types of proposals and deals that, at this point, nothing would surprise me. Entrepreneurs have to remember that the money invested in their companies is not Monopoly money- it is real cash that someone had to earn at one point. There seems to be an acceptance in the entrepreneurial community that entrepreneurs should seek the highest valuation that they can get in a round of equity financing. This assumes a few things: First, it assumes that you will get what you ask for as an entrepreneur. Second, it assumes that at a given valuation the investor can get a decent return. There’s an old adage in real estate that goes: you make money when you buy real estate, not when you sell it. This is true when investing in private companies as well. Investors need to get a good enough deal that they can get a positive return.
This principle should even be applied when considering whether raising money at a particular stage of a business is wise at all. There is a term called proof of concept, which is the point at which a business has proven its concept in the market. It basically means the business is ready for investment. In my experience, entrepreneurs believe they have achieved proof of concept way earlier than when they actually do. I suppose this is borne of their positive expectations of the business. But it is often a fallacy. And as entrepreneurs, we can say “buyer beware,” but we have a responsibility to treat our respective shareholders as true partners and to give them an honest assessment of where the business actually stands.
But suppose you don’t buy into what I’m saying above. What’s the cost for you as a business owner? If you don’t apply a reasonable approach to raising money where you are giving people a likely return, no matter what the law says, you are going to have a bunch of very unhappy people. In my experience, people are not happy when they lose their capital. This could result in possible legal distractions, as well as a diminished reputation (definitely). The bottom line is when you raise money, you have to think over the long run and not just the short run, which is difficult to do when your business is cash-strapped and you are operating in a buoyant capital market.