Last week, a Networking for Entrepreneurs in Wilmington (NEW) event featured four roundtable speakers who each offered tips for bringing a startup from seed to exit. The four speakers were David Jones of Bull City Venture Partners, Doug Ellis of M&A advisory Decision Point International, Sean O’Leary, former CEO of the recently acquired StrikeIron and the interim director of NC IDEA, and Peter Meath of the venture bank Square 1 Bank. Each speaker’s particular role in the business-building process offered a unique and valuable perspective.
The event was titled VIP4 and covered a total of nine topics each beginning with the letters V, I and P (the four signifies the four speakers).
The Vs: Valuation, Venture Banking, and Validation of Market Need
Tech investor David Jones took on valuation, explaining that the process of valuing a business occurs at three main points: when raising funding, offering options and upon exit. While he emphasizes that many aspects of the valuation process are “more art than it is science,” he makes it clear that there are techniques to the process.
There are certain qualities of a business that can be evaluated for the sake of valuation. For instance, David mentions that the entity’s cash flow is a good, real world indicator of traction. Its comparables— qualities or aspects that compare to a similar and already valuated entity—also plays a part. How does your business compare to another in the same industry or to a company that provides the same service?
If what you offer seems obviously more valuable than the competition, that plays well toward valuation. Another common measure used in determining the valuation of a company is the experience of the team. Bringing in a strong individual who’s already worked with a successful startup or is a leader in the industry is a powerful indicator of your business’ value, but more on this later.
The valuation becomes highly important when considering dilution, particularly to the owners and founders of a business. On average, about 15-25% of a business is sold during each round of funding or investment. This becomes more important to consider when calculating your business’s option pool, which itself will be about 15-25% of your business.
David warns prospective entrepreneurs not to get too tied up in the valuation process, however. There are many techniques one could apply to attain high seed valuations above $3 or 5 million, but a high valuation is not the goal.
“The financing is not the win…The win is when you exit the business,” he said.
It’s also wise not to seek too high a valuation—an over-generous valuation can be dangerous. Investor-share preference—the policy that investors are the first in the ownership chain to be paid back if the exit is below the valuation of the company—can hurt startups if they set valuation too high. In such an event, the founders may never see positive capital gains. In short, build your business, get a fair valuation, then get back to work.
Serial entrepreneur Sean O’Leary spoke on validation of your business model—the key to determining it is separating fact from fiction. An investor looking at your startup will need to feel certain that your business can perform in the real marketplace. There are several aspects of your business used to determine this.
The amount of traction: This refers to your startup’s relative momentum. A startup that already shows positive signs of growth will obviously be more attractive to an investor, as it comes with an argument towards its own validation already.
Sales: For startups that are already in the market, the amount of revenue earned and the rate at which it was earned can help provide testable evidence to rationalize an investment.
Users/customers: A business’s users or customers are another measurable indicator of its traction. Having reached an existing audience or gathered a fan base willing to do business with you indicates validation proven against at least some fraction of the market.
These factors, Sean says, absolutely have to be measurable and truthful. Collect actual data on your business, such as your key performance indicators or KPIs, and convert these into facts to put toward your valuation.
From this, we can read that the stops on the road to presenting a validated startup is to bootstrap, then gain audience traction, earn revenue, and get a fair valuation.
While the above are affected largely by past and present activities of your business, there are validation factors that involve future activities as well. An example is the plan your business has for its capital, including the equity from its valuation.
What expenditures will this capital go into? Equipment? Team members? Marketing? Why? Ask what these expenses add to your product or service. Again Sean urges the business owner to make certain that these expectations, and the rationalization behind them, are based in measurable and truthful reality.
Startup banker Peter Meath reminds us that one of our primary jobs is to convince others that you know what you’re doing. Certainly Sean’s advice on real and measurable facts can go a long way toward this effort. Either way, you should be able to present a case for what creates your business’s value. Further, when creating the answer to this question, consider what an investor might think of that answer.
Peter delivered an interesting anecdote regarding his own Square 1 Bank. During its startup phase, leaders had to present the case for starting a venture bank, that is, a bank that loans money in one of the riskiest investment arenas that exists.
There was two-fold value to his story. On one side, it explains how a successful and mainstream venture collected data and made plans in order to present a validated model. On the other, it reminds us that banks are granular to value building. Venture bank-backed value is a debt, which is all the more reason to have a valid business model since the debt will have to be repaid.
The Is: Introductions, IPOs and Exits, and Intellectual Property
IPOs and Exits
M&A expert Doug Ellis opened with some advice for weighing IPOs, mergers and acquisitions. He mentioned that it is important to start building your business with the end goal in mind. That is, do you want a lifestyle business or an exit with equity value? This end destination should largely determine how you run the business and which hoops you will jump through toward the goal that will ultimately satisfy you.
Buyers will further want a predictable revenue stream that fits your business model, whether that’s subscription-managed services, licensing or rental. In short, your company would benefit from having some method or strategy to hold your customers captive. Your growth rate also factors in, Ellis mentions. There is somewhat of a revenue-to-valuation ratio. Sean also adds that you can think of acquirers as partners and vice versa; the partners you work with provide validation to your business.
Once you have determined and set your trajectory, you can consider who might want to potentially acquire your business. This exercise can help avoid many problems during an acquisition. Five to 10 years from now, your business and all if its activities will be scrutinized under a microscope, so make decisions, build a team and gain the traction that will be favorable to that event. A wildcard on your founders team, a nondisclosure breach, or a red flag in your books at the founding of your startup could become an obstacle to exit years after its occurrence.
In the end, Doug says, the results of your exit are largely based on what the market is willing to pay.
What the market is willing to pay, however, also depends on what you have to offer. Peter mentions that intellectual property has always been important in underwriting, but during the dotcom bubble the game changed quite a bit.
IP isn’t a magic pot of gold. You must ask yourself if your Intellectual property is actually defensible. In a semiconductor, high tech or biotech industry, it may likely be so, but otherwise, it may be best to focus on the market, Peter says. In other words, simply owning IP might not add to your business’s traction. You should focus on intrinsic uniqueness before securing patents. Doug notes that with a technology startup, you either need to begin with a unique technology or with an existing technology that is stacked into a denser product.
David Jones gives some advice about meeting and talking to investors. Generally, the question is not how to introduce yourself, but if you can get introduced. Often with small business and startups, it is in the best interest of your lawyers, bankers and other professional partners, to introduce you to potential investor opportunities. After all, if you make more money, so do they. Investors get hundreds of propositions a year and have to filter out startup noise. They want their connections to vet you. It is proof that you can be “scrappy” enough to work up the chain to them.
Peter points out that investors can provide the most expensive but most valuable capital in a startup’s life. Since you are going to be considered against your entire ecosystem, you want to nurture it with strong partners.
“How do your service providers measure up?” should remain a question you ask yourself. Do they add value to your business? Find the best ones to work with and grow into teams and partnerships that help lead to your success.
The Ps: Profit, Persistence and People
We promised to get back to the subject of bringing strong people onto your team, and the actual role of people in building a business from startup to exit. David says that 80 percent of an investor’s decision is based on the people that surround a product or service. Sean adds that it is best to work with experienced people. Experience on your team is beneficial, not only because of the answers and foresight those team members bring to your company, but because of the perceived value they bring to your entire startup.
It isn’t your internal team alone that can influence the value and exit of your company. Doug says that your clients might become your buyers. Since it is better to be bought than to be sold, be compelling to those to whom you are providing service and a great business strategy and value. These clients already respect the value you provide, and, if you fill a whitespace in their business, they will likely utilize your product or service. That may be a good opportunity for a potential acquisition.
When it comes to people, there is the question of whether talent or passion is more important. While the jury is officially out, talent generally wins. If you go to a pitch event or an entrepreneur event, no one will talk about the passion they have. Passion is assumed, but talent is what will differentiate the quality of your business.
But it doesn’t have to be either or. It’s definitely best to exhibit both. Fill all the gaps. That said, persistence is a key factor in each facet. An investor is going to expect a successful founder to be able to surround her or himself with a powerful team and instill within them a persistence toward building a successful company.
So how does the team itself profit from an exit? Doug mentions that there is a dichotomy after an exit, in which some team members are more valuable than others to investors or acquirers. In a product industry, more valuable will be developers or engineers. But in a service industry, the C-suite members would be critical. Investors want to make sure your team gets a decent earn-out to incentivize them to stay on the team and be focused on success, even after the exit.
The journey from startup to exit is an exciting although risky one. There are many things to consider and many things to learn from different individuals that interact with your business at each point of its growth, from funding to selling.
The primary goal of a founder looking to take his idea to exit should be to gain momentum and never lose it. Create a compelling and obvious case for the value your company provides, and make it easy and desirable for others to get involved. In culmination, Sean reminds us that entrepreneurs are crazy to begin with. It’s important to stay grounded in reality—stay smart and self aware.
As a good follow up to this event, Bull City Venture Partners is hosting a Venture Capital outlook panel
in Raleigh on Jan 19, where investors will share what they’re looking forward to in the new year.