Preparing a Business for Equity Investment
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How to Prepare a Startup for Equity Investment?
Startups, by their very nature, are generally growth-based companies. This means that the company attempts to grow as quickly as possible to reach a critical customer base. The company’s metrics for success include: users, recurring users, rate of user acquisition, revenue, and recurring revenue. Generally, to achieve this growth, the company must employ all available capital. This will (or may) include founder investment, operational revenue, debt, and equity from outside investors. The idea is that investing a dollar in growth returns more value than that dollar. This is because these growth-based companies are generally valued at some multiple of its revenue. In doing so, the companies will generally sustain significant losses as it meets its growth thresholds. The loses are not a negative, as the investors expect the company to use “or burn” the investment capital to meet the growth agenda. Ultimately the company should sell for or go public at a valuation based upon some multiple of the growth metrics it has reached. The company reaching a maturity stage can cut marketing and expansion costs to eventually become profitable. The losses are then valuable to offset future profits. With this understanding of the nature and objectives for a startup venture, the question of how to prepare for equity funding becomes relevant.
In this article, we discussion the general process of preparing the company raising a funding round for a startup.
Preparing the Company for Equity Financing
Investors look for a company that meets specific criteria. The company must be scalable in nature and have the possibility of return some multiple (typically 10-20x) of their investment within 3-5 years. The only method for achieving this type of returned is to achieve a high valuation at a later date in funding or upon sale or public offering. The company is generally valued at some multiple of total revenue. It is not necessary (or generally even desired) that the company be profitable. If the company is profitable, it shows that the company does not have use for additional capital for growth. As such, investors are wary that the company cannot meet its lofty growth targets. With this in mind, here are some metrics that investors look for:
Product-market Fit - Regardless of the value proposition, investors want to see that the company has developed a value proposition that meets and recognized and understood market need or want. This is normally demonstrated through company sales and customer review.
Scalability - The revenue model for the business must be repeatable without additional effort. This means that the company can create the value proposition one time and transmit that value proposition to multiple customers as easily as one customer. Think about software. Once the product is developed, it can be scaled extensively with very little additional effort. This is not the case for a business model that charges for use of a finite resource (such as work hour).
Business Team - The investor will look for a competent and qualified business team. There is a saying that investors invest in people as much as businesses. There must be a good fit between the startup team and the investor for the company to ultimately find success.
Organizing the Business
The business will want to clean up operations to attract investors. This means making certain that operations are being carried out in an efficient manner. This could mean establishing appropriate supply and distribution channels. If the operational channels are haphazard, it is a warning sign to investors.
The business will also want clean up the organizational structure. This will mean making certain that the company ownership interests are adequately recorded. It will also want some certainty in the rights and obligations of company owners. Most of this is handled through well-drafted articles of organization, bylaws, and shareholder agreements.