Martin Brassell, CEO of Inngot, considers how founders can realise value from their hard work in a pre-start context
There are many areas in which expectations differ between investors and entrepreneurs seeking investment. One of the areas that often proves hardest to resolve is the question of valuation, especially if a business is yet to generate first revenues.
‘Sweat equity’ is the delightful term coined to describe the value to be placed on the efforts expended to bring an opportunity to the point of realisation. At the point when a business is first presented to independent investors, rather than a more receptive first audience of ‘friends and family’, entrepreneurs will often strive to place a financial value on their labours. From their viewpoint, this is a perfectly reasonable thing to do: after all, no-one doubts that bringing an innovative idea to market involves a lot of perspiration as well as inspiration.
Any investor worth having knows that the road to success is generally a steep one, and likely to require a good deal more sweat to be expended. He or she also understands that it is counter-productive to leave a founder so short of equity that they lack the commitment and energy to make the climb. However, the risk climate dictates that this is a buyer’s market at present, in which any valuation is bound to be subjected to close scrutiny, and needs to be as objective and well-evidenced as possible.
How does sweat get expressed? Generally as a factor or multiple of the salary that the entrepreneur(s) would be earning if they were in some notionally equivalent employment (or still in a previous job). The more senior time and energy put into an opportunity, the more it should be worth, and this method quantifies it – right?
Sorry – wrong, on a number of counts. To begin with, this approach assumes that hard cash and theoretical cash are equivalent in value. In reality, there is always an exchange rate in action. Sometimes this works in the founders’ interests, if they manage to get an opportunity to a point where it clearly has vastly more value than the time they have expended on it would indicate. But on other occasions, the investor is being expected to put in new cash to realise an opportunity that the theoretical cash has failed to deliver on its own. They will understandably take the view that their ‘real’ money is more risky and should attract a premium.
Even if a pound-for-pound calculation were appropriate, an investor has no way of auditing the amount of time that has actually been invested, or knowing whether the salary sacrifice implied is real or not. Certainly, people do sometimes jump out of highly paid jobs to create new ventures: but on some level, the saying that “necessity is the mother of invention” is generally applicable to entrepreneurial motivation as well as to the innovations themselves. And there is a more fundamental problem, which is the underlying premise that cost is equivalent to value.
Plainly, it’s not. The fact that it costs one company twice as much as another to produce a given widget does not translate into 2x value that the market can see. To take a less obvious example, many endeavours involve going down a number of what prove to be blind alleys. This creates ‘negative know-how’ – understanding what doesn’t work. It has some value, but clearly not as much as actually discovering the ‘secret sauce’.
To present a more compelling case requires a focus on what a pre-startup has actually been able to deliver to date. This involves consideration of assets, and since few start-ups are well enough funded to invest much in tangible ones, it inevitably comes down to the value that an investor can see in the opportunity and the company’s capacity to realise it based on a) the quality of the team (if there is one) and b) the quality of the approach embodied in its intangible assets.
An investor needs to see how the sweat invested by founders has translated into assets that create income, ‘freedom to operate’ and/or ‘barriers to entry’. Not all these assets are equal, and the type most highly prized will generally firm orders, often in short supply. However, any such orders are likely to have been secured based on capabilities that are underpinned by intellectual property and similar rights.
The more comprehensive an inventory of assets a business can produce, the better its prospects of attracting favourable attention, and the more likely it is that an investor will see that there is something of value at the heart of it. The present day value of those assets can then be extrapolated from the scale of the opportunity they enable a company to realise, and the length of time it will take for an investor’s new money to enable that opportunity to start to be realised. This comes down to having a credible and well drafted business plan, in which the risks and their mitigants are given proper consideration.
So the secret of expressing the value of sweat is simple: don’t focus on how much time you’ve spent – instead, show what you have been able to do with it.
Visit www.inngot.com today to find out more..