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Equity for Funding? The Ins and Outs of Giving Equity in Exchange for Funding

For some entrepreneurs, giving away equity in your business can feel a bit like selling part of your soul. Other cash-strapped business owners eager to grow will take funding at almost any cost.

Juliet Pitman

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Equity 101

Very simply put, equity deals involve giving away a percentage ownership of your business in return for funding, resources or skills. How these deals are structured can take a variety of different forms, but the basic principle is the same: equity is given away in order to gain the things that will help take the business forward to the next growth level. Because most entrepreneurial businesses are almost perpetually cash-strapped, they either can’t afford to buy in the skills and resources needed, or they can’t access the funding required to grow. In many instances, the only thing they possess is the equity in the business and this is used as a means of exchange for what they need but cannot access through other means.

It’s a common misconception that equity deals only involve funding. While funding is what most entrepreneurs lack, resources and skills are equally common reasons for giving away a share of the business. For example, this might involve taking on a partner who brings to the table certain skills that the owner does not possess but which are needed to take the business forward. Alternatively, one might give away equity in return for resources such as equipment or contacts. Someone who can open doors to the right deals can be of immense value to a business and many entrepreneurs choose to give away equity to a person who brings such benefits to the table.

Equity changes through the business life-cycle

Pavlo Phitides, CEO of business incubation company, Aurik, explains that the equity needs and deals change as the business moves through different business development life stages.

“In the start-up phase, businesses are typically under-resourced but they need skills to cement solid foundations and get sales going. Entrepreneurs are often strong in their particular ‘subject’ area but weak in others like marketing or financial management. So they are faced with a number of options: They can try to muddle through their weak areas alone, however this often comes back to bite the business. They can hire someone who has the strengths they don’t possess, but being under-resourced presents a problem because they can’t pay market-related salaries for good talent. Or they bring in a partner who possesses those skills and give that person equity in the business.”

In the growth stage of the business, equity needs change. “Businesses can either grow organically, which is appropriate for certain businesses but can be frustrating and slow, or they can grow aggressively but for this they typically need funding,” says Phitides.

There are two key funding options: debt funding and equity funding. “You need assets to secure debt funding and you need to be able to pay back the loan as well as the interest on a monthly basis. Equity funding on the other hand means you don’t need to dedicate a certain amount of money every month – at a time when money is most needed in the business – to service interest and repayments,” explains Phitides. Of course, many entrepreneurial businesses simply can’t access debt funding, so equity funding is the only option available to them, unless they are able to raise capital on their own.

Before you take the leap…

This last point is an important one. “Giving away equity is akin to giving away your future wealth. Entrepreneurs often don’t realise this. They are so desperate for the money now, that they don’t properly explore all alternative options,” says Phitides. Before you rush into an equity deal, you need to make sure you’ve asked yourself some important questions, he says.

Most important of all is to determine whether the skills, resources or funding you think you need is really critical to the future of the business. Many successful businesses manage without funding, particularly in the early stages – ask yourself if it’s not possible for you to do the same.

If you’re looking for a certain skills set but can’t afford to pay a salary for the right person, it might be worth exploring the possibility of paying a once-off fee to get what you need. In other words, you might choose to bite the bullet and pay a marketer to put together a marketing plan for you, rather than taking on a partner with marketing expertise and giving them equity in return. Serial entrepreneur and investor, Vinny Lingham says, “I generally don’t recommend giving away equity for once-off transactions. If someone does a referral for you but there is no long-term relationship, equity shouldn’t be given away – rather pay cash if possible, or give a payable note for a future date with interest.”

Phitides agrees: “The value that the person brings should be ongoing. If not, you might find yourself five years down the line and feeling very resentful about the fact that someone owns 25% of your now highly-valued business, in which they do nothing, just because they gave you a marketing plan when you needed one in the early stages. I have seen this kind of deal lead to lots of bitterness, unhappiness and conflict.”

This is not to say that giving away equity is a bad idea in itself. “Often, it’s unavoidable. My view, however, is that it’s only a bad idea if you haven’t explored all alternative options and if you haven’t properly considered the consequences of the deal – and made up your mind about whether you can live with them or not,” says Phitides.

How it will change your business

Make no mistake, an equity deal has immediate and long-term consequences. “Once the deal is done, your business is seldom the same,” says entrepreneur Howard Blake, chairman of Blake & Associates. “Entrepreneurs thrive on their independence and own leadership style in achieving their objectives. They find it challenging and stifling being confronted by the endless compliance and governance requirements of outside shareholders. Innocence lost is never regained, in a sense,” he adds.

Bear in mind that investors will want to see structures and systems put in place, and will expect regular detailed reports on the business’s activities. If you don’t have the stomach for this – and many entrepreneurs don’t – then you don’t have the stomach for such an equity deal. Phitides adds an interesting point. “Often, the reason that entrepreneurs aren’t meeting their goals is because they can’t work within the parameters of the investors. Frustrated or stifled, they lose enthusiasm and passion and deliver a lack-lustre performance where once they excelled.”

Whether you exchange equity for an active partner in the business, or a ‘silent’ shareholder, the fact remains that you give away a degree of autonomy when you give away equity. You will, to some extent, be answerable to others for the decisions you make. “Your funder will want things rolled out and achieved as forecast in the business plan you presented and as agreed when you struck the deal. But I have never seen a business achieve its forecasted plan – ever – and this can leave entrepreneurs in an impossible position,” says Phitides. Depending on the deal, investors may become punitive. “The deal may allow them to increase their equity share because you have failed to deliver what was required and agreed, so you find yourself incrementally losing more and more ownership” he explains.

Common mistakes

This brings us to some of the common mistakes entrepreneurs make when doing an equity deal. “One of the worst and most damaging mistakes is that they don’t formalise the agreement, setting out clearly the expectations, deliverables and consequences. My advice is to watch The Social Network on the Facebook story before you go into any kind of partnership,” says Phitides, adding that most entrepreneurs don’t formalise their contracts because they lack money for a lawyer. “Things are agreed verbally but are hardly ever written down, and it leads to endless problems and conflict,” he says.

Another common mistake is for entrepreneurs to take on partners for the wrong reasons. Just because you like and trust someone doesn’t make them an ideal business partner. “When you’re starting out I suggest you find one partner to start the business with. One of you should have technical or product skills and the other should be business or marketing focused, for example,” says Lingham. It’s comforting to go into business with a partner who is similar to you, but what’s actually needed is someone who has complementary, but different, strengths and skills. “If you both enjoy sales and marketing, the operational and financial side of the business will get neglected,” says Phitides.

“Being too generous or too greedy is another pitfall,” says Lingham.

While you might believe that your business will be valued at R1 billion in five years’ time, remember that this is only a projection. Any investor who does an equity deal is taking a risk, so bear this in mind when you find yourself becoming greedy. On the other hand, don’t undervalue your business to the extent that you give away so much and find yourself five years down the line owning only 6% of something really valuable that you’ve put your heart and soul into building.

Valuing the business

One of the most difficult aspects of doing an equity deal is how to value the business, not only on paper but in your own mind. After all, you need to have a sense of what the business is worth to know what your top and bottom end will be for any equity deal. Vinny Lingham discusses how to weigh the decision: “If you bring on a partner or investor, you need to determine if the equity you are giving them will deliver a greater return on your existing equity than not having them will do. Let’s assume you have a business that is worth R1 million and that you own 100%. You give 50% to an investor who puts R1 million into the business. So you now have 50% of the business, but it’s now worth R2 million. In theory this puts you back in the same position, of ‘owning’ a share worth R1 million. But, if you are able to use the cash to double the value of the business to R4 million then your 50% is worth R2 million and you’re ahead. The question to always ask yourself is, ’By taking on this partner, can I grow the business so that my new percentage of the grown business will be worth more than I have now?’”

What makes for a good equity partner?

Pavlo Phitides’ insight into what to look for in an equity partner:

  1. An ongoing contribution in one or, ideally, all of the following: funding, skills, resources and relationships.
  2. Someone who buys into and supports your vision. While you will be answerable to them to some extent, their involvement shouldn’t quell or interfere with your passion. It is this, after all, that drives the entrepreneur’s tenacity and allows them to stick with it when the going gets tough.
  3. Patience. Nothing ever goes according to plan and it may well take longer than expected for an investor to see returns from an entrepreneurial enterprise.

Advice on equity contracts

If you can’t afford a lawyer to put together your equity contract (and many businesses can’t) Phitides recommends you put together a deal sheet.

“This should include who gets what percentage for what contribution, what each person needs to do in the business and what areas they are responsible for, and what the consequences are of not doing these things,” he says.

Juliet Pitman is a features writer at Entrepreneur Magazine.

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Attracting Investors

The 3 Most Essential Points To Keep In Mind For Your Next Accelerator Pitch

No surprise that a great source for inspiration and lessons on speaking technique are TED talks.

Dan Lauer

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Startup accelerators have been around since about 2005, when Y Combinator was founded in Cambridge, Mass. Since then, they’ve exploded in popularity – expanding from start-up hotbeds like Boston and Silicon Valley to assorted locations around the globe.

Milwaukee, though not traditionally known as a tech hub, is home to Gener8tor, an accelerator that recently launched an artist fellowship program. Sydney is an international city in its own right, but it’s also attracting tech entrepreneurs with its Future Transport Digital Accelerator.

And, while Cairo certainly has a rich history, it’s also preparing for the future of innovation with the Flat6labs accelerator, which celebrated its 10-year anniversary in 2018.

As the number of accelerators has grown, so has the number of applicants. For example, for the Ameren Accelerator, our own 12-week program for energy-tech startups here in St. Louis, we went from about 200 applications in 2017 to in excess of 330 this year. Such explosive growth, however, can be a double-edged sword for those hoping to earn a spot in an accelerator:

More opportunity may abound, but the competition is also stiffer than ever.

Related: Why You Need A Million-Dollar Pitch Before Your Start a Business

Standing out in a sea of applicants

Responding to the increase in applicants, accelerators these days are asking tougher questions: “How close are you to revenue?” “What’s the business model?” “How do we [investors] ultimately make money?” Therefore, if you’re one of the applicants, you need to not only know the answers to all these questions, but to deliver them clearly, succinctly and in a way that sets you apart. That’s a tall order, to be sure, but if you follow these three key steps, you’ll be on your way to nailing your pitch.

1. Cut out the “maybes” – focus on the facts

Most startups fail because they don’t solve a problem. Just look at Juicero, the now-famous startup that raised about $120 million before it shut down last September. That $400 juicer simply wasn’t filling a need, and as a result, couldn’t find a solid customer base. Juicero is not the first or the last company to make this mistake. According to an analysis by CB Insights, 42 percent of start-ups go under due to “no market need.”

Accelerators always want to know that there’s an actual customer need. In fact, this is critical. Don’t recite a laundry list of problems your solution might solve; instead, focus on the most important one – and detail step by step how you came to that conclusion. The best way to prove your problem exists is through market research. Engage directly with potential customers by conducting surveys on pain points, wants and needs. When you come with hard research in hand, accelerators will take you much more seriously.

2. Lay your cards on the table

cards-of-table

Once they’re convinced of the problem, accelerators want to understand your solution. That sounds simple enough. Yet according to research from Marketing Experiments, companies often struggle to identify and articulate their value proposition.

A good value proposition is easy to understand, concrete and unique; it doesn’t rely on fluff, superlatives and jargon. So state your solution, and more importantly, state how it’s different from all the other ones already out there. Ideally, people will be able to understand your value proposition in fewer than five seconds.

Take Uber’s value proposition, for example: “The best way to get wherever you’re going.” This simplistic copy accurately captures its offering. And its homepage copy expertly sums up what makes the service more appealing than a traditional taxi: “Tap a button, get a ride; always on, always available; you rate, we listen.”

Additionally, accelerators want to know what you, as the founder, bring to the table. Show up, add to the chemistry and culture and be an active participant. At the Ameren Accelerator, we specifically look for leaders who come in ready to roll up their sleeves and drive growth.

Related: 3 Components Of The Perfect Elevator Pitch

3. Stay on track and weave a story

There’s nothing worse than an applicant who drones on and on. Try to keep your pitch clear and simple. For inspiration, look at TED Talks. Though those speakers pitch ideas rather than businesses, they are coached to become master storytellers. Most talks are fairly brief – they can’t be longer than 18 minutes – but more importantly, they’re succinct. An analysis of the top 20 TED Talks showed that all speakers stated their “big idea” within the first two minutes. Follow this format in your accelerator pitch.

Additionally, rather than spouting off statistics to make your point, try telling a dynamic story, lacing supporting facts throughout. Stanford University professor Jennifer Aaker tested the power of stories through an informal study. She asked her students to give one-minute pitches and then had the others write down what they remembered from each pitch. Sixty-three percent of participants could remember the pitches that were stories, compared to the mere 5 percent who could remember statistics.

Since I started working in this field, I’ve seen enormous growth in the number of accelerators across the country and around the world. However, those who wish to participate in these programs are up against fierce competition, and gaining one of these accelerators’ coveted spots will take more than passion and a potential patent. By following these three tips, you’ll set yourself up for success on your next pitch.

This article was originally posted here on Entrepreneur.com.

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Attracting Investors

3 Components Of The Perfect Elevator Pitch

Can you clearly demonstrate value when faced with a time crunch?

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After filming two seasons of Entrepreneur Elevator Pitch, I’ve come to realise that there are three key elements to delivering the perfect pitch.

Our show is unique when it comes to pitching: Potential entrepreneurs have just one minute to pitch their idea, service or product. Those 60 seconds have added pressure because the contestants are being filmed, and they are talking to a camera (instead of people) while riding up to the penthouse suite in an elevator.

Related: 6 Tips for Perfecting Your Elevator Pitch

In real life, with a different set of distractions, it’s essential to know how to deliver a convincing elevator pitch. Whether you are pitching a product, a service or yourself, here are the three essential components in a pitch:

  1. Stimulate interest
  2. Transition that interest
  3. Share a vision.

Can you stimulate interest?

The first step, stimulating interest, is the most important. In fact, an “elevator pitch” is usually determined by the limited amount of time you have, and circumstances may only give you the opportunity to stimulate interest. If you do a good job of stimulating interest, this can yield a second opportunity, where you transition that interest and share a vision with those you are pitching to.

Keep in mind that people generally buy based on emotion, using logical reasons as their impetus for action. So, make a point to connect with them emotionally in order to stimulate their interest. Don’t be afraid to show your feelings; demonstrate high energy and excitement for your idea, business or service. Your passion and belief need to come through in your pitch!

Use the 100/20 Rule to your advantage: Have the energy that you are providing R100 worth of value and only asking for R20 in return. This attitude will generate enough attention, giving you the opportunity to transition the interest that you’ve garnered.

Make the transition

But people don’t buy exclusively on emotion. There needs to be some logic in the decision to make a purchase. Therefore, you must address some sort of pain, fear or guilt in your pitch, that those without your product or service may experience. And if you can illustrate how you (efficiently) solve a big problem, you’ll have more statistical success in your elevator pitch.

Making a genuine connection can help you transition interest. Learn to make yourself equal, then make yourself different.

Simply having connections to the same people or a point of similarity in your backgrounds will help bridge the gap with those you are pitching. Then you can emotionally connect, following that up with the logic portion of your pitch.

Related: (Video) Crafting Your 30 Second Elevator Pitch

Transition the interest you’ve generated with a clear explanation of what differentiates you. Build credibility by discussing your sales, distribution, revenue, awards and/or successes. All of these different ways to “attract” allow you to segue from emotion to the logical reasons to buy.

Of course, it is of the utmost importance to be honest when you are pitching. The truth always comes out, so ensure that you aren’t over-promising with your pitch. Don’t create a void that you are unable to fill.

What’s your vision?

Finally, in order to excel when sharing a vision, you need to have a value proposition that backs the 100/20 Rule. Make the value that you bring to the table as clear as possible. The value you’re asking for in return also needs to be clear. If you don’t display confidence in what you’re asking for, you won’t instill confidence in those you ask.

Tell others exactly what you want, why you want it and what you’re willing to give in return. You should have already proved your valuation when transitioning interest, then reiterated that valuation as you progressed in the pitch.

Take the people you are pitching through the reasons why you can be of value to them, the impact that you can have on their life or organisation and the capabilities you (or your product/service) possess that makes working together beneficial for all involved.

Practice your pitch, then get rich

After following each of these three steps, close with one simple question to gauge whether you are aligned or not: “Can you see any reason you wouldn’t want to move forward?”

If you utilise your pitch to stimulate interest in your product/service/self, transition that interest, then share a vision with those you are pitching to, the answer is almost always a resounding “no.”

And if you get objections or rejections, so what? Address whatever objections there are and if you still can’t get aligned, that’s OK. Take the perspective that the universe has a set number of rejections you need to get to before you find the right partner.

Related: How To Pitch

Be grateful for an opportunity to prove others wrong, and believe that if you keep working on your pitch, product, service or self, everything will come to you in the right way at the perfect time.

This article was originally posted here on Entrepreneur.com.

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Attracting Investors

Alan Knott-Craig Answers Your Questions On Finding a Funder To Managing Your Staff

What you really need to know to land an investor.

Alan Knott-Craig

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Focus on one customer at a time. Make that customer happy. Move to next customer. Aim for ‘1 000 true fans’, then keep them happy.

The rest will come.

1. How do I find an investor?

You have 4 options:

1. Angels

Applicable if you only have an idea, and you need cash to make your idea a reality. Usually between R500 000 and R1 million. You need to milk your network: Parents, friends of parents, colleagues, parents’ friends, friends. If you have no network, you need to build a network or use your savings. There is no math to these investments. You get money because they believe in you, not because they seriously expect a return.

2. Early-stage VC

Applicable if you already have a working product with traction, ie: users and/growth, and you need cash to build out. Usually between R1 million and R2,5 million. There are a number of early-stage VC’s in South Africa, just ask around. Knife Capital are amongst the best. Ideally you want an introduction from a trusted party. Failing that, just email them directly. Give a simple pitch. They’re looking for 15X return on investment.

3. Late-stage VC

Applicable if you have a critical mass of users and meaningful revenue, ie: R10 million a year, and you need cash to grow. The late-stage VC’s are the likes of 4Di, hard to get access without an introduction from a trusted third party, usually one of your existing investors. They are looking for a 5X return on investment.

4. Private equity

Applicable if you have a cash-generative business that requires capital to either exit a shareholder, or to grow profits exponentially. Looking for 25% IRR.

There are also state-sponsored sources of capital for entrepreneurs from previously disadvantaged backgrounds, for example the Technology Innovation Agency. This is ‘soft’ money, requiring no equity or personal surety. If you can get it, take it.

Investors are looking for return on capital. If I invest R100 in an early stage company, I want to get R1 500 (15x) back within a reasonable period of time, ie. no longer than five years.

The key metric is Total Addressable Market (TAM). The size of the market you’re targeting determines the potential size of your business.

Assume you target a market with a TAM of R100 million (profit), and you assume you can get 10% of that market by 2020. That means your business will have R10 million of profits in 2020.

A private company is valued at a maximum of 7x profit, so your company will be worth R70 million in 2020. If you ask me to invest R1 million today, I need 21% of your company in order to realise a 15x return (R15 million) by 2020.

Start with TAM, work from there. Remember, every assumption you make will be questioned. Minimise your assumptions. Maximise the evidence for your assumptions.

Related: Alan Knott-Craig Answers Your Questions On Money And Partners

2. If you are a start-up, what’s the most important thing you can do to grow?

Focus on one customer at a time. Make that customer happy. Move to next customer. Aim for ‘1 000 true fans’, then keep them happy.

The rest will come.

For consumer products, always make it easy for your customers to share. Friction-free sharing is the easiest marketing tool you can have.

Feature-creep is a big risk and can be a big distraction. You need one single value proposition that is enough to get customers. Having fifteen cool features will never compensate for the lack of one killer use case.

Related: Alan Knott-Craig Weigh In On Living Your Entrepreneurial Dream

3. Our staff is growing, more than 20 now. Any tips on management? 

Having four or five staff is not hard. You don’t need to be a good manager or leader. You can muddle along. It’s when your team starts growing past the twenty number that management becomes a skill rather than a word.

There are hundreds are articles written on the art of management, but Jack Welch (former GE CEO) broke it down to this:

  • People want to know who they report to.
  • People want to know how they’re being measured.
  • People what want to know how they’re doing.
  • That’s it.
  • One boss. Clear KPIs. Regular feedback sessions.

Read this

13-rules-for-being-an-entrepreneur-coverAlan Knott-Craig’s latest book, 13 Rules for being an Entrepreneur is now available.

What it’s about

It’s easy to be an entrepreneur. It’s also easy to fail. What’s hard is being a successful entrepreneur.

For an entrepreneur, there is only one important metric of success: Money. But life is not only about making money. It’s about being happy.

This book is a collection of tips and wisdom that will help you make money without forgoing happiness.

Get it now

To download the free eBook or purchase a hard copy, go to www.13rules.co.za.  To browse Alan’s other books, visit bigalmanack.com/books/ 

Ask  Al

Do you have a burning start-up question?

Email: alan@herotel.com

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