A study done by Shikar Ghosh, a Harvard researcher, indicated that 75% of start-up businesses fail. Why is the failure rate so high and what sets the remaining successful 25% apart?
In the majority of cases, it simply boils down to money — having adequate financing available. Any business requires the necessary finances to initiate, maintain, develop and subsequently expand their business.
What your investor could be looking for
When a business is seeking outside financing from a third party, such as an investor, the third party is likely to look at the expected rates of return of the business, its existing commercialisation activities, its assets vs liabilities, the existing and target users, market potential and its current and expected turnover rate and profit margins.
However, the average start-up has not been trading for a sufficient amount of time to have the level of financial data needed for an investor to value the company adequately in this manner. How can a realistic value then be placed on a start-up?
The role of intellectual property
Unlike valuing companies with revenues, assets and longer track records, there are no agreed upon standards for start-ups. As it is unlikely that a start-up would possess any tangible assets, it is paramount to focus on the intangible assets such as ideas and the intellectual property protecting the ideas such as patents, trademarks, copyright and registered design rights.
Although it may be challenging for a start-up to spend money in order to obtain such intellectual property rights, it should be kept in mind that intellectual property rights are recognised as property and assets. Intellectual property rights may also be ‘the shiny object’ that attracts potential investors.
What intellectual property is telling your potential investors
Intellectual property is also indicative of a sustainable competitive advantage, a well-managed company, good growth prospects and a niche market. As such, it provides a means of setting the start-up apart from other players in the industry.
A significant amount of money is spent on getting the start-up off the ground in terms of advertising, research and development, development of prototypes and the like.
These ‘negative’ but realistic expenses may be equalised or outweighed by intellectual property rights, as once an intellectual property right is applied for, it becomes an enforceable right that is not easily taken away and may also attract a stable and predictable financial income if licensed, by providing royalties to the owner.
Intellectual property may assist a company if troubled by risk or bankruptcy as it may be assigned, and thereby transferred from one owner to another owner, or licensed — for income.
The commercial potential of intellectual property
Start-ups in a quest for capital have two options: Equity financing or debt financing. Equity financing may be advantageous if the start-up’s revenue is limited. In terms of debt financing a start-up may be required to pledge their intellectual property, which could be the only and/or the most valuable asset they have.
The intellectual property may then serve as security, however, it is arguable and also dependent on the start-up what the financial value would be. Such security is more beneficial as it is not debt per se but rather a predictable income.
Intellectual property as an asset
The value of intellectual property as an asset is dependent on economic, market, technical and legal factors. A start-up that creates intellectual property with commercial potential already has a foot in the door, as this creates confidence in both the founder of the start-up and potential investors.
Being realistic, it is entirely dependent on the type of start-up as intellectual property is not always an option or possibility. Should intellectual property not be a viable option, it is recommended that start-ups emphasise their future promise and also rely on evidence demonstrating growth, drive, engagement, talent, execution and worthiness. The key is to create excitement amongst investors.
As an end note to the founders of start-ups, keep Colin Powell’s quote in mind: “There are no secrets to success. It is the result of preparation, hard work, and learning from failure,” and to investors, keep Peter Drucker’s quote in mind: “Whenever you see a successful business, someone once made a courageous decision.”
Alan Knott-Craig Answers Your Questions On Money And Partners
From starting the right business, to managing business partners and finding your magic number, there is a secret to happiness.
If I get rich will I be happy? — JC Lately
Does money equal happiness? Mostly, yes. Research in the US shows that your happiness is proportionate to your earnings up until you earn $80 000 per annum. Thereafter, incremental income gains have a negligible effect on your happiness.
In other words: More money will make you happy as long as you’re poor. Once you break out of poverty and enter a comfortable middle-class existence, more money will not make you happier.
These are the top three for old folks:
- I wish I’d spent more time with family.
- I wish I’d taken more risks.
- I wish I’d travelled more.
Therein lies the secret to happiness. Spend time with your family. Take risks. Travel.
But first, make money. Don’t do any of the above until you’re making enough money not be stressed about money.
What is the magic number? — Mushti
The magic number is the amount of money you need to not worry about money ever again. If you don’t need toys like Ferraris, yachts and jets, the magic number is R130 million. Here’s the math: R130 million will earn R9,1 million in interest annually (assuming 7% interest). After tax that is R5,46 million.
Assuming you need 50% to maintain a good lifestyle, that leaves approximately R2,7 million for reinvestment, which is enough to keep your capital amount in touch with inflation for 50 years. The balance of R2,7 million (after tax) is for your living costs. In South Africa, R2,7 million will afford you a lifestyle that allows you to send your kids to a great school and university, to travel overseas a couple of times a year, and to live in a comfortable house.
Over time your living costs (and inflation) will eat into your capital amount. After 50 years you should be down to nil, assuming you earn zero other income in that time.
In 50 years, you will probably be dead. If you’re not dead, your kids will be able to support you (because they love you and they have a great university education).
I am the sole director of a company (the others still have full-time jobs and don’t want to be conflicted) and there is pro-rata shareholding based on our initial shareholder loans. However, I am putting in most of the hard work, together with one of the other actuaries. How best do I manage the director/shareholder dynamic? I obviously want to make as much progress as possible but there are times when I need the input from the others (and their responses aren’t always as quick as I would like). — Mike
If you have any perception of unfairness regarding effort/risk vs reward, deal with it NOW! You can’t do so later. The best approach is honesty. Call your partners together. Explain your thinking. Perhaps argue for 25% ‘sweat equity’ for yourself. Everyone dilutes accordingly. Ideally cut a deal whereby you have an option to pay back all their loans, plus interest, within six months, and you get 100% of equity (unless they quit their jobs and join full-time).
Equity dissent must be resolved long before the business makes money, otherwise it will never be resolved.
What do you think of WiFi in taxis?— Ntembeko
It’s a good idea, but not original. Before embarking on a start-up, you should survey the landscape for competitors. Just because there are none doesn’t mean no one has tried your idea.
It just means that everyone that tried has failed. You need to be 100% sure that you have some ‘edge’ that makes you different from everyone who came before you (and failed). Otherwise you will fail. What is your advantage that is different to everyone who came before?
Read ‘Be A Hero’ today
What You Need To Know About The Lean Start-up Model
The Lean Start-up philosophy was developed by Eric Ries, a Silicon Valley-based entrepreneur who also sat on venture capital advisory boards. He published The Lean Startup in 2011, igniting a movement around a new way of doing business.
The model follows key precepts that include:
Taking untested products to market
The fact that too many start-ups begin with an idea for a product that they think people want, spending months (or even years) perfecting that product without ever testing it in the market with prospective customers.
When they fail to reach broad uptake from customers, it’s often because they never spoke to prospective customers and determined whether or not the product was interesting. The earlier you can determine customer feedback, the quicker you can adjust your model to suit market needs.
The ‘build-measure-learn’ feedback loop is a core component of lean start-up methodology
The first step is figuring out the problem that needs to be solved and then developing a minimum viable product (MVP) to begin the process of learning as quickly as possible. Once the MVP is established, a start-up can work on tuning the engine. This will involve measurement and learning and must include actionable metrics that can demonstrate cause and effect.
Utilising an investigative development method called the ‘Five Whys’
This involves asking simple questions to study and solve problems across the business journey. When this process of measuring and learning is done correctly, it will be clear that a company is either moving the drivers of the business model or not. If not, it is a sign that it is time to pivot or make a structural course correction to test a new fundamental hypothesis about the product, strategy and engine of growth.
Lean isn’t only about spending less money
It’s also not only about failing fast and as cheaply as possible. It’s about putting a process in place, and following a methodology around product development that allows the business to course correct.
Progress in manufacturing is measured by the production of high quality goods
The unit of progress for lean start-ups is validated learning. This is a rigorous method for demonstrating progress when an entrepreneur is embedded in the soil of extreme uncertainty. Once entrepreneurs embrace validated learning, the development process can shrink substantially. When you focus on figuring the right thing to build — the thing customers want and will pay for, rather than an idea you think is good — you need not spend months waiting for a product beta launch to change the company’s direction. Instead, entrepreneurs can adapt their plans incrementally, inch by inch, minute by minute.
Start-Up Law: I’m A Start-up Founder. Can I Pay Employees With Shares?
Bulking up employee salaries with equity is a common method to attract, retain and incentivise top talent.
Every early stage start-up company battles with restricted cash flow and not being able to pay market related salaries to their employees. Bulking up employee salaries with equity is a common method to attract, retain and incentivise top talent.
Can I pay salaries with shares?
South African labour laws require that employees be paid certain minimum wages, and “remuneration”, as defined within the Basic Conditions of Employment Amendment Act, either means in ‘money or in kind’. ’In kind’ does not include shares or participation in share incentive schemes, as determined by the Minister of Labour. As such, there is no room for start-ups to completely substitute paying salaries with shares or share options. However, there is no restriction in topping up below market related salaries with equity via an employee share ownership plan (‘ESOP‘).
Employee Share Ownership Plans
There are a variety of ways in which employees can be incentivised, and it will always be important for the start-up founders to consider what goal they wish to achieve by incentivising their employees.
ESOPs can be structured in several ways, for example: employees may be offered direct shareholding in the company, options for the acquisition of shares in the future; or alternatively, a phantom / notional share scheme can be set up.
ESOPs permit employees to share in the company’s success without requiring a start-up business to spend precious cash. In fact, ESOPs can contribute capital to a company where employees need to pay an exercise price for their share options or shares.
The primary disadvantage of ESOPs is the possible dilution of the Founder’s equity. For employees, the main disadvantage of an ESOP compared to cash bonuses or bigger salaries, is the lack of liquidity. If the company does not grow bigger and its shares does not become more valuable, the shares may ultimately prove to be worthless.
Some key features to consider when setting up an ESOP are:
- ELIGIBILITY – who will be allowed to participate? Full time employees? Part-time employees? Advisors?
- POOL SIZE – what percentage of shares will be allocated to incentivise employees?
- RESTRICTIONS – will employees be able to sell their shares immediately?
- VESTING – will there be a minimum period that service employees will have to serve with the start-up to receive the economic benefit of his or her shares?
Employee share ownership plans are great corporate structuring mechanisms for attracting and retaining employees, as well as fostering an understanding of the company ethos and encouraging loyalty and productivity. It is essential when implementing an ESOP that all the tax implications are considered and that the correct structure and legal documentation are in place.
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