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Risk vs. Reward: How To Increase the Value of Your Business
The Primary Focus: Risk vs. Reward
When you boil down all the variables involved when an investor is calculating a value for your business, there is a conceptual framework which should be very clear: risk vs. reward is the primary focus of any professional investor. Simply put: the higher the perceived risk, the greater the targeted return (reward) for the investor – and the lower the current valuation.
So in order to maximize your valuation, your goal should be to find ways to minimize the perceived risks of investing in your venture. How do you know what the risks are? Read, observe and ask.
Risks? What Risks?
By the time an investor is doing its homework on you in the form of due diligence, you should already know their “hot spots.” Read the information about the firm to see what they believe are their strengths – web site information, brochures, articles – what they bring to the companies in their portfolio. For the most part, these strengths will outline their focus and where they believe companies need to be strong. So these are the areas that you will want to address in discussions with the firm. And as discussions and diligence progress, you will want to support these areas with documentation and planning.
Remember to pay close attention to the questions and discussion points in your first meeting(s). Like in most business negotiations, the topics you cover first have a way of becoming the framework, if not the principal focus, for the eventual deal.
Management, Management, Management…Planning
It may seem obvious, but good investors really do back the jockeys and not the horses. In business terms, it really doesn’t matter what the product is, an investor will want to know how strong is your management team. The most important aspect? In most investors’ eyes, the key ingredient for a management team is experience. Experience not only in an industry, but experience in growing a company through its various stages of development. If your company doesn’t yet have that expertise, at least know that you need it. Nothing will turn off an interested investor faster than management with blinders on.
The first and best way to show a strong management team is to have one. And the way to show how strong your team is? Formalize your planning in a comprehensive (but not tedious) document and be able to show how well you are executing that plan.
Perhaps the most important goal of any company to achieve is that of sustained profitability. From a risk viewpoint, your business will have overcome many hurdles to get to that goal. For valuation purposes, your company can now be compared to other successful companies in your industry, especially those whose shares are publicly held.
Exit Strategies & Market Conditions
Like any other business, the investment business runs in cycles and investment firms vary in experience and focus. The truly experienced firms know two things: you raise capital and gain liquidity when you can and you settle in for the long haul when the capital markets are squeezed and neither capital nor liquidity are available.
Depending on the stage of development of your business, you should be able to speak coherently to the question of likely exit strategies. You may even know likely strategic buyers. Always remember that the investor is not in the business of running companies – they are in the business of investing in them, helping them grow and then cashing out!
Time Is Of the Essence
In calculating internal rates of return; time is one of the key variables. It is not necessarily that they investor earned 5X their investment; it is that they did so in three years! We always recommend that you fully investigate the “return discussion” with potential investors. Even though this strategy rarely works for venture capital investments, find out if any investor is willing to reduce, even incrementally, the holdings if certain liquidity goals are met ahead of time.
Essential Terms – Downside Control & Upside Preference
A lot of the term sheet negotiations will center on downside protection – what rights and preferences the investor will have in case things don’t go well. Understand that this is more about controlling the destiny of their investment and less about controlling your company.
Similarly, the investor is going to look for a preference return – generally in the form of preferred stock – that puts them ahead of management and other early shareholders. There will be a number of provisions on this stock -- all of which help the investor to mitigate risk by controlling liquidity events.
What is the fundamental knowledge to help increase the valuation of your company? Anything that lowers investor risk will give them a more clear return picture – which will help increase the valuation of your business – which keeps more of the ownership in the hands of the present shareholders. And that should be your ultimate goal.