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Making the pie bigger

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Founders spend lots of time, money, blood, sweat, and tears in creating a new business, and they obviously want to maximize the financial return on their investment.  Thus it is important to understand how to value either a) new strategic hires or b) investment capital, as both will reduce the founders equity stake and controlling interest in their business.

I think the question to ask when valuing new hires and investors is “How does this new hire/investor make the pie bigger?

For example, if you are a technical founder but don’t have the key contacts within your target industry that will get you in the door with potential customers, how much is it worth (in equity terms) to get someone with those contacts on board?  This person will probably demand a significant chunk of equity but if you are confident that they can get you in the door with potential partners and get deals closed, maybe they are worth the dilution you’ll experience as a founder.

Now let’s turn to the investor case.  If you have bootstrapped your company and are able to become cash flow positive without raising outside funds, then you have a business that self-financed and quite possibly sustainable.  However, if your company is burning cash or has ambitious growth targets that can only be met by significant investment in product, sales, or marketing (beyond what you can finance through cash flows or your own wallet), then you will need to think about outside funding.  Taking on outside funding is going to dilute your ownership stake but may also allow you to make the pie (the size of your company in revenues, valuation, etc) bigger.

If taking in $X million in investment will allow you to hire 3 sales people to sell into target accounts and create a channel sales program but will reduce your ownership stake by Y%, is it worth it?  Do you believe that the $X million investment (and the hiring capability, etc that it affords you) will help you build a $50 million dollar company instead of a $5 million company?  Taking said investment may reduce your ownership stake to 50% from 100%, but my guess is that most entrepreneurs want to own 50% of a $50 million company versus 100% of a $5 million company.

Obviously you will never be able to accurately compute that adding $X of investment or giving up some % of equity to a key employee will grow the overall pie by a specific amount.  However, you should think about (in orders of magnitude) how these decisions will help you grow the overall pie (your company’s value) as well as the absolute size of your piece of the pie (the value of your share of the company at exit).

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Written by John Gannon

December 30, 2008 at 12:27 pm

Posted in Uncategorized

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