After watching a number of episodes of one of those “pitch to the investor” reality shows on television, I just had to put pen to paper.
It’s clear to me that the featured entrepreneurs did not do their homework or simply don’t know how investors think.
They made the common mistake of valuing their business ideas at millions of rands.
For instance, one participant wanted an investment of R5 million to start trading. When the investors asked what they would get in return, the entrepreneur offered only 25% equity in the business.
In the mind of an investor, what this means is that the business idea is worth R20 million – even before it is proven to work!
This puts off investors and is very likely to close off opportunities to further engage them (or their capital).
Entrepreneurs often think their business ideas are unique and the best ever and are therefore unwilling to share much with other people of what they believe could be the fortune they will make in the future from these ideas.
What these entrepreneurs forget is that a business idea is worth nothing until it is proven to work. To prove it, a large sum of money – which they do not have – needs to be spent first. No cash, no business!
In the case of a business that has been trading for a number of years, its value can be determined by using various valuation methods.
The common method is to multiply its annual profit by a number ranging from 3 to 5. In some business types (e.g. service stations), the number is high.
From this valuation, the investor will determine a fair equity that his or her investment should buy in the business.
Loan financing might seem like a simpler option, because you don’t have to give away equity to other parties, you just need to pay back the loan with interest to the lender.
But the challenge here is that you need to provide collateral against the loan, which is often difficult if you require a loan of R1 million or more.
In this case, finding an investor seems to be the only option you have to make your business dream come true.
Personally, the investor option is the best, because somebody else is prepared to take the risk with you, whereas in a loan scenario, you’re taking the risk alone – you use your property to secure the loan and sign an unlimited surety-ship. Provided that investors are convinced that your business proposal is viable and profitable, the language they understand is risk and return – the higher the risk, the higher the expected return.
Simply put, return is the profit investors expect to make on the amount they will invest in your business over a period to be agreed upon, usually expressed as a percentage.
In the private equity and venture capital space, the expected return in unsecured investments averages about 35%, but it can be more, depending on the level of risk investors are exposed to in the business. Think about it. These people withdraw their money from secured and low-risk environments and invest it in someone else’s dream or business where there are no guarantees besides expectations, and hope for the best. If you ask me, this is plain crazy.
Why then wouldn’t you want to share the fortune you will create from your idea or business with them? If I had a good business idea and needed investors, I would make up to 49% equity available to them, depending on the return they want, with an option to buy back that equity in five years’ time. If that isn’t enough, we can look at other structures that could enable them to get to the required returns.
My assumption here is that in five years’ time, the business will have a good enough track record to be able to secure a loan to buy back the shares. If the business does not go as planned and fails, I wouldn’t start worrying about losing my belongings, because all the parties involved were prepared to take the risk. The key in dealing with investors is to understand their game and negotiate all the way until a fair deal is concluded.