Understanding the financial intricacies of equity investment, valuation, and growth management is crucial for any tech services founder. This article helps you understand the economic and intangible factors in taking equity investments.
You’ve heard the phrase that investment is about sharing a bigger pie. Intuitively we know what this means. Investment allows you to grow your business, so your eventual outcome is more than the share of the company provided. But what does that look like in terms of actual numbers?
At a high level, the additional funding goes towards the growth of the revenue. This can increase the size of the pie for you in one of these ways:
Revenue is used as a multiplier in high-growth companies.
By spending more money, you can accelerate your growth rate - which gives you the premium of a higher growth company.
As companies become bigger, they can automatically command higher revenue multiples because they are inherently less risky.
These factors will result in an increase in valuation for the company as it grows. So when deciding to seek out investment you need to decide if the increase in valuation you get from deploying the capital is more than the value of the business you will give away to get the capital.
Paul Graham talks about this in his essay about the Equity Equation. But the logic is for you to take money you must believe:
(Without investment %age) x (Without investment valuation) < (With investment %age) x (With investment valuation)
Or
(Without investment %age) / (With investment %age) < (With investment valuation) / (Without investment valuation)
Which means
1/( 1 - fraction of equity given) < (Expected increase in valuation from investment)
So to try a few examples.
Let's say you take in a $2M investment for 20% of your company. Will your company valuation increase by more than 25%?
Vixul takes 4% of an equity share in your company. For the Vixul program to be worth it, your company needs to be 4.2% better under the learnings and guidance of Vixul.
When making the comparison it is essential to understand that the timeframe has to be the same. You cannot compare two different timeframes because the question of value without taking in investment is irrelevant otherwise. It’s not that you won’t eventually reach that level without the investment. It’s just that it’ll take you longer to reach that level. And this growth will bring you more wealth.
Let’s take a look at this below, as changes in founder outcomes and equity vs valuation over the same time period.
Consider you have a company with a million-dollar valuation. Assume you have an organic growth rate of 20%. Consider the scenario of taking an investment in exchange for 10% of equity every year and that allows you to increase the growth rate to 40% annually. After ten years the no-investment scenario gives you roughly $6.2M while taking investment is above $10M as shown in the graph below:
Having nearly $4 million more in the bank is a pretty sweet spot to end up in, but let’s take a look at how we actually got here.
In the organic growth scenario, you kept 100% of your organic equity and your company grew - slow and steady - to its $6.2M valuation at the end of ten years. Because you’ve got 100% equity, that’s your own organic wealth as well.
However, in the inorganic growth scenario, you steadily sold off your equity each year, with your final stake being only 35% after ten years. But this time, the pie got much bigger. Your company’s inorganic valuation grew at the inorganic growth rate of 40%, landing around $29M by the end of 10 years. And as owner of 35% of that pie, you now have almost $4 million more.
While we discussed the basic economic equation of when it makes sense to take in money, you also need to put thought into intangibles. And this is about your personal ambition and goals more than anything else.
Almost every investor will look at the investment from a purely financial perspective. When you bring in an investor, you have a new stakeholder whose needs you have to cater to. So your vision needs to align with that of the investors. You will need to focus on maximizing the financial outcome for yourself and the investor. Don't take the money unless you are willing to accept that as the goal.
Similarly, it is a lot harder to run a fast-growing business than a slow-growing business. Running a fast-growing business will give you more wealth in the long run. But the journey will be far more stressful. You’ll need to put a lot more care into perfectly hitting the bulls-eye. This will weigh on you, especially since you took money from someone else and are now beholden to them to produce outcomes.
This article gave you an understanding of the economic and intangible concerns when taking an investment. It helped you understand what your expectations need to be from the investment. But the most important thing is to make sure you have something to invest your money in that can give you the desired outcomes.
For that, you first need to build a solid business. This is why we started Vixul with an accelerator first. Services companies are able to pay for themselves. So before they try to grow, they need to fix many of the fundamentals and become solid companies. They should have a clear and differentiated market position backed with solid planning for the future.
If you want to put your company on a high-growth trajectory but don’t have the fundamentals in place yet, then we may be able to help you with the Vixul accelerator program. You can apply to be a part of the Vixul portfolio here.