How to Pitch a Startup Idea by Email.
How to pitch a startup idea by email? I scoffed a bit when I saw the question, on Quora. Nobody invests in ideas, I mumbled to myself. And pitching by email? Fat chance.
But then I read the answer here, written by Bret Fox, former CEO of Touchstone Semiconductor, and now a CEO coach.
Here is Bret’s answer:
And the following is Bret Fox’s answer to how to pitch a startup idea by email, on Quora. Direct quote.
When I was feeling really desperate (a common occurrence when I was raising our initial funding), I would build up a list of potential investors I had no way of getting a warm introduction to.
You can learn how to develop a cold email that works too. Just follow these three steps:
Email Pitch Step 1: Narrow the Target
Step 1: The first thing I would do was make sure I was targeting people who were investing in our product area.
It seems obvious. But you’ve got no chance if you target a random group of VCs.
So do your homework and make sure the firm is investing in your business area, and you identify the partner that actually does investments in your business area. Oh, and make sure the firm invests in the stage of operation your company is at.
Email Pitch Step 2: Make your subject line to the point.
In our case, we were making Analog ICs. So my subject line was: Analog IC investment opportunity.
That’s it. You can’t trick people into opening your email. They’re either interested or not.
Email Pitch Step 3: Make your message short.
Introduce yourself and tell them what you’re doing. A key point is don’t try and sell the deal in the email.
You want to provide enough information to let them know what you’re about, but not so much that you’re trying to pitch in an email.. The goal is to get a meeting or a phone call.
So, I did something like this:
Hi Name,
My name is Brett Fox. I am the CEO of Touchstone Semiconductor.
Touchstone is a high-performance Analog IC company (think Linear and Maxim) that achieves profitability with minimal funding.
The founding team, including the design team, are alumni of Maxim. The designers average over 20 years of experience.
We have a term sheet from a very good VC on Sand Hill Road, and we are looking for an additional investor. Please let me know how you would like to proceed.
Best regards,
Brett Fox
Let me break this down for you, so you can understand what we were doing.
Each sentence had a purpose.
Each sentence had a purpose. The sentences in your cold email should as well.
The first sentence was introducing myself and the name of our company.
My name is Brett Fox. I am the CEO of Touchstone Semiconductor.
The second sentence explained what we did, how to think about our company, and how we were different in a meaningful way:
Touchstone is a high-performance Analog IC company (think Linear and Maxim) that achieves profitability with minimal funding.
The two companies I referenced, Linear and Maxim, were considered the two most successful companies in the Analog Semiconductor space. The reference to minimal funding addressed a concern that investors had about the costliness of investing in semiconductor companies.
The third sentence showed that the team was strong:
The founding team, including the design team, are alumni of Maxim. The designers average over 20 years of experience.
The final sentence explained where we were at in the fundraising process:
We have a term sheet from a very good VC on Sand Hill Road, and we are looking for an additional investor. Please let me know how you would like to proceed.
Already having one investor in the bag, especially a highly regarded VC, is a good thing.
So what were the results of this simple, to the point, email?
It worked.
We got meetings with this simple pitch. I think we had about a 20% success rate.
Now we didn’t get an investment with this approach (the traditional warm-introduction approach eventually did the trick), but that’s not the point.
The point is you can get meetings with cold emails. Target the right investors and be direct and you put yourself in play.
For more, read: The Nine Facts Of Fundraising You Need To Know – Brett J. Fox
Know Your Industry: Average Margins
Know your industry. In a recent post here, I wrote that the most common stumbling point I see in multiple business plans is absurdly unrealistic profitability. Specifically …
Most of the business plans I see project profits too high, or profits too early. In the real world, startups choose growth or profits, not both. The plans I see are aiming at angel investment. And for that, the investors win on growth, not profitability. Think about it: If a startup is profitable early on, it doesn’t need investors.
You can’t expect to make the same profits as the industry averages. Every business is unique. But you should still be aware of what’s reasonable, standard, or average. That information is readily available. You can go from there to what’s different in your specific case. I really like this NYU page Operating and Net Margins. My thanks to the NYU Stern School of Business, specifically Aswath Damodaran, who keeps this data up to date and makes it accessible.
Here’s a view of his data, the downloadable Excel file, sorted by EBITDA/Sales:
Or, if you are a LivePlan user, make sure you know about the LivePlan Industry Benchmarks that are built in.
You Have to Know When to Quit
I recommend you read Nat Eliason‘s piece No More Struggle Porn. He’s attacking one of the more pervasive startup myths around, the idea that the struggle itself, the overwhelming and overpowering struggle that pushes everything else out of your life, is a good thing. He defines struggle porn as:
I call this “struggle porn”: a masochistic obsession with pushing yourself harder, listening to people tell you to work harder, and broadcasting how hard you’re working.
And his take on it, in a nutshell, is this:
Working hard is great, but struggle porn has a dangerous side effect: not quitting. When you believe the normal state of affairs is to feel like you’re struggling to make progress, you’ll be less likely to quit something that isn’t going anywhere.
The Myth of Persistence
I agree with him. Emphatically. I’ve posted here before on The Myth of Persistence:
Why: persistence is only relevant if the rest of it is right. There’s no virtue to persistence when it means running your head into walls forever. Before you worry about persistence, that startup has to have some real value to offer, something that people want to buy, something they want or need. And it has to get the offer to enough people. It has to survive competition. It has to know when to stick to consistency, and when to pivot.
So persistence is simply what’s left over when all the other reasons for failure have been ruled out.
Knowing When to Quit
And, with that in mind, I like Seth Godin’s take on quitting, which is the main point from his book The Dip (quoting here from Wikipedia🙂
Godin introduces the book with a quote from Vince Lombardi: “Quitters never win and winners never quit.” He follows this with “Bad advice. Winners quit all the time. They just quit the right stuff at the right time.”
Godin first makes the assertion that “being the best in the world is seriously underrated,” although he defines the term ‘best’ as “best for them based on what they believe and what they know,” and ‘world’ as “the world they have access to.” He supports this by illustrating that vanilla ice cream is almost four times as popular as the next-most popular ice cream, further stating that this is seen in Zipf’s Law. Godin’s central thesis is that in order to be the best in the world, one must quit the wrong stuff and stick with the right stuff. In illustrating this, Godin introduces several curves: ‘the dip,’ ‘the cul-de-sac,’ and ‘the cliff.’ Godin gives examples of the dip, ways to recognize when an apparent dip is really a cul-de-sac, and presents strategies of when to quit, amongst other things.
Don’t let the struggle porn startup myths get you down. I’ve been through startups. I’ve been vendor and consultant to startups for four decades, and I started my own and built it past $9 million annual sales, profitability, and cash flow positive, without outside investors. And I’ve never believed that anybody is supposed to give up life, family, relationships, and the future to build that startup with 100-hour weeks and forget-everything-else obsession. Here’s what I say:
Don’t give up your life to make your business better. Build your business to make your life better.
10 Common Mistakes with Startup Financial Projections
I was glad to be asked about common mistakes with financial projections. I read about 100 business plans a year for angel investment and business plan competitions. Most show unrealistic profitability. More people doing business plans should realize that most startups are unprofitable at the beginning; and that high growth correlates with losses, not profits. High projected profits indicate lack of understanding, not reasonable expectations of profitability.
Profitability mistakes
- The most common mistake is with profitability. Most of the business plans I see project profits too high, or profits too early. In the real world, startups choose growth or profits, not both. The plans I see are aiming at angel investment. And for that, the investors win on growth, not profitability. Think about it: If a startup is profitable early on, it doesn’t need investors.
- The second most common mistake is underestimated marketing expenses. Many successful tech businesses, especially software and web businesses, spend 30% or more of sales on marketing.
- Don’t underestimate development expenses, testing, certifications, and expenses of regulations.
- If you are selling physical products, don’t underestimate the impact of selling through channels, as distributors and retailers take their margins and often demand admin and co-promotion expenses. And distributors often pay very slowly, like six months or so after receiving the goods.
- Never project sales by applying a small percentage to a large market. That doesn’t work. Nobody gets half a percent of a $10 billion market. Instead, sales forecasts should be built on drivers as assumptions. Drivers might be web visits and conversions, emails sent, paid search terms, or, for physical products, channel assumptions such as distributors, chains, stores, and sales per store.
- Don’t project big growth in sales with only small increases in headcount. If you are going to sell $100 million in the fifth year, get a clue: you won’t do that with only $2 million in employee expenses. Divide your projected sales by your headcount, and compare that to industry benchmarks. For most industries, $250,000 per employee is really good. If you are getting $2 million per employee, that doesn’t mean you’re going to be that efficient. It means you don’t understand the business.
Cash flow mistakes
- Having a profit doesn’t mean you’ll have cash in the bank. Good startup financial projections need to include cash flow. Always. For more on that, see points 4, 6,
- Another very common mistake affects cash flow. Businesses selling to businesses (B2B) normally sell on account. A sale generates not money directly, but money owed, to be paid later, which goes on the balance sheet as Accounts Receivable, or AR. Every dollar in AR is a dollar that shows up as sales in the P&L but not in cash.
- Many plans underestimate the length of the sales cycle and expenses related to selling directly to enterprises.
- Many plans underestimate the cash flow affect of inventory. Every dollar in inventory is a dollar that hasn’t yet shown up in the P&L but may have already affected cash balances.
Your Profits Are Way Too High!
The most common mistake in startup business plans is having the profits way too high. There’s no sense whatsoever to priding oneself in projected profits, as in profits you predict your business will have in the future. That’s like having replicas of future Olympic gold medals made and putting them into a trophy case. And in most business settings, it just lowers your credibility. I read 100 or so startup business plans every year, and I’ve getting tired of it. I’ve discovered a new 50-50 rule of profitability in business plans, as in, 50% of the plans I’m looking at project 50% or higher profits on sales.
Pick one: high growth or high startup profits
In real business, there is inherent conflict between high growth and high profits. That is the collective result of lots of small decisions owners make as they choose to spend marketing money or not. Every dollar you keep in profits is a dollar you didn’t spend to generate growth.
It’s not just coincidence that the history of high-growth online business successes started with losses. Facebook founder Mark Zuckerberg resisted charging membership fees in the early years, when Facebook was losing money but staying free to users. Sure, later, through advertising, Facebook found a way to make money – but first it had to grow its user base to gain the critical mass that made advertising a practical source of revenue. And Facebook is still free to users. Twitter is still free, struggling to figure out how to make more money, but not even for a second considering charging a fee for participation. LinkedIn is still free, and was free and losing money for years. Revenues came later, after the user base was established.
And even with more traditional businesses on main street, startups are rarely profitable. There are always expenses before launch, and those cut into profits. And few businesses manage to generate revenue to cover costs from the very beginning. Most have a deficit phase as they gain traction and grow.
And as they do establish themselves, they still have to decide, dollar for dollar, whether they spend available money on marketing, or save it and keep it as profits.
Find realistic levels of startup profits
Real businesses make five or 10 percent profits on sales, at best. The NYU business school keeps an updated web page that lists profitability by industry, with an overall average of 6.4%
Occasionally a very successful startup will come up with something so new that it can, for a while, chalk up very high profit margins. That’s extremely rare. Out here in the real world, though, nobody really makes much more than 5-8-10% or so profits on sales. The real startups might make 15% or even 20%.
Projecting 40%, 50%, and even 60% profitability on sales doesn’t tell me you have a great business; it tells me you haven’t done all of your homework. You’re underestimating cost of sales, expenses, or both.
I find this particularly galling in business plans with some social implications, related to health care, or education. I’ve seen many startups planning to sell something offering huge medical benefits to people suffering from serious medical problems, projecting profits of 100 percent or more. Do you agree with me that this is wrong? Nobody chooses to buy these things. Can’t they charge a fair price, that allows a fair profit?
What would I like to see instead? First, find out average profitability for the industry you’re in. Put that number into your plan. Then explain why your company’s projected profitability is higher. Proprietary technology, specialty niche market, new processes? Okay, I can take that; just be aware of what the normal is, so you know what you’re up against. Please.
Standard financials are available from several vendors, for less than $100 per industry (and here I can’t resist adding that they’re bundled with LivePlan, my company’s software product. Sorry. I’m an entrepreneur. I can’t help it.) You can also get those from Oxxford Information Technology, or the Risk Management Association (RMA). And some summary profit by industry data is available for free, from sources such as the NYU page above.
3 Things You Need to Remember About Profits
Are you a small business owner? Are you looking to start your own business? The politicians can misunderstand profits, and so can the general public, but you’d better not. Profits are good, not bad; but your business runs on cash, not just profits.
1. Profits are an accounting concept, not actual money.
Yes, they lead to money, in most cases. But profits are sales less direct costs less expenses, three concepts that are all subject to detailed accounting definitions and general principles. Timing can make a huge difference. I can book a sale today and not get paid for six months, so no money yet. And I might have paid the direct costs months ago. And I might pay the expenses months ago or in months to come.
2. Profits don’t guarantee cash.
Again, profits are likely to mean cash at some point, but not always. There are those timing issues built in. And businesses pay out money that doesn’t affect the profits at all, such as buying assets, repaying debts, and paying dividends. Lots of profitable companies go under for lack of cash flow.
3. Profits Aren’t Necessarily More is Better
There’s an inherent tradeoff between profits and growth. You as business owner decide whether to spend more on marketing to generate growth, or less on marketing to generate profits. I think real businesses need to find a point of balance. We need enough profits to sustain growth ( extra credit: “sustainable growth rate”) and keep ownership compensated for risk. But on the long term, growth is better than profits. And cash flow peace is better than growth.
Bonus Point: Most Newbies Overestimate Profits
The most common mistake in business plan financials from first-time entrepreneurs is overestimating profits. Occasionally there is a high-tech wonder business that yields extraordinary profitability, but that’s almost always just a short-term phenomenon. Real businesses make 5-10% profits on sales. When a business plan shows huge profitability, that’s a sign of not understanding the business, not of an exceptionally profitable business.
If you’re curious, try this link: NYU study on average profitability by industry.
And if you’re curious about why this fourth point is labeled bonus point, I wanted my title to list three, not four. Maybe I’m numbers obsessed. Go figure.
What ‘Accurate’ Means in a Business Plan
I just answered this question on Quora. I think it’s an interesting question, one that comes up often enough, and one whose answer is worth considering.
How can I write a very accurate business plan. I’m hoping to win a grant in a business plan competition?
The rest of this post is my answer on Quora, reposted here with Quora’s (implied) permission:
This is an important question, but also a big one, hard to answer in a few hundred words. And I’m going to stick with the subset of business plans that apply to business plan competitions. These are more traditional and formal business plans, written to communicate with outsiders, and therefore significantly bigger than the lean plan (see below) you need to just run a business.
What Accuracy Means in a Business Plan
It starts with this: in your summary and descriptions of the business model, company formation, market, business offering, and management team, your readers take accuracy for granted and so should you. Tell the truth about your business and what you plan to do. Period. Accuracy isn’t a variable.
I have to guess that you bring up accuracy in the context of projections, specifically your market forecast, sales forecast, projected profit and loss, projected balance sheet, and projected cash flow.
Accuracy in market information
With market information, make sure you distinguish between the statistics, demographics, and descriptions you present as facts – external available information, with sources cites – and estimates and projections.
Approach this with the understanding that there are no facts about the future, just guesses; and there is no guarantee that the information you’d like to have will be publicly available. So therefore you have to develop reasonable estimates, based on assumptions, for which accuracy is mainly a matter of making your assumptions logical, and transparent.
Here’s a real example from a plan I was involved in recently for a social media consulting firm (Have Presence):
- The target market is small business owners who want social media presence, don’t want to do it themselves (or don’t have time), and have the budget to pay for a service.
- To develop an estimate for the U.S. portion of the market, I start with known statistics on small businesses in the U.S. and cite the source (in this case, the U.S. Small Business Administration), to arrive at some number, say 5.5 million (I’m not taking the time, while answering, to go check the actual number; but it’s a real number, publicly available, with a reliable source).
- From there I have to make an estimate of how many of those 5.5 million business owners meet the criteria of wanting presence, not doing it themselves, and having budget. There is no way to get the actual number with any accuracy. I have to estimate. And whether I end up saying it’s 2%, 5%, 10% or 20%, the quality of accuracy in this specific case is a combination of going from known statistics to estimates, and keeping the estimates clarified.
- If I really cared – perhaps because I was entering a business plan contest with my plan – I could probably figure out how to educate my guess in point #3 by looking at Facebook statistics, Twitter statistics, businesses by number of employees, and so forth – that would still leave me with estimates, but better estimates. In fact, I’m fine with what I did in point #3 because that tells me there is enough market to go for … whether it’s half a million to two million potential clients is irrelevant for business decisions, because it’s enough.
So this is just one example. Accurate in market description is a matter of combining what can be known with what can’t be an has to be estimated.
Accuracy in Financial Projections
Financial projections are always wrong, by definition, but they’d better be laid out correctly, reasonable, transparent, in line with industry standards, and, above all, credible.
- The goal is to connect the dots in the financials so that spending is in proper proportion to sales and capital resources, and cash flow is sensitive to factors such as sales on account and inventory that make it different from profit and loss. Show that you understand how the financials are going to work in the real world. What drives what.
- The sales forecast has to be credible. Make sure you lay it out from the details up, not from top down. That means transparent assumptions about drivers, so for a product in retail channels it’s something like monthly sales per store, and stores carrying the product; and for a web business is traffic via organic, traffic via PPC, and conversion rates; and so on. Definitely not a top-down forecast, meaning show a huge market and a small percent of market.
- Profitability has to be credible. One of the most common flaws I see in business plans for competitions is absurd profitability, 30%, 40%, and more as profits to sales, in an industry in which the major players make 5% or 10% on sales. That’s a huge negative. Accuracy in P&L means having realistic percent of sales for marketing expenses, general and admin expenses, and development expenses.
- Cash flow has to be credible. Another common flaw is failing to understand how sales on account and accounts receivable affect cash flow for business-to-business businesses; and yet another is failing to see the cash flow implications of having to buy product inventory and carry it before selling it.
Accuracy in the main body, descriptions, etc.
For the rest of the plan, industry information, competitive information, and so on, what’s really important is that you clearly distinguish between factual information from valid sources and guesses and estimates.
One of the worst things you can do in a business plan competition or pitching investors is to get caught presenting as fact something that one of the judges or investors knows is inaccurate. If you aren’t sure, clarify, disclose, call your guesses guesses. And it’s particularly bad to fudge the facts regarding your personal history, your business history, or those of your team members. Don’t cross the lines of accuracy related to degrees, job positions, and past jobs. You need to protect your integrity. And if you blur the truth on purpose, such as saying you studied business at Harvard or Stanford when you were just there for a few weeks in a special course, or when you failed to graduate, that can kill a deal.
Q&A: Winning Business Plan for a Competition
How do you do a winning business plan for a business plan competition? I’m glad you asked. I’m a frequent judge of these competitions so it’s in my interest to help you improve your chances by developing a better business plan, pitch presentation, summary, and elevator speech.
So that you know, I’m answering this question with reference to the mainstream high-profile business plan competitions I’ve judged many times, including the University of Texas’ Global Venture Labs Investment Competition, the Rice Business Plan Competition, and the University of Oregon’s New Venture Competition. I’ve done these three at least 10 times each. I’m assuming they are typical – but I could be wrong.
Here’s how the process works, with regard to what you deliver and how decisions are made:
- You submit either a business plan or executive summary to a steering committee that selects a few dozen entrants from hundreds of submissions. These committees vary. Many still use the full plan, but trends favor just the summary. This step takes place behind the scenes, before the visible portion of the competition begins. The entries selected are called semi-finalists. They are invited to go to the competition, at the site, which usually involves a Thursday, Friday, and Saturday, most often in April or May.
- Semi-finalists are divided into groups of four to six. Semi-final judges, mostly angel investors, venture capitalists, and executives from sponsor companies, read and evaluate the full business plans before the competition starts.
- An elevator speech round happens on the Thursday, in the evening. The teams do a 60-second elevator speech for prizes and awards. Winning that competition doesn’t formally help win the main prize, but informally, it affects the judges who see it. About half the judges will attend that first evening.
- The semi-final round takes place on Friday. Teams do pitch presentations and answer questions from the judges assigned to their group, who have read their business plans. Judges choose a finalist based not on the quality of business as a potential investment. The plan matters of course, and the pitch matters as well, but the choice is ultimately about the business. Judges try to make decisions based on investment criteria, including growth potential, defensibility, scalability, and experience of the management team.
- Finalists go through the same gauntlet on Saturday. Finals judges read the plans, listen to pitches, and ask questions. They choose the winner based on the same criteria they use to choose investments.
In all of these competitions, the judges are told to choose the best plan for outside investors, not the best-written or most attractively formatted business plan. So, a mediocre business plan for a great business will always beat a great business plan for a mediocre business. What you want from your business plan is to present your business well in a way that makes it easy for judges to see what you have. Your business plan alone isn’t enough to determine your fate in these competitions, but it does provide the first impression and the detailed background. In fact, all three of the competitions I mentioned above have special prizes for the best business plan, but those awards pale in comparison to the main prizes.
Therefore, the best way to help your chances with your business plan is to make sure the judges see the critical elements that make a business attractive to investors: potential growth and scalability, proprietary technology or some other kind of barriers to entry, and an experienced management team.
Here are some related tips that might also help:
- Make sure you cover the information investors want. Tell a convincing story about the problem you solve and the solution you offer, in a way that will interest the investors and let them believe your market story. Show whatever traction you have, and as much startup experience in the management team as you can. Show how your business will defend itself (proprietary technology, trade secrets, whatever secret sauce you have) from competitors entering the market. Show how you can scale up for high growth. Show that you understand how exits might work in 3-5 years.
- Keep it brief. Be concise. Don’t show off your knowledge, push your main points forward. Bullet points are appreciated.
- Show your numbers and your key assumptions. Numbers without assumptions and underlying story are useless. Forget present value and IRR games that depend on future assumptions. Show unit economics and build forecasts bottom up, from assumptions, not ever as some small percentage of a big market.
- Use illustrations that simplify and explain. Have the detailed numbers to back them up, of course, but use bar charts and line charts and pie charts to help readers get the idea quickly.
- Check your numbers against real world benchmarks. Investors will react negatively, not positively, to unrealistic profitability projections.
- Maintain alignment between the key points you emphasize in the business plan, the pitch presentation, and the elevator speech. Ideally your business plan is like the screenplay for the pitch presentation and the elevator speech.
- Don’t be afraid to revise numbers constantly, and don’t apologize if the numbers you show today are different from what you showed yesterday. Plans are supposed to evolve constantly.
(Image: shutterstock.com)
Save the Patient. Make Exorbitant Profits. Is This Okay?
How do you feel about projecting excessive profitability in a health care business plan?
Over the weekend I saw the pitch for a brilliant business plan, with great technology, for developing medical electronics that could significantly reduce some kinds of complications in some kinds of surgeries.
“The world needs this,” I thought. “I hope these people succeed. I hope they get the investment they need.”
But then they got to the financial projections.
Their sales forecast soared to tens of millions of dollars, but their technology was so good that it seemed credible. They had PhDs and patents and a strong team. No problem there.
But they also projected 80-85% EBIT (earnings before interest and taxes). And that got my attention. It’s not just my chronic skepticism about absurdly high projected profits in business plans; it’s also about intentions, exploitative pricing, what Wikipedia calls price gouging. And about ethics.
It reminded me of the Steven Bill cover story in Time Magazine a couple of months ago, called Bitter Pill. Or if you want the short version, watch this Jon Stewart interview with Steve Brill. He says:
It’s the people who organize the care, who sell the equipment, who sell the drugs; they’re the ones making the money.
Later I asked the inventor about the ethics of pricing. He understood the problem. He gave me a sensitive respectful answer. He said he trusted his more-businesslike co-founders who set the prices. He explained that pricing is set by the whole system, pretty much what Brill’s piece suggests. He didn’t say that profits from this one product would go straight back to research for other products, more inventions, and more improvement in surgical equipment. Insurance companies set the price. His company can beat the existing costs with something much safer. So, if they can execute their plan, they’ll make huge profits.
Medical costs will still go down, if it works, because it reduces complications. Patients will benefit too, with less pain, illness, and death. But according to their own numbers, they could charge a third of their planned price and still make healthy profits.
What do you think?
(Editorial note: I’m not giving specifics on purpose. I don’t want to make this about a specific company. And at this point it’s all hypothetical anyway, just a few numbers in a business plan.)
Sticky Questions on Startup Ownership and Buy-Sell
I received this interesting detailed question from the ask me form on my website. I’ve decided to answer it here. I think my answer might be useful for others with similar questions. I’m putting the question in quotes, paragraph by paragraph, and adding my response directly where it comes in the question.
It starts like this:
A person ‘X’ owns 15% stake in a startup company – not by investing money but purely by virtue of having dedicating hours for building a product for the company. No salary was to be paid as per an initial agreement. The 15% stake was deduced by a simple calculation: (value of company) / (number of hours worked) x (dollars per hour).
Was it clear in the initial agreement that the formula here was to be used in future buy-sell transactions? Was that agreed to by all?
The question continues:
The value of company is therefore, sum of [(number of hours worked) x (dollars per hour)] and [hard cash invested by a person ‘Y’, also taking into consideration year-on-year appreciation of this hard cash]. Lets call that VC.
No, it’s not. The value of the company is what somebody pays for it when they buy it. And if nobody is buying it, then the value of the company is an estimated value. There are lots of formulas for estimating it, and estimates will vary widely. I’ve got more on that below, in my specific recommendations.
However, it could be valued like you propose, for purposes of a buy-back transaction, if there was a buy-sell agreement that set that formula in the beginning. That’s if and only if. Issues like these are the reason experts recommend that partners and cofounders talk about the eventualities and agree, before the business starts, on how they’ll be handled. You have to agree beforehand or you’re stuck with arguing and negotiating the valuation afterwards. And when you try to pull it apart afterwards, without the benefit of an agreed-upono buy-sell formula, then many formulas might apply.
And here’s the heart of the question:
The company is not profitable yet. Person ‘X’ decides to give up his 15% stake of the company. My questions:
– How much is ‘X’ entitled to receive as the value for 15% stake?
– Calculating backward, would X receive as much as [(number of hours worked) x (dollars per hour)]?
– How does this change if the only buyers of the 15% stake are also two other stake-holders within this company, one of them by virtue of cash invested in the company, and the other by virtue of hours spent working for the company?
Normally, unless otherwise specified, owning 15 percent of a company means you own some shares that amounted to 15 percent of the total shares issued when they were issued. Ownership privileges are defined in company documents. You might have a seat on a board of directors, or not. You might get dividends when that’s relevant. And you’ll be able to sell those shares subject to securities and exchange regulations.
Just hypothetically, as an example, say you agreed two years ago that you got 15% because you had put $15,000 worth of work on it for free and the founders agreed then that it was worth $100,000. If it’s launched and very successful now, with sales of $1 million annually, then it’s worth something like one or two times revenues, less a discount for debts, less a discount for not being liquid. In that case your 15% is worth something like $100,000. On the other hand, if it launched, has no sales, no profits, and has spent all its money, then your 15% is worth about zero. Companies are almost never worth a formula based on hours worked.
So unless you have that buy-sell agreement stipulating the formula you’re using, then it doesn’t apply. Here’s what I recommend.
- Agree on an estimated valuation. The formula you’re suggesting seems like it might be one-sided and self-serving. Good luck with it because it’s going to be hard. Expect disagreements. Depending on how much money is at stake and how severe the disagreement, you might need to work with an attorney and a valuation expert you can agree on. Here are some posts on this blog about valuation. This one is particularly relevant: 5 things business owners need to know about valuation. Sales, sales growth, profitability, and scalability and defensibility make it worth more. Debt, and not being liquid shares, low growth, and losses make it worth less.
- Take 15% of that valuation and negotiate with your cofounders based on that value. I hope for your sake and the sake of your cofounders that things are going well for this business and they’re happy to buy you out. If they aren’t, then you’ll have to keep discounting until you get to an amount they’ll pay you. Or just keep your 15% of the shares, stop working for the company, and hope that someday they’ll be worth something.
The moral of the story: please, the vast majority of business marriages (partnerships, startups with founders, etc.) end in divorce. Do a business pre-nuptial agreement, which is what they call a buy-sell agreement.
Greatly appreciate your response and all your help!
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