As your business grows it should go up in value. The more success you have in selling to customers, the better your margins, the more under control your expenses are and the more profit you generate (or the lower your losses), the more your business increases in value.
Whatever valuation you place on your business today, at some stage in the future you’re going to have to be able to justify it with your financial performance. Your valuation might be derived from a multiple of turnover, or profit or other valuation criteria. But your day of reckoning will surely come.
Each time you go for a new round of fundraising you want the valuation of your business to be higher than the last round – you want an Up Round. In an Up Round you can raise more money and give away less equity. If you gave away 20% in the first round, maybe you can go for 5% or 10% next time but raise more money. Up Rounds mean your business is working, and investors like that, because their investments are increasing in value too.
If you have to go with a Down Round, then your valuation is lower now than last time, which means you’re not making the progress expected. That's a disappointing message to give an investor. And it can mean you’re going to have to give away a lot more equity as punishment.
Think very carefully about how much money you need to raise in each round, what valuation you’re looking to achieve and hence how much equity you’ll need to give away. Your objective is never to give away more than 49% of your equity across all rounds if you want to retain control.
For example, I might be able to successfully argue that the value of my new business is £500,000 at the first fund raise. Of course, it’s all future value because I’m just starting out – but my business plan shows profitability in 2 year’s time that justifies a £500,000 valuation now. That means I’ll need to give away 20% of my equity to raise the £100,000 I need. The money will see me through to the next raise, where the numbers will justify a valuation of £2m. At that stage I’ll raise £200,000, which will cost me another 10% of my equity. By the time I’ve worked through that investment I’m generating cash but want to go for a big expansion. But my business is now worth £10m and the £1m I need will cost me only 10% in equity. Altogether I’ve raised £1.3m and I still have control.
I think you can see that in a Down Round I'll need to give away more equity even if I'm raising the same amount of money. That's the road to loss of control.
So, the lessons are:
Don’t go for too high a valuation for your next raise, which might force you into a Down Round next time – that will be expensive.
Plan all your raises, not just the next one. Your plan won’t be entirely accurate because business is unpredictable, but it will give you some guidance.
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