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Starting or expanding a business requires money, so how do you get your hands on some? And let’s say your product is a hit. What do you want to do—keep working or sell?

Experience and Equity First

Family and friends are a typical source of start-up funds, but with the downside of problems with them if your business doesn’t do well. So where else might you go? State and federal agencies have been providing lots of advice, and sometimes money, to folks who want to start a small business.

Congresswoman Judy Chu is a member of the U.S. House Committee on Small Business. She is one of the leaders in the small-business economic recovery. Chu has a site to provide information for small businesses (www.chu.house.gov). This site includes links to state and federal agencies that assist businesses and entrepreneurs in securing loans, exporting their products, and contracting with the government.

There are grants, funding, and loan initiatives from the government, such as through the U.S. Small Business Administration (SBA), which wants to invest in the future economy. Its site, www.sba.gov, is perfect for new businesses like yours!

Invest some sweat equity in someone else’s business. Specifically, go to work in the natural foods industry—particularly on the manufacturing side. Make a place for yourself in a new natural foods company that is going to grow. And the money? Work toward getting some equity in the company. Trade salary and time for a piece of the action. Of course, that is not so easy to do. Perhaps you are married, maybe have children, or are young, unemployed, and living at home. But starting a new business is going to be about making tough choices anyway, so there’s no time like the present. However, I do have a warning about working for someone else for a piece of their equity, so let’s look at that next.

SHELF CHECK 22

Get It in Writing

I helped build a brand, nearly from conception. There was a family-like environment in the company, and we seemed to be good friends. Together we were a small but powerful team. We all did our jobs and we did extraordinarily well. Deals were closing all over the country. Our sales numbers were climbing. However, to my knowledge, no one in the company earned a competitive salary. We all sacrificed higher salaries to build something of our own. The owner indicated that when the company sold we were all going to benefit: “Everyone will receive a piece, right down to the receptionist. You can go back to making your films.” I was satisfied with his response. For three years, we labored together. Then a venture capital group purchased the company. However, I received no share of the promised proceeds of the sale, which, rumor had it, was over $20 million. For my $1.2 million annual sales as regional Southern California manager, I was rewarded with only half my promised bonus because the original owners were supposed to pay it. The fact that the company sold because of our high sales made it doubly insulting that I did not get even close to what I was entitled to. So learn from me: A promise isn’t a commitment until it’s in writing!

Choices: Selling or Expanding

Picture yourself a few years down the road. You have worked hard, put in a lot of long days. Might you decide enough is enough? You don’t want to just stay small and keep doing the same thing. You can decide to sell to get your money out. Or you can decide that you want to expand, and need capital to do so.

However, because finding a buyer and finding investors if you want to expand both use the same process and people, let me discuss them in the context of getting investors to invest in your company.

SHELF CHECK 23

Be Realistic When Presenting a Valuation

I enjoy Shark Tank, or, as it’s called in the United Kingdom, Dragons’ Den. A common theme on this show is participants overvaluing their company. Contributing factors to this delusional state are endless. I see laziness and I see an unwillingness to learn about basic business management. And, when faced with their own dismal sales numbers (which always tell a story), show participants act shocked.

When entrepreneurs enter a meeting with potential investors and present inflated evaluations, they quickly face reality. How can they be so naive? Often the sad explanation is that company owners along with family and friends have all invested copious amounts of money and have become too emotionally vested in their business.

Another reason for overvaluation is ego. I once consulted for a team that was almost exclusively run by high-net-worth individuals. As often happens, their past successes made them overconfident. Natural products were uncharted territories for them. Unfortunately, their resume and prior successes did not transfer into this brutal industry. I arranged a conference call for them with a major industry investor. He was excited to meet the team, and at first the conversation was just dandy, but that was short-lived. My leaders mentioned closing major chains and popular retailers. My investor contact responded, “What are your sales?” Their answer? “We are selling off the charts, roughly $500,000 per year. Our valuation is north of $30 million.” At that moment, I sensed a pain deep in my chest. Certainly they meant to say $3 million, right? Or maybe 30 million . . . pesos?

After the call, I had a private chat with my investor contact. He said, “These guys are high. Are you kidding me? North of $30 million? There was nothing proprietary about that product. Don’t ever call me about this company again.”

This investor is proven and accomplished in the natural foods industry. Although it stung, he was right. If I had known they would use that figure in advance, that call would not have happened. I reported the grim news to my team, omitting the colorful “high” comment. They didn’t understand why they were turned down. This is a problem.

After this epic failure at raising capital, I “thought” my team would come around with a more reasonable evaluation. So I brought to the table a venture capital group to help raise capital and evaluate the company properly. I set up a phone meeting with this venture capital group, and the conversation, again, went sour. Again a valuation north of $30 million. I could not believe this was happening again. Ignoring the first investor completely, they attempted the same stunt.

I’ll never forget the words the venture capital group said to this ego-driven company: “Your company is too small.” Do you know what deflating egos sound like? I didn’t either until that call.

What Investors Want to See

Consider looking for a private investor if you want to expand even further. I know that means sharing control of your baby. But if you want to expand, that can be part of the territory into which you are moving. Most investors in this natural industry want to invest in brands that they can build and sell within three to five years. Investors want a good return on investment and will want answers to their questions. When will they get their money back with profit? How will the investor’s exit strategy be structured? In other words, you have to look at their investment using their eyes.

David Bonrouhi and Leslie Lum at Calabasas Capital were kind enough to answer some questions so you can understand the investment from the investor’s perspective:

Q: Where do you suggest that start-up, prerevenue-generating companies seek initial seed capital—are there companies you work with and can refer them to?

A: Angel groups (Tech Coast Angels, Pasadena Angels, Maverick Angels), friends, and family.

Q: Who would typically be the best sources of information for these early-stage companies that are well suited to advise on business/corporate operational strategy, accounting, management, capital-raising issues, etc.?

A: Angel groups, attorneys, accountants, and business consultants.

Q: Please explain the various types of capital that you raise for companies, when this capital is needed (e.g., typically when companies make $1 million in EBIDTA), and what are the common structure and fees that investment bankers charge for each?

A: Private equity and subordinated mezzanine debt. Success fee: (1) cash (7 percent of first $5 million, plus 5 percent over $5 million); (2) warrants to acquire up to 2 percent of company at offering price; (3) retainer to offset against the success fee: $35,000.

Q: Please describe when it is appropriate for a company to hire an investment banker to raise capital, or buy or sell a company.

A: If the company has at least $10 million in revenues, they should hire an investment banker if they want to either buy or sell a company or if they want to raise either capital or senior or subordinated debt capital other than just traditional bank debt. If they only want or need plain vanilla bank debt, they do not have a need for an investment banker. Ask CPA for referrals.

Q: In the case of an unfunded sponsor wanting to acquire multiple companies, when is it prudent for them to set up a fund (e.g., a search fund, versus raising money with a PPM [parts per million] to start a fund that is set up for acquiring certain industry-focused companies)?

A: After three successful exits.

Q: When are business consultants/coaches best utilized in the growth process of an early-stage firm?

A: Before the company is ready to raise institutional capital.

Q: What are the most attractive types of companies/industries to raise capital for?

A: High growth, high margins, recurring revenues supported by long-term contracts. Already with at least $10 million in revenues and profitable.

Q: What is the current state of the market as it pertains to capital raising and buy-and-sell-side M&A (mergers and acquisitions)? Any noticeable trends in the market (e.g., private equity firms selling their underperforming companies, high valuations, limited capital for certain industries, capital requirements changing)?

A: Overall activity was down in 2013 by about 20 percent versus 2012. M&A activity at the end of 2012 saw a spike because of expiring low tax rates. Valuations are at all-time highs now because supply of good deals is well below the demand. Overall activity is still down, however, because there are not enough strong companies coming to market. It is also a haves and have-nots world. Many mediocre deals cannot get done. Only the highest-quality deals are going through. Valuations are also high because debt is very cheap (low rates) and easy to access.

Q: What characteristics tend to separate successful companies from those that cannot attain success (e.g., inexperienced management, technical/engineer types at the helm of management with no strategic/operational experience, lack of capitalization, high overhead, business model not competitive in the current market, no clear business plan or competitive advantage)?

A: Strong management team.

How Much Is Your Business Worth? Valuation in a Nutshell

Whether you want to sell out or you want to obtain capital for expansion, you will need a clear idea of how valuable your business has become. There are a variety of approaches to valuation. The real truth is that the price of your business is ultimately what someone will pay for it—it is market driven. However, you do need some figure in your head when you begin to negotiate. Getting that figure can be a bit tricky, so my first advice is to get some—advice, that is. Spending some of the offered purchase price to ensure you don’t leave money on the table is not a bad idea at all. But for the moment, let’s look at a couple of approaches.

Seller’s Discretionary Income

In her New York Times article, “Determining Your Company’s Value: Multiples and Rules of Thumb,” Barbara Taylor looks at valuation from the seller’s point of view—which would be your point of view. She suggests using some rules of thumb. For example, if you are in manufacturing and have annual sales in the $1 million to $5 million range, then your business is worth three to four times its SDE (seller’s discretionary earnings) plus inventory.

Now that requires a bit of explanation. Taylor examines any expense that is considered discretionary (a conference expense, or even owner salary), extraordinary, nonrecurring (repairing damage from a storm), or noncash (depreciation); adds in the current value of inventory; and multiplies the total by a rule of thumb: a small manufacturing SDE should be multiplied by three or four.

Middle-sized businesses and public companies are typically valued as a multiple of EBITDA (earnings before interest, taxes, depreciation, and amortization). Small businesses, on the other hand, are analyzed and valued as a multiple of seller’s SDE, which can be defined as EBITDA plus owner’s compensation. For general purposes, SDE is the net income (or net loss) on a given company’s tax return plus interest expense, depreciation expense, amortization expense, the current owner’s salary, and owner perks. This can be viewed as the foundation of small-business valuation.

Present Value of Future Income

Present value of future income, or PVR as it is called for short, looks at valuation from the buyer’s point of view. To do that you keep in mind the value of money in a buyer’s hand. Money in that hand has interest and investment potential. Let’s say you have $2,000 and you invest it for 10 percent interest. So now you can earn $200 in one year. Your $2,000 now is worth $2,200 next year. But $2,200 next year is the same as $2,000 now. One can see why that old saying sticks: “Money in hand is better than money down the road.”

But money that arrives in the future has less value. So a buyer will give you less for a second year’s earnings from your company that the buyer has purchased. And the buyer will give you even less for the third year’s stream of income. So how could a potential buyer articulate their expectations so as to have a basis for comparing your future income to those expectations? This is where net present value comes into play. There is a mathematical formula that you can use to calculate the value of a dollar in the future. Fortunately, for those of us who are challenged by arithmetic, you can go on the Internet and find websites that do the calculation for you. So if you present a forecast to a potential buyer that your net income next year will be $300,000, followed by $400,000 in the following year, the buyer can calculate what that would be worth in current dollars. You will notice that the websites will ask for an interest rate such as 5 percent or 8 percent. That’s a measure of risk. If your buyer wants a low-risk investment like a government bond, they would accept a relatively low rate of interest, such as 3 percent. But your buyer probably will look at your company and see that buying it represents a higher risk, so they will want a higher rate of return. Perhaps that might be 12 percent or 18 percent. So their offer might be to buy X years of income with an expectation that they will earn Y%.

You might argue that your company is worth the present value of five years of income. Perhaps a potential buyer may respond with an offer that shows they are only willing to buy the next three years of income. As I’ve said, your company is worth what a buyer is willing to pay. And again, to emphasize the risk of overstating your case, if you present a $34 million valuation with $5 million in sales, $500,000 in inventory and payroll, and operation expenses of $1 million per year to potential investors, you might get laughed out of the room.

Now perhaps you want to stay on and build your company worth up to $20 million. This will mean you need to take your product to the next level. It’s time to hit the summit. Kroger is calling!