When a startup decides to pursue venture capital (VC), they should build a comprehensive equity story when preparing their pitch. An equity story summarises an enterprise’s strategy, often via a business plan, and is designed to appeal to investors and business partners through financial outlooks and future market/industry development and growth opportunities.
In this article, we explore some of the key equity considerations that startups should factor in, ahead of planning their pitch and equity story for venture capital.
Determining how much to raise
In the previous article in our Private Capital 101 series, Preparing for Venture Capital, we recommend that businesses segment their budgets and forecasts into three categories: The necessary amount, a realistic amount, and an ideal investment amount.
A necessary amount refers to the minimum investment amount that a startup is willing to accept for a dilution in their equity. This amount of funding should cover the company’s immediate needs until they can raise again and is the absolute minimum amount to cover the development of the startup’s operations. The exact amount will be dependent on the stage of business the company is in and what their business goals are – whether they need capital for operational costs or to scale their teams, or for costs as early on as developing the minimal viable product and testing proof of concept.
A realistic amount is an investment that the company reasonably believes it will achieve. It is a balance between necessary and ideal and is based on assumptions made about the investors and what they have historically invested in other startups or would potentially invest in the company being considered. This is the amount that most companies should hope to reach at the end of negotiations.
The ideal investment amount is the best-case scenario, providing the startup with a level of capital that meets all their immediate needs and more. It provides additional runway and a financial buffer for future growth and operational costs. However, a startup should take care to not over-value their company and raise beyond what is necessary, at risk of not meeting investor expectations and having to de-value in future rounds.
Assessing a startup’s valuation
A startup’s valuation is dependent on a variety of different factors: the founder’s own perceived valuation, the investors’ perceived valuation, market conditions, industry growth forecasts, financial forecasts and more.
Founders should have a precise valuation in mind before approaching investors so they can enter negotiations confidently. BDO recommends approaching the startup’s valuation with a range rather than a static number. A startup should assess an upper and lower range for a valuation and understand how much equity they are willing to divest for the desired investment amount.
Investors will also have a perceived valuation of the startup and inversely work to achieve the best deal for their firm or selves. This valuation is usually influenced by valuations of similar companies both in and outside of their existing portfolios and capital market conditions. Depending on the macroeconomic conditions of the market, they may be particularly bullish towards some industries, and reserved towards others.
Whilst the previous few months have seen increased uncertainty in the capital markets both domestically and globally, technology businesses remain a desirable industry for both venture capital and private equity firms.
A founder may choose to let the market, or an investor set the price; ultimately, the valuation is down to what the investors are willing to invest. However, a founder should accept only a valuation that they are comfortable with, with an acceptable level of equity dilution. Some founders only consider what would happen if they were undervalued, but overvaluation is also a concern.
An overvaluation will make it difficult to raise in future funding rounds as the startup may struggle to match their earlier valuation and then will face the challenge of needing to justify their need for additional funding and their forecasted financial performance.
Financial Forecasting
A startup’s financial forecast is not only vital for the pitching process but also helps the business understand the projected income, expenses, and growth of the company in the coming months or years. BDO recommends a financial forecast that covers three years when raising capital, but some investors may ask for up to five years.
Financial forecasting should be completed by someone who is very savvy with accounting and numbers, or a trusted adviser. BDO also provides a series of recommendations for best practices in budgeting and forecasting.
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