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The Entrepreneur's Investment Cheat Sheet

The Entrepreneur's Investment Cheat Sheet

It’s tough to build a business that can grow and take on investment.
It gets even harder when people start throwing around technical jargon that confuses the conversation.

This terminology is shorthand – a quick way of communicating a complex idea.
Unfortunately, it often feels like an inside joke, one that you’re not part of.
This article is designed to demystify those complex ideas, so that in the heat of the moment your options are clear.

Investment property

Investment
A place you put your money where it will work hard for you.
That is, somewhere it will grow over time, usually over a few years.
It is something you own, rather than a bet.
It is money you intend to see again, unlike a present or a grant.

You might invest in a property, like a house or apartment, or you might invest in a company.
In each scenario, you’re buying an asset - and as the owner of that asset, you receive the income that your asset generates.
If you owned an investment property, you’d receive the rent from your tenants, and you’d benefit from the house price going up when you sell.
If you own part of a company, you’d receive the profits the company makes, and you’d benefit from the company value going up when you sell.

While there’s a chance that it could fail, all investments are made with the hopes that they’ll succeed and make everyone money.
Therefore, investors are keen to ensure that their company makes money – and that the entrepreneur doesn’t do anything stupid.

Grant
A deal where a generous person or institution gives you money to achieve a noble task.
It might be to build something, teach something, run an event or design a new program.
There’s no expectation that the money will be returned, but there’s definitely an obligation to prove that you’ve done what you promised – a process known as an acquittal.

Grants can kickstart your business, but they’re not free money.
In delivering on your promises, you’ll spend a lot of the money hiring staff or buying ingredients. If this aligns with your mission, great.
If not, grants can become a bit of a distraction.
They’re also hard to get – you’re competing with lots of other organisations, and need to spend a lot of time on the applications with no guarantee of a result.

Capital
The assets that a business uses to create money.
This might be machinery or equipment that gets used to create a product or deliver a service, a brand name, software or a patent.

These are the things you need to buy/own in order to generate revenue, and some industries are more “capital intensive” than others.
For example, opening a café is much easier than starting an airline, because you only need to acquire a coffee machine and kitchen equipment, rather than a fleet of planes.

Working Capital
An amount of cash used to cover any shortfalls while running your business.
Most businesses buy raw materials or hire staff before they receive payments for their goods and services, so they need some extra cash in the business to tide them over – hence the need for working capital.
The longer the gap between spending money and receiving revenue, the higher the amount of working capital required.

Patient Capital
Money that can be used to establish a new business, then is gradually repaid over time without any interest charge.

This gives an impact investor the ability to have their money be useful, get it back, and redeploy it to another cause, whilst not charging the entrepreneur any interest.

If this goes well, the investor will not have lost any cash, just the opportunity cost of receiving interest from another investment.

Debt
The lending of money for an agreed period of time, in exchange for an agreed interest payment.
An investor lends out their money to an entrepreneur, who then uses it to grow a profitable business.
The entrepreneur then gradually repays the loan, along with an interest payment to reward the investor for their faith.

When used correctly, debt is a win-win for both parties.
It allows the borrower to buy something they otherwise couldn’t afford (e.g. a house or a business) and pays the lender more of a return than they would receive from a term deposit.
However, if the business fails or the borrower runs out of money, the lender will have to re-possess the assets (e.g. selling the house or the business’s equipment to repay the loan).

trading stocks market board

Selling Equity
Equity refers to the value and ownership of a company.
Owners are entitled to the profits that a business creates, which gets divided up like a pie.
If you have two founders, they might have 50% equity each, so they get 50% of all profits made by the business.
If it’s a successful company, then that equity is worth a lot of money.
If it’s a failing company, then that equity is worth almost nothing.

Some companies will choose to sell some equity to an outside investor, and use the investor’s money to grow the business.
Let’s say they sell 15% of the company:
When the business makes $100,000 in profit, $15,000 goes to the investor.
When the business breaks even, the investor gets nothing.

This ownership is permanent.
Whereas a debt goes away once it’s repaid, the person who owns the equity receives part of the company’s profits forever.
That’s why you hear stories of early investors whose shares in startups are worth billions of dollars, while those who owned shares in failed companies earned nothing.

Interest
The payment made by a borrower to a lender, as compensation for the use of their money.
This is used to make a deal fair for the lender – they are losing access to their money, and so need to be suitably rewarded based on how much risk they are taking.

For example, investing in a term deposit is incredibly safe, so pays 2-3% interest each year.
Investing in a large company has a bit of risk, so you might expect a 6-8% interest rate.
Investing in a startup carries a lot of risk, so a lender might charge closer to 20% interest.

These payments are made at agreed times, and usually are agreed amounts.
e.g. an investor lends $20,000 at 10% interest, paid back in one year.
Therefore, the borrower will repay the $20,000, plus $2,000 in interest.

Dividend
The splitting of profits amongst shareholders, and is the way an equity investor earns some income.
If a company earns $1,000 profit, and has 100 shares, each share receives a $10 payment.
If you owned 15 shares, you’d receive $150 of dividends that year.

Whereas interest payments are predictable, dividends are variable.
Dividends go up and down over time, depending on how much profit is made and what the company chooses to do with it.
For example, there might not be any profits to split, or the company might choose to re-invest profits into an expansion.

cookies on a baking tray

Debt vs Equity
This is important to think through.
Let’s say you’re starting your own gluten-free cookie factory.
You need $100,000 to buy all the machinery, set up the factory and arrange delivery to your distributors.

You can:
a) Borrow the money at 10% interest
b) Sell 50% ownership of your company
c) Do a bit of both

If you borrow the money, you’ll be repaying the $100k plus up to $10k in interest each year, no matter how well the business goes.
Let’s say that equals $25k per year, which can feel either cheap or expensive depending on your success.
If you sell partial ownership, the investor gets 50% of whatever profits you make, and has the ability to vote on important decisions.
When times are tough, you pay them nothing, and when times are good, they make a lot of money – but so do you.

This is a complex decision – the loan might end up costing you $150k all up then it disappears, but you must pay it back.
Selling equity could cost you nothing, or it could make your investor a millionaire. You also have a permanent partner, which is good or bad depending on your relationship with that person.

That’s why some entrepreneurs go for a bit of both, because the debt feels cheap if the business is successful, and they get the benefits of having an investor without giving up half of the company.

Valuation
How much is your company worth?
How much is 1% of your company worth?
This is a very tough question to answer, and causes a lot of headaches in any investment deal.

All parties need to agree on how they will calculate the value of a business, so that they can work out how much each share should cost.
A common approach is to base the value on the profits a business makes in a year, times an agreed multiple.
e.g. a safe business might use a multiple of 4, whereas something riskier might use a multiple of 2.

Valuation is tricky, because of each party’s natural perspective.
The entrepreneur sees the grand future, and wants to factor that in to the price.
The investor isn’t so confident, and doesn’t want to overpay based on the entrepreneur’s wild fantasies.
Emotion can often get in the way of reason, because it can feel like the entrepreneur is agreeing on a price for selling one of their children.
For this reason, it’s often wise to use an impartial third party to help with these negotiations.

climbing ropes looking up

Risk & Return
The likelihood that a business will succeed or fail.
For example, some investments are seen to have low risk, like buying a property.
Sure it could burn down, but that’s unlikely.
By contrast, investing in an oil exploration company is less likely to succeed.

The Rate of Return refers to the benefits an investor receives from their investment.
For example, an investment in a property might return 6% each year (e.g. $10,000 invested earns $600)
An investment in oil exploration might earn a 40% return (e.g. $10,000 invested earns $4,000)

However, the investor has to make an assessment – do I want a safer, smaller return, or a larger but less likely return?
Just because one investment earns more than another doesn’t make it “better” – if it takes a lot more risk, then it might not be a good investment over the long term.

Generally, Risk and Return are connected – the more risk you’re willing to take, the more you stand to gain.

Internal Rate Of Return
Unfortunately, your business doesn’t have a neat Rate Of Return sticker on the front of it.
The returns are going to fluctuate, and they’ll be very low at first.

To counteract this, an investor wants to see the Internal Rate of Return (IRR), which averages out what they expect the business to deliver on average per year.
This is a nice comparison tool – allowing you to gauge the overall attractiveness of a project with volatile returns.

This is usually calculated in excel, based on the cash position of the business at the end of each year.
The investor will want to see that the IRR is higher than what they could ordinarily get from their usual investments, otherwise they’ll stick with what they’re already doing.

Net Present Value
$1 today is worth more than $1 in a year’s time.
This is due to inflation (e.g. my dollar buys less in the future) and opportunity cost (e.g. I could have put that dollar in the bank and earned interest)
For this reason, we need a way of describing how much “future money” is worth today.

This is calculated through Net Present Value, which answers questions like “How much is $1m in 2023 worth in today’s money?
Depending on your circumstances, it might be worth $700k-800k, because you could put that $800k in the bank and it would grow to $1m in that time.

Investors use this to work out if an deal is worthwhile.
Let’s say they’re looking at buying a business they think will be worth $1m in 2023, they will calculate the Net Present Value, which might be $750k today.
Therefore, they’ll be happy to buy the business today for $600k or $700k, but not $900k.

Seeds growing in a tray

Seed Funding
A small initial sum of money used to start a business – like planting seeds that will eventually grow into crops.
This funding is used to recruit the necessary team members, buy equipment and begin the sales process.

Seed funding can comes from a grant, the team members, or the Three F’s – Friends, Fools and Family.
These are each people who are not cold-hearted investors, and who are loving/silly enough to give you money before you’ve actually made any sales.

Angel Investor
An Angel Investor is someone who helps young businesses grow through an early stage investment, like seed funding.
They are usually quite experienced businesspeople themselves, and often have a close relationship with the founder/founding team.
This is an investor who sees great potential in the company and its founders, and is willing to take a lot of risk in exchange for a potentially high reward.

Board
A board is a team of experienced individuals who ensure that a company is operating in a safe and wise manner.
Whilst the CEO is there to manage the business and its day-to-day activities, a board is responsible for setting the strategy and ensuring that the business is well positioned to survive the next decade.

Boards comprise a range of skilled members, such as lawyers, accountants, and those with experience in the industry.
This ensures that the company is making good choices, and that investors’ money is being used effectively.

Champagne glasses celebration

Exit Strategy
Not many investors or entrepreneurs want to stick around forever.
They have plans to sell their portion of the company to someone else, be it other employees, a rival company, or to sell shares on the open market.
Either way, the founders should be able to articulate their plan for getting out, be it in 2, 5 or 10 years.
This allows other investors to understand where the company is headed, and they can forecast when they’ll be able to sell their shares as well.

 

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