The Core Responsibility of a Founder

As a founder, your most important concern should be the obstacles you are overcoming and the customers you are serving. I try to focus as much time as possible on these two things.

Funding Your Startup: Profit vs. Equity

To solve interesting and complex problems, you need to hire a team and potentially buy equipment. For startups, there are basically two main ways to get resources: turn a profit or sell equity. You either sell goods and services for more than they cost, or you sell shares. No self-respecting bank would lend money to an untested startup. And you probably shouldn’t risk your own savings either.

Turning a profit as a product company is hard. It means you have to create a product that is valuable to someone else. That usually requires an upfront investment in both product development and distribution. Services is easier to get started with, but less profitable in the long-run.

Understanding Startup Valuations and Funding Rounds

Startups typically raise money by selling shares. A so-called “funding round”. Startup people can’t stop talking about funding rounds: pre-seed, seed, series A, and so on. If you decide to raise money by selling shares, you will quickly discover that the future value of your company is critical. This is also pretty obvious: the higher a company’s expected future value, the higher its current value. The main job of an investor is to estimate a company’s future value and compare it with the current price of its shares. Given a set of share prices and expected future values, the investor can begin comparing the relative attractiveness of different companies. A rational investor will buy shares in the company with the most attractive returns profile. A returns profile takes into account several different things: how much capital can be invested, how much return can be expected, and how long it will take to get that return. Many books have been written on investing, but the basic idea is simple: the higher your annual return, the better.

Valuing Your Startup at the Earliest Stage

Let’s say we start from zero: you have no product, no customers, no revenue. You create a company and offer shares to angel investors. How do you appraise this company? One way to do it would be to ask: “How much do we think this company could be worth in 10 years if this team is super-successful?”. From what I understand, experienced early-stage investors will almost exclusively look at one thing at this point: the founder. Will this person persevere through the countless challenges that lie ahead? Will they be able to attract the right people along the way? Will they be able to make the right decisions? Pricing at this point is primarily a function of competition. If the founder has ten investors lined up competing to invest, the price will be high. The counter-acting force is that the founder needs to put the company on an attractive equity journey. It’s unlikely in your interest as a founder to maximize valuation in every round. Ideally, you price the company so you can raise enough capital to reach the next milestone, without pricing it so high that you can’t raise capital at a higher valuation next time.

Metrics and Valuation at Later Stages

As companies grow, valuation becomes as much a function of the company’s performance as of your expectations for the future. Emphasis slowly shifts from the founder and the expectations, to metrics like growth, margin and profitability. Of course, leaders at a company, and expectations, are always a part of the equation.

This introduces the next critical concept: Enterprise Value and Shareholder Value. Together with the Cost of Capital, these are the three most important financial concepts a founder needs to understand. Enterprise value is the value of your company. It’s determined by multiplying the price per share by the number of shares. The price per share is determined by supply and demand: how many shares are available to buy, and how much are people willing to pay for them? The company’s expected future value determines willingness to pay. Shareholder Value, on the other hand, is the value shareholders get from holding your shares. Shareholder value primarily comes in two forms: 1) an increase in share price or 2) dividends.

If a company needs capital to grow, it’s essential to understand if the expected increase in enterprise value over time exceeds the cost of capital. If it does, you will create shareholder value. If not, you will destroy shareholder value.

The Ultimate Goal: Creating Shareholder Value

The purpose of a company is to create shareholder value. If your goal is not to create shareholder value, you should find a different way to solve the problem you are focused on. You can start an NGO, or a charity. Or go into academia.

As a founder, you need to take this into account. If you determine that it is in your interest to raise capital, you need to convince investors that your company’s future value will be high. The valuation of your company today determines your cost of capital. The cost of capital, in turn, determines how much and how fast you can invest in product development and distribution. If you get a really high valuation that translates into a low cost of capital. But to create shareholder value, you need to increase your company’s enterprise value significantly. You need to weigh the following things:

  • The cost of capital at which you can raise money
  • The expected future enterprise value of your company
  • The need for capital

When Should You Raise Money?

If you think you can convert capital into enterprise value at a higher rate than the cost of capital, you should raise. If not, you should aim to turn a profit. I think many startup founders get this wrong. They believe the goal is to raise and spend money, when in fact the goal is to create shareholder value.

Let’s say you have a company that is growing at 100% per year. You generate $20M in revenue with a 45% margin. Should you raise money? The answer comes down to: will it generate long-term shareholder value? Is the cost of capital today versus the expected future enterprise value in favor of raising money?

Conclusion

This is a complex question without a simple answer. This post only scratches the surface. But I hope it gives you some food for thought. As a founder, you need to understand the financial concepts that drive your company. That said, the most important thing is still to focus on the problem you are solving and the customers you are serving.