Think Like an Investor

Entrepreneurs sometimes think that they are the ones “doing the work,” and that investors are but a necessary evil: parasites looking for a free ride on the back of the hardworking startup.

This false dichotomy blinds entrepreneurs to the reality that they, too, are investors and must always think like one. It deeply affects your decision-making process.

The Business Case

Why is your entrepreneurial endeavor a good idea? In a capitalist system, all entrepreneurial activity has just one purpose: to make money. Presumably, your business idea will require the investment of some of both your time and your money. Your time has opportunity cost associated with it (what you could be earning doing something else); and your money could be in the markets earning 5-7%. Over time, your business idea should return a value greater than 7-10% compounded in order to make it worth doing at all. Many businesses can yield several hundred percent returns, either in the form of free cash flow or an exit (selling that cash flow) later on.

You might argue 1) there are other reasons besides making money to start a business, 2) capitalism has flaws, 3) we don’t actually live in a capitalist system. These are fascinating, valid arguments, but let’s put them aside for now.

If you accept the idea that making money is the only reason to start a business, then why would you spend your time and invest your money in a business concept that you would not ask someone else to invest in as well?

Bad answer: Because you don’t think an investor will “get it” and you don’t want to waste your time figuring out how to convince people you don’t know that your idea and team are worthy of their cash.

Good answer: Because you don’t need additional cash and don’t want to give up equity right now. You might consider taking investment after your prototype is complete to make a couple of key hires.

This “bad answer” is a kind of exceptionalism: you think that you are special, that you have all the answers you need, that this time it will be different, and that you won’t ever need investors. But like most exceptionalist attitudes, this mindset is a self-deception.

Always Be Transactable

In economics, transactability is the degree to which something can be traded, usually for money. If you don’t think like an investor yourself, you are adopting a mindset of non-transactability early on. You’re essentially saying, “I don’t even want to think about trading equity for money because I am exceptional and I don’t care about what anyone else thinks of my business.”

The problem with adopting a non-transactable mindset is that it tends to persist and self perpetuate. When do you go from being non-transactable to transactable? When do you decide it’s okay to give up equity to key hires or partners? When do you decide it’s okay to accept a small amount of investment? What will I do when it’s time to sell the business?

Many early-stage entrepreneurs dismiss these questions, assuming that they will “figure them out when they get to them,” or they say that they’ll “never sell their business.” These are both flawed arguments: if you don’t think about how you would trade equity for cash (and vice-versa) from the start, you are likely to handle any situation that requires it poorly.

Your Business Has a Valuation From Day One

This morning, Apple has a market cap valuation of $184.64 Billion (more than Google, less than Walmart). Your business is probably worth less, but it still has a value!

The “valuation” of your business is, quite simply, what someone else would be willing to pay to own it. That is usually a combination of the depreciated value of your assets, less your liabilities, plus a multiple of whatever free cash the business might be available after operating expenses. Some businesses get really high exit multiples (product companies, 8-10X net) and others get lower exit multiples (service companies, 3-4X net). There are no “rules” for business valuation; it’s a lot like home prices. You can look at comparables and take some guesses, but it boils down to what a buyer is willing to pay. It’s nice to have a lot of buyers, too.

You should always be thinking about maximizing the value of your business. What would somebody else pay to be in your shoes? In the early stages, the answer is almost “not much” or even negative. That’s to be expected, but over time, if you succeed the answer will start to be $100K, or $1M, or $10M. You need to be thinking about that trade all the time, and at least have some sense of what your business valuation is and how you might maximize it.

Everybody Is an Investor

You may not think so at first, but you are always asking for investment. If you are hiring someone, they are evaluating your business plan, your chances of success and whether your company represents something they want to invest their time in.

Your trading partners are also evaluating you and determining if they want to enter a relationship with you. Your customers also evaluate whether they should bet on doing business with you.

By keeping transactability always in mind and caring what others think of your business, you will be more likely to appear viable to these constituencies. And being transactable helps you make better deals with partners and customers: you learn what can be traded and what can’t.

I’ll Never Sell!

Some people have no intention of ever selling their business, and instead just want to be their own boss and make some money. This is fine, and most people call this approach running a “lifestyle business.” It’s well suited for sole-proprietors and can offer great personal freedom.

But this can be a treadmill: most often, you’re trading money for your time. Even at a high hourly rate, your income is tied to how many hours you can bill. Take a month off and you lose a month’s pay.

Or, you may have built up a clientele that pays recurring subscription fees or other residual income. While this can free up your time somewhat, if those recurring revenues are not high enough to sell to an acquirer, you can still be stuck.

At some point, you will want to get off this treadmill. What then? Do you just shut down the business and throw it away? That’s a very bad idea. Ask again, what would someone else pay to be in your shoes? The answer might be $50K, or $200K, or $1M depending on your business. You can and should capture this and shop it around in the market.

Or, you might have a service company that you want to pass on to your family. What then? What’s that worth? How do you manage your estate planning effectively?

Any business where “you” are the face of the business can be tough to sell in the market. But even these kinds of businesses can be sold. I’ve seen this happen, and it’s usually for meagre amounts of money. (Think computer sales + repair, HR services, accounting.)

Precisely because of their low market valuations, I’m not big on lifestyle companies. But my point is that they too have valuations that someday need to be reckoned, and to start any company – even a lifestyle company – without thinking about business valuation, investors, and transactability is foolish.

Always Have a Pitch

The simple way to keep your head on straight is to always have a pitch. You should always think about how you would explain your business to an investor. It may well be that the only investor you are concerned about pitching early on is yourself, your partner, your friends and family, or even your spouse. But you should also be thinking about what other kinds of investors (angels and yes, even VCs, where and if applicable) might think too. Because you just might need them later.

You are your own lead investor. If you cannot articulate why you’re doing what you’re doing and why it might generate good returns in the long run, then why do it?


#1 davetroy (Dave Troy) on 10.23.09 at 10:59 am

Why entrepreneurs should always think like investors – – new on my blog!

#2 ecocollaborator (Gordon Steen) on 10.23.09 at 11:31 am

RT @davetroy: Why entrepreneurs should always think like investors – – new on my blog!

#3 davetroy (Dave Troy) on 10.23.09 at 1:39 pm

Why entrepreneurs should always think like investors – – new on my blog!

#4 davetroy (Dave Troy) on 10.23.09 at 1:45 pm

Why Entrepreneurs Need to Think Like Investors, – from my blog! (for you, @adrianbye)

#5 NowIsTimeForYou (jay singer) on 10.23.09 at 7:01 pm

Think Like an Investor — Dave Troy: Fueled By Randomness

#6 savvymarketer99 (Savvy Marketer) on 10.24.09 at 4:05 am

Think Like an Investor — Dave Troy: Fueled By Randomness

#7 Adrian Bye on 10.24.09 at 3:15 pm

much better with disqus!

#8 Adrian Bye on 10.24.09 at 7:15 pm

much better with disqus!