Over the next few episodes we’re going to imagine what it might be like to present our creative business on Shark Tank. Of course this will never happen, because creative service businesses are not nearly scalable enough for investors. But addressing the kinds of questions that startup founders get asked can be extremely helpful as we endeavor to build sustainable and profitable businesses for ourselves. This week we’ll begin by considering exactly what an investor buys, when they make a deal with a founder—we’ll consider the value of equity, and ask the question—what’s the equity in my creative business worth today?
When a founder enters the tank to pitch the sharks, right after they introduce themselves, they make their offer. They ask, for example, for $100,000 in exchange for 10% equity in their company. Ask soon as those numbers come out of the founder’s mouth you’ll see the sharks start scribbling in their notebooks, doing some quick math. They’re calculating the valuation of the company—in this example the founder considers their company to be worth $1,000,000 (if 10% equity is worth the $100,000 they’re asking). So many times founders fail to get a deal because they drastically overestimate their valuation—and they either get laughed off the stage, or a shark will demand way more equity for their money, effectively lowering the company’s valuation. In one case I remember a shark asking for all the equity, when the founder has completely deluded himself about the value of his company.
When a founder makes a deal with a shark they get money in exchange for a percentage of equity. But what exactly is equity?
Owning equity in a company entitles you two basic rights. First, you own the right to the corresponding percentage of the profits generated by that company—or that percentage of the sale price, if it’s ever sold. Secondly, equity gives you voting rights in determining the direction and decisions of a company.
Sometimes when a shark makes a counter offer, demanding much more equity than was offered, you’ll see the founder squirm—not simply because they’ll lose more of their future profits—it may be because they’ve already sold so much equity to other investors that if they give up too much it would reduce their total ownership to less than 50%. In which case they’ll have lost control of the company. Should all the other equity holders turn against the founder—they could vote them out of the very company they founded.
When you begin your creative practice you own 100% of its equity. But what is that equity worth? What is its valuation? Well on day one—not very much. Technically, if you opened up a business bank account and deposited $100 as your opening balance—your company at that moment is worth $100. But let’s say you begin working for clients and depositing checks into your account. As you increase your balance you increase your equity. Of course as you withdraw funds, to pay your bills, or to pay yourself, you decrease your equity.
You see, your equity is not the same as your revenues. If you bill out $100,000 this year, that would not make your business worth $100,000. You first have to subtract all your expenses and liabilities. Then you get your equity. That remaining amount of money—your profits, or sometimes called “retained earnings” on a balance sheet—that’s a more objective basis for a valuation of a company—a much better number for determining the value of your equity.
Even if you billed out $1,000,000 you might not have any more equity than if you billed out $100,000—if you incur as many expenses as you gain revenue. You could have high billings for decades without ever building equity, if you don’t produce profits. Since many creative practices operate on a close to breakeven basis, owners are often dismayed at their valuation—or lack thereof—if they ever seriously consider selling their company. It’s quite possible that a creative founder pours blood, sweat, and tears into their business for years—but never builds equity. And when they want to exit, they’d have to walk away offering 100% of their equity for virtually nothing in exchange.
What’s the equity of your creative business worth today? Over the coming weeks we’re going to look at more questions that founders get asked, which all go into evaluating the overall health or risk in owning equity in a business.
Until next week: don’t let the business of creativity overwhelm your creative business.