Invent It, Sell It, Bank It!: Make Your Million-Dollar Idea Into a Reality (16 page)

Let’s say you’ve redesigned your packaging, or you’ve had to fix a design flaw on a product that you’ve already manufactured and it is sitting in a storage facility. It can cost tens of thousands of dollars to pay someone to empty each package, fix the product if necessary, put it in a new package, then put it into the master cartons (giant boxes that hold multiple units for shipping). It’s called
reworking
, and it’s a service often offered by the fulfillment centers many young businesses work with to store and ship orders.

For this reason, once you have established your budget with all contingencies, add another 5 to 10 percent to it and call it the “Stuff Happens” account. Murphy’s law states that anything that can go wrong will go wrong. I like to add the following caveat: anything that can go wrong, will go wrong, unless you stay on top
of every aspect of your business and are prepared to jump in to solve problems immediately.

The more investors can see that you’ve looked at your business from every angle, and have a strategic and financial plan in place to deal with shifts in the market, glitches, changes in regulations, and any other potential pitfalls, the more they will feel confident that their money will be well spent and that they will be supporting a successful venture. But of course, there will always be instances where something inopportune occurs that you simply could not foresee.

Overspending on Image

You need to be responsible and frugal, and wise. When starting out, you don’t need a fancy office, or staff, or anything other than the bare bones of what you need to get the job done. Companies offer perks to their employees because they have to make them happy, productive, and loyal. Your perk is that you don’t work for anyone but yourself anymore, and if you haven’t already quit your day job, this invention will (you hope) allow you to do so. You don’t get a comfortable office, summer Fridays, or gourmet snacks. You can have those wonderful things later. Better yet, you can have that for yourself and your employees later, when you’ve grown your business and are reaping the profits. But right now, do without as much as possible.

Unfortunately, if there is one piece of conventional wisdom that is true, it’s this: you’ve got to spend money to make money. However, you should, at all costs, avoid using up your nest egg or that of your parents, or of leveraging your home. It’s worth it to take on partners with greater financial resources or clout, if necessary. Even if they don’t come through with all the money you need, their credit worthiness or status in the business community can help immensely as you round up funds.

VALUING YOUR BUSINESS

One of the first things you hear on every
Shark Tank
episode is how much money the entrepreneur wants and how much equity he or she is willing to give up for it. For instance, the entrepreneur might ask for $50,000 for 10 percent of the company. All the sharks quickly jot down these numbers and do a calculation. We take the money asked for and divide it by the percent of the business offered.

$50,000 / .10 = $500,000.

The entrepreneur is telling us that he or she believes the company is worth $500,000.

Now it’s up to us to decide if it really is. Confession: I hate math. I can make calculations in my head, but not always as fast as I need to on the show. The producers don’t let us take our phones or even a calculator on the set with us, so I use a little Excel cheat sheet. It’s a big chart that lists possible “Asks” down the first column and all the different percentages across the top row. It comes in very handy when I need to calculate quickly.

What’s a Business Worth?

You’ll hear my fellow shark Kevin O’Leary often mention that the “multiple” on some type of business is “five times free cash flow” or “one times sales.” In simple terms, a venture capital (VC) multiple calculates how much a business is worth based on a number of years of the business’s future projected income. When he says “five times free cash flow,” he means he wants to see an earnings line that produces enough excess cash that his initial investment is paid back in five years. What he’s really asking is, “When do I get my money back?” (That’s another frequent Kevin line.)

You’ll hear Mark Cuban make fun of Kevin for applying a VC multiple to the
Shark Tank
businesses. I agree. You can’t use a multiple on a brand-new business or start-up. You need to have a few years of history before you can really start applying broad ratios. But the concept is good to understand, because most of the people you ask for money are going to be coming from this type of background. I basically want to see my money come back in one to three years.

What do I look at when valuing a business? First, I look at the product or idea, and I gauge whether it’s unique and interesting. Do I feel this is something that will sell well? Can I help make it sell well? If yes, I look at the entrepreneur’s manufacturing costs to determine whether the item can sell for a good price that will motivate people to buy. If the answer to that is yes as well, then I think about all my distribution channels (for example, QVC, department stores, Bed Bath & Beyond, Walmart, Costco, drugstores, grocery stores, and so on) and how many would sell to each. If it looks like in one year it can produce more profits than my investment, I’m basically in.

As I said, I don’t even
think
about valuing the business until after we get some proven sales history and momentum going. To be fair to Kevin, though, all the sharks are thinking, “When do I get my money back?”

RAISING CAPITAL

There are many ways to get money for your product, but the safest way is to use your own money as wisely as possible. Often, however, even inventors who operate with the frugality of Scrooge just can’t carry their invention all the way to production. So with or without partners, where do inventors turn to raise the capital to fund their dreams?

Family and Friends

Family is probably the easiest source of money for new entrepreneurs. It is wonderful if you have family members who can offer not only emotional support as you embark on your new endeavors but financial support as well. However, though family is often the first place people turn for a loan, it’s also one of the riskiest. Be extremely careful in how you set up your arrangement. It may be best not to formalize the loan details to anything more than an agreed-upon financial amount and interest rate, which is required by the IRS for any loan over $10,000. Without that stated interest rate, the loan will be considered a gift, sticking your family member with a gift tax at the end of the year. Regardless, any family member who loans money to another family member should, for all intents and purposes, treat the loan as a gift.

So, take the expectation and pressure of a specific repayment date out of the equation by drafting a contract that states, “Repayment will occur when the business starts producing net income and the company has greater than three months’ cash to keep its inventory and liabilities paid.” Yes, it’s possible that the business will never earn that much money. Yes, this is still the best kind of financial agreement between family members.

Many experts will disagree strongly with this advice, however. They will say that every detail of the loan and repayment schedule should be established ahead of time, and that lenders should have a reasonable expectation of getting their money back by a certain date, even if you’re not earning a profit. But I don’t believe any family member should loan any money with the expectation of getting it back. The family member can
hope
to get it back, but should give it with the understanding that it’s entirely possible that won’t happen. And I’m not the only one who feels this way.
When he was interviewed for
Time
magazine
after being nominated 1999 Person of the Year, Jeff Bezos admitted that he said as much when he solicited investments from his friends and family to fund his crazy idea for a new thing called Amazon: “I think there’s a 70 percent chance you’re going to lose all your money, so don’t invest unless you can afford to lose it.”

You should insist that if family members cannot loan their money with that attitude, they shouldn’t lend it at all. It’s the only way to guarantee that your relationships will not suffer if, for any reason your business doesn’t succeed the way you think it will, or at least as fast as you think it will. If you draft an airtight legal lending document, and the borrower fails to honor the agreement and repay at the promised time, the only recourse a lender has to make sure he gets his money back is to sue. Is that really something either of you is prepared to face? It is a tragedy when a family tears itself apart over money, yet it happens all the time. If you think there is any possibility that your relationship with a family member could be damaged should your business not succeed, or you find yourself unable to repay the loan in a timely manner, do not take the money. But if you do, make sure your agreement establishes in writing what will happen if you succeed and what will happen if you don’t succeed. Ensure that no one can say he or she wasn’t warned.

In the event you feel you simply must draft a more formal loan agreement, you might consider going to a bank, applying for a loan, and having a family member put up a CD (Certificate of Deposit) as collateral. Let the bank give you the money directly rather than to your family member. If you default, and the bank cannot satisfy the outstanding balance from your business, only then will the bank go to the CD for the balance. In the meantime, the person’s money is gaining interest and any funds taken to satisfy your loan can be treated as a business loss for
tax purposes. This will reduce the family member’s personal loss by offsetting future income taxes.

Make sure everyone’s expectations are the same, and are documented to avoid problems later. Worse than your business failing is losing a friend or family member along with it.

This advice goes for borrowing money from friends, as well. Often, you can get a group of your friends excited about getting in on your big idea, and you can raise some capital by consolidating small amounts of money from each of them. But if you take money from friends, try to set your agreement up without specifying a repayment due date, the same as you would with a family loan. Tell your friends up front that you are asking them to take a risk, and that you’ll do everything you can to pay them back, but in the event you cannot repay, they have to be able to absorb the loss and still maintain their friendship with you. Then document your agreement so that everyone has something to refer to in the future.

If you just cannot raise the funds from your friends in this manner, you may be forced to offer some equity in the form of a convertible note. This means that if you do not repay the loan within a certain amount of time, the lender has the option to convert it into equity shares in your company. You’ll need to get advice on how to draft this kind of loan, but your goal should always be to give away as little equity as possible. Give away too much now, and you could face big problems later when you try to get more money. Don’t be the person who allocated 50 percent of his business to a group of friends in exchange for a $500 loan. In addition, the share conversion value should be tied to
the business value at the time of conversion, not the date of the loan, so that you don’t end up giving half of your business away for a very small amount of money that you might have needed when you were desperate.

Try to avoid allocating any equity in this early stage of raising money. It can significantly impact you later on if the business is a success and you need to raise large amounts of money.

Banks

If you’ve got good credit and your business looks good on paper, you may be able to get a small business loan from a bank. Typically, though, a bank loan will require collateral. Be careful when negotiating a bank loan, and make sure you aren’t taking such a high risk that you could wind up losing something you can’t live without, like your house.