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Why Invest in Creative Entrepreneurs?

BogotaWhat are creative entrepreneurs, and why should investors spend time and money on them?

Let’s start by explaining what creative entrepreneurs are and how they differ from entrepreneurs in general.  Of course, all entrepreneurs create companies, so they are all creative, but I’m using the term in the sense of Creative Startups:

“Creative entrepreneurs drive global change, create economic value and promote cultural tradition and innovation. They . . . are found across the creative industries: fashion design, music, film, cuisine and local agriculture, architecture, tourism, museums and cultural centers . . . . Wherever culture is thriving, creative entrepreneurs are busy building ventures that generate economic opportunity and a diversity of creative and cultural expression.”

Generally speaking all entrepreneurs do some of the items in the first sentence but not all. Creative entrepreneurs are unique in that they are driven to create economic value with a greater emphasis on creative and cultural expression.

In an earlier blog posting, What Expectations of Time and Money Do Investors Have?, I explored the differences between time investors and financial investors. Let’s now explore why each of these types of investors should care about creative entrepreneurs.

Should Time Investors Invest in Creative Entrepreneurs?

As ecologist E. P. Odum pointed out in 1971, variety and diversity increases on the “edges” caused by changes in population characteristics or community structures. Thus when people with diverse backgrounds work together, the results are far more impressive than the sum of what they could produce individually.

This is just one of the many reasons why teams that include diversity such as creative (in the artistic sense) genius, financial talent, sales talent, and marketing talent (to name just a few) can be so productive.

Running a company is highly interdisciplinary. It requires skills in product leadership, marketing, finance, human leadership, accounting, sales, negotiation, and so on. That is why most successful startup companies are managed by teams, not just one individual.

Wasserman’s Founder’s Dilemmas is a great book about this and other issues relating to startup founders. A mentor can supplement a startup’s team during its formative stages with complementary skills, prior to its ability to fully staff.

I recently had the opportunity to look over the companies in Creative Startup’s 2015 accelerator program (http://www.creativestartups.org/participants), every one left me in awe of its founders. All have a product or service and a creative raison d’etre.

Creative entrepreneurs couldn’t thrive without time investors.  The answer to the question of whether investors should invest time in creative entrepreneurs is unequivocally “Yes”!

Should Financial Investors Invest in Creative Entrepreneurs?

To start to answer this question, it’s valuable to understand how companies in creative industries stack up against other companies in terms of revenue growth rates, M&A activities, and multiples.

Revenue Growth

Revenue growth rates vary tremendously from company to company and have little relationship to industry.  This suggests that revenue growth rates should not be a major factor in influencing financial investors to focus on or steer clear of creative entrepreneurs.

M&A Activity

M&A activity is very much tied to industry. According to Price Waterhouse and Cooper, the four industries with the most active M&A activity in the first half of 2015 were technology, pharmaceuticals, entertainment & media, and oil and gas.

Of the four, entertainment & media clearly includes many companies whose humble beginnings were envisioned by creative entrepreneurs.

In a 2015 survey by KPMG, respondents were asked which industries would be the most active in M&A. Here are the results:

  • 84% – Healthcare/Pharmaceuticals/Life Sciences
  • 62% – Technology/Media/Telecom
  • 36% – Energy/Oil & Gas
  • 34% – Consumer Markets
  • 30% – Financial Services
  • 24% – Industrial Manufacturing

Of these, both media and consumer markets clearly include companies whose beginnings could have been envisioned by creative entrepreneurs. However, creative entrepreneurs and their companies can play a role in all industries; just look at the artistic creativity behind any of Apple’s products as one example. And technology companies are just as likely to acquire a design company to enhance their products as another technology company.

Multiples

According to Hoover’s, the average valuation for all small companies in 242 industries the US in 2014 was:

  • 1.2 times revenues, or
  • 5.1 times EBITDA

I extracted 11 industries from this list that seem dominated by creativity (once again, I need to acknowledge that creativity can exist in any industry). The industries I selected were catering, apparel manufacturing, bakeries, candy manufacturing, cookie manufacturing, jewelry manufacturing, art dealers & galleries, jewelry retail, music stores, architecture services, and graphic design services. Using just these 11 industries, the average valuations for small companies in 2014 was:

  • 1.08 times revenues, or
  • 8.75 times EBITDA

This leads one to believe that valuations should not be a major factor in influencing financial investors to focus on or steer clear of creative entrepreneurs. .

The Team

The final, but incredibly important, factor that influences investors to become involved with a company is its team. Investors like teams with experience and or knowledge. There are four ways to gain credibility as an investible entrepreneur (this list excerpted/edited from “’A-Team and B-Product’ Better Than ‘B-Team and A-Product’”):

  • Team with others who have “been there before.” Perhaps the most difficult thing for a first time entrepreneur to understand is that you are much better off with 10% of a $100M company than 100% of a $100K company.
  • Compete for a spot in an accelerator. Competition for entry is fierce, but you will learn a lot and some investors will consider your experience to be as good as having “been there.” Creative Startups in Albuquerque and Santa Fe is one of the few that welcomes creative entrepreneurs. Three others are briefly described in Where is All the Love for Creatives?
  • Plan to grow slowly with little or no investment money. Learn the tricks of Ries’ The Lean Startup, especially the creation of a series of minimally viable products.
  • Put your idea on hold and join an experienced team pursuing their dream.

The answer to the question of whether investors should invest money in creative entrepreneurs is another resounding “Yes”!  Financial investors should be attracted to creative entrepreneurs as much as to any other entrepreneurs.

Summary

Ultimately investors have goals that they need to meet and all entrepreneurs, creative ones included, must demonstrate that they are the best horse to back.  Those that can clearly articulate why investors should invest their time and their money are demonstrating that they understand every element of their startup and their environment and have the knowledge needed to succeed.

About the Author

Dr. Al Davis is a mentor for Creative Startups in Albuquerque and Santa Fe, NM and was formerly a mentor for startups in the Colorado Springs Technology Incubator. He has published 100+ articles in journals, conferences and trade press. He is a passionate world traveler and has visited 8o countries.

He is the author of 8 books, including, Will Your New Start Up Make Money? He was a founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003. He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting and optimizing their business strategies. Click on the following to see a short video on Offtoa:

 

How Investors Value Your Startup

Let’s start by discarding two myths:ダイヤモンド査定

  • Investors do not want control of your company! That is the last thing they want. What they do want are (a) handsome returns, and (b) for you to responsibly manage your own company so they don’t have headaches.
  • Investors do not care what past valuations were. On previous rounds, you may have received poor advice and valued your company at, say, $5M, and you found some unfortunate investors to purchase stock at that ridiculous valuation. Oh well, that’s too bad. It has zero effect on what the company is worth today.

What do investors want?

So, what do investors want? And how will they decide what your company is worth? Five main factors influence them:

  1. Is the opportunity exciting? If it isn’t exciting, they won’t bother valuing the company at all.
  2. Is the team qualified to execute on the plan? If not, you just aren’t worth the risk.
  3. Valuation based on current performance. Based on current trailing financials (i.e., what you have already done regarding revenues and profits), and multiples applicable to your specific industry, what is your company worth today?
  4. Valuation at desired time of liquidity. Based on expected performance (i.e., what you say about expected revenues and profits in your plan), and multiples applicable to your specific industry, what will your company be worth in the future? See below and blog on Determining Future Valuation.
  5. At what stage is the company? The biggest hurdles a startup has are:
    • building a product
    • getting the first revenue
    • demonstrating a repeatable sales model
    • demonstrating sustainable growth without continuing to invest external cash.

As you jump each of these hurdles successfully, the risk of total failure decreases significantly. Investors have their own rules of thumb about how that “risk of total failure” affects valuation. Here are my rules of thumb:

  • If you have not yet built your product, assume valuations will be no more than 25% of the valuations calculated using the techniques shown below.
  • If you have built your product but have not yet received revenue, assume valuations will be no more than 50% of the valuations calculated using the techniques shown below.
  • If you have built your product, started receiving revenue, but have not yet demonstrated a repeatable sales model, assume valuations will be no more than 75% of the valuations calculated using the techniques shown below.
  • If you have demonstrated a repeatable sales model and are looking for investments to “ramp up,” then the following techniques for valuation are applicable.

What To Do With Future Valuation?

Let’s talk a bit more about item 4 above. What will investors do with that future valuation once it is computed? They certainly won’t use it for today’s valuation. What they will do is use it to determine what value the company needs to have today so they can receive an acceptable return on their investment. Assuming that FV is the computed future valuation of the company at the time of liquidity, IRR is the investor’s desired rate of return and n is the number of years between now and the liquidity event, the calculation goes as follows:

Current Value of Company = FV / (1 + IRR)n

So, for example, let’s say the FV is determined to be $15M (using the techniques of the blog, Determining Future Valuation), and the investors desire a 50% IRR (not unreasonable considering the degree of risk) over 5 years. Plugging those numbers into the above formula, we get:

Current Value of Company = 15M / (1 + .5)5 = $1.98M

So, if you are looking for those investors to invest $500K now, expect them to ask for 25% of the company (because $500K is 25% of $1.98M); if you are looking for those investors to invest $250K now, expect them to ask for 12.5% of the company. And so on. But this applies only after you have demonstrated a repeatable sales model.

Now you need to factor in the risks described above. If your company is:

  • Pre-product, valuations decrease by around 75%. So continuing with the above example, the company now has a current valuation of around $500K. So, if you are looking for those investors to invest $500K now, expect them to ask for 100% of the company (obviously not a good idea); if you are looking for those investors to invest $250K now, expect them to ask for 50% of the company.
  • Pre-revenue, valuations decrease by around 50%. Continuing with the above example, the company now has a current valuation of around $1M. So, if you are looking for those investors to invest $500K now, expect them to ask for 50% of the company; if you are looking for those investors to invest $250K now, expect them to ask for 25% of the company. And so on.
  • Pre-repeatable sales, valuations decrease by around 25%. Continuing with the above example, the company now has a current valuation of around $1.5M. So, if you are looking for those investors to invest $500K now, expect them to ask for 33% of the company; if you are looking for those investors to invest $250K now, expect them to ask for 16.6% of the company. And so on.

None of the above is motivated by greed or a desire for control; it is pure economics. Investors want (and deserve) a fair return for their investment.

Of course many other factors come into play including experience, negotiation skills, degree of desperation to obtain cash, and availability of competition for deals (for the investor) and investors (for the entrepreneur).

Alan DavisDavis is a serial entrepreneur currently in his fifth startup. He is also an angel investor and the author of six books.