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The Delicious, Yet Dangerous Valuation

Everybody has a friend like Mickey (not his real name), the lovable extrovert who is always working on his next big idea. “My new company has a $5 million valuation now,” Mickey excitedly told me at a recent social event. That valuation surprised me because I knew enough about Mickey’s latest idea to know it wasn’t yet worth anything near $5 million. “How did you get to that valuation?” I asked, to which he confidentially replied, “My wife’s uncle invested $50,000 for a 1% share, we’re off to the races if I can raise another $2 million.”

Another $2 million, I thought to myself, that’s a big leap from $50,000. But I know what Mickey is doing. He is using the uncle’s “friends and family” investment to set a faux valuation for his company, hoping he can get a $2 million investment by giving an investor a 35-40% equity share. You’d think no intelligent investor would fall for that. But I have learned over several decades of buying and selling businesses, just because someone has money doesn’t mean they are smart about how to invest that money.

Now don’t misunderstand me, Mickey is not a con man; he isn’t raising money on false pretense. He has an interesting business idea that just might turn into a successful business. But the point is, he has an idea, not a business, not even a product. Right now, just an idea. As I see it, Mickey is trying to raise money too fast, or should I say, raising too much too soon.

Mickey didn’t ask me for advice, but I think he’d have a better opportunity to raise capital from smart investors (who could help him along the way) if he focused on smaller chunks of capital while proving that his idea is viable. Going for the whole $2 million now seems risky, and likely to not work.

I hope Mickey proves me wrong and turns his idea into a huge success. But trying to raise all the capital he needs at one time puts the entire idea at risk and makes the likelihood of anyone seeing a return on their investment a long shot.

Friends and family will invest in ideas. Investors (or buyers) will invest in results. When you hear an entrepreneur excitedly describe their valuation, you can usually assume they haven’t yet reached that elusive product viability stage. Let’s just say, it is a dangerous sign when an entrepreneur is more excited about their valuation than their product/service.

JIM CUMBEE is President of Tennessee Valley Group, Inc. a retainer-based business brokerage and transition mediation firm in Franklin, TN. Cumbee is an attorney and has an MBA from Harvard Business School. Jim is the author of Home Run, A Pro’s Guide to Selling a Business. .  He has a wide range of corporate and entrepreneurial experiences that make him one of the most sought-after business transition advisors in the state of Tennessee. The principles above are true, but the names and fact patterns are changed to preserve the parties’ identities.

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Tennessee Valley Group

Jim is an attorney (non-resident status with the Missouri Bar) and though he no longer practices law, he has read and negotiated enough legal documents to fill a cargo tanker. He has an MBA from Harvard Business School and knows how Wall Street and private equity operates. Jim is a Tennessee Supreme Court Rule 31 listed general civil mediator with tons of experience helping business owners (large and small) work through sensitive problems to achieve winning results. He is the author of "Home Run, A Pro's Guide to Selling Your Business, Seven Principles to Make Your Company Irresistible."

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