In our previous blog, you may recall that old-style pitching damages trust and eventually generates a low valuation with investors. This low valuation means you lose control and much of your power; this creates chaos in the boardroom because of your loss of control and is the source of endless headaches. Adding pain to the ache, you have less cash at the exit and maybe no deal because you can’t agree on a valuation at all.
We also talked about how this happens: A strong negative visceral reaction triggers an undesired cognitive reaction in most people; psych 101. So when you use old-style pitching, doing so causes fear and a lack of trust, which is a negative visceral reaction. This creates skeptical disbelief, an undesired cognitive reaction. Another way to say this is that a visceral distrust causes the investor to switch into a skeptical mode.
Here’s the problem. When an investor is in a disbelieving, skeptical mode, they don’t believe your financial projections and your claims of ability to execute. In short, everything that they DON’T believe is exactly what they MUST believe in order to give you a reasonable valuation. Before discussing how to fix this, we have to drill a little deeper.
We want to see how this undesired process plays out in dollars and cents. We talked briefly about how valuation is calculated by discounted future cash flow. A higher perceived discount factor produces a lower valuation. The higher the discount factor, the lower the valuation for each year. Most critical, the discounts are compounded. Three, four, five years in the future, your sales and profits are reduced more than the first two years because the discount rate is compounded. The net result is that a high discount factor is HIGHLY undesirable for you and your valuation.
What we’re trying to get to here is that inflating or exaggerating profit projections doesn’t make much difference for your valuation. In fact, doing so might hurt. Here’s how:
Inflating or exaggerating sales and profits makes you sound like a salesperson. This is because you’re trying to persuade the investor about something speculative: namely the future. To do this, there are various arguments you have to make, such as the growth of the market, the uniqueness of your solution NOW AND IN THE FUTURE, the attractiveness of your solution to clients, NOW AND IN THE FUTURE, your planned marketing strategy, your defenses against the competition, and of course your projections of sales and profits, and so on, all NOW AND IN THE FUTURE. That’s a lot of argument about the future; which is highly speculative. This will naturally put you in the mode of persuading someone about inherently unknowable facts; i.e. you sound like a salesperson.
What’s the problem with sounding like a salesperson? You trigger a reaction of fear and distrust in the listener. And this visceral reaction triggers a cognitive reaction of disbelief. The harder you work to convince investors of the truth of your speculative statements, the worse it gets. The more they distrust and don’t believe your claims.
So, inflating or exaggerating future sales and profits is a lot of effort for no results. There’s a much better way, with much more leverage. If you can reduce the discount factor, it makes a huge difference no matter what your sales and profit projections are. So that’s where we want to focus. That’s the opposite of what everybody else teaches. And probably the reason no one else teaches that is that they don’t know how to reduce the discount factor in the mind of the investors. All they know how to do is project higher sales and profits. Okay. So what we’re trying to do is get the discount factor lower IN THE MIND OF THE INVESTOR.
Let’s look at how these numbers work. Suppose you’re projecting your company sales for the coming five years: $5, 10, 40, 70, and $100 million dollars. And suppose your company forecasts 30% profit margins after all your marketing and development expenses. Now those of you offering SaaS software think your profits are much higher than 30%. That’s not what the experience shows, but by claiming a very higher than normal profit margin, all you’re doing is generating distrust and disbelief. And therefore, the investor discounts your claims, and your high-profit calculations make no difference.
So back to the issue of how do we reduce the investor’s tendency to discount your claims? We’re going to stay with this very conservative 30% profit margin, but we’re going to consider two cases. The fearful untrusting unbelieving discount rate would typically be around 50% discount per year. In contrast, the trusting and believing discount rate is a much lower 25% per year. The lower the discount rate, like a golf score, the better your score, right? The question remains, how do we reduce the discount rate that our investor uses in their mental valuation calculation?
Let’s look at the extreme cases to see how this works. A zero discount rate (in the mind of the investor) means there’s no discounting at all; they’re taking you at face value. The investor believes everything you say without any risk whatsoever. In contrast, a hundred percent discount rate means they don’t believe anything at all is going to happen, and you’re worth nothing. These extreme cases show you the way forward.
The way forward is this: you’re trying to get the investor’s perceived discount rate down from a hundred percent closer to zero. Like golf, you want a lower score. So what this shows you is the effect of having a 50% discount rate each year, vs say 25%. Well, remember, you’re discounting every year. So the fifth year of $30 million of profits is discounted one, two, three, four times. So the $30 million of projected profit in the fifth year ends up being worth $1.9 million of value, not very much. This is the power of compounding at work against you.
Now let’s assume they trust you. This visceral trusting reaction causes belief at the cognitive level. It might cause the investor to assume a 25% discount rate in their mind. This is good for young innovative companies. This is assuming you’re a fast-growing early-stage company. An investment banker rate of, say, 6% on a very mature company doesn’t apply to you. So using the $30 million profit in the fifth year, this $30 million is discounted in their mind one, two, three, four times. One, two, three, four times at 25% a year is worth $9.5 million. So you can see that a lower discount rate gives you much more value in the fifth year. The same process applies to the second, third and fourth year. You see then, a very untrusting discount rate works against your company’s valuation whereas a trusting discount rate works FOR your company’s valuation, in your favor.
We just totaled up these valuations for each year to get the entire company’s five-year valuation. All we care about is five years. Anything more than five years is fantasy anyway, in most people’s minds. So if they don’t trust you, untrusting, they’re putting a 50% discount rate on it. You’re worth $10.5 million in their minds. If they do trust you, hence believe your claims and projections, your you’re worth $29.0 million in their minds. So that’s why we are trying to get the discount rate lower.
We’re now going to do the numbers on the impact of these two different discount rates. So along the top row, here are those two valuations I just showed you, $10.5 million versus $29 million. So if your investor put in $6.5 million, I won’t bore you with the math, but your percentage of control would only be 38% if they don’t trust you and 78% if they DO trust you. This is a big difference. If they don’t trust you, you lose control. If they do trust you, you retain control. Which do you prefer?
There’s a similar impact on the cash you get at the exit. Again, I won’t bore you with the math; your expected cash at the exit would be $146 million if the investor trusts you. If the investor doesn’t trust you, it’s $71 million to you. That is an incredible difference brought about by updating your pitching style.
Note that the investor gets a little bit more than their percentage share because they get something called liquidation preference — i.e. they get their investment back first, actually twice their investment typically. This kind of preference is normal with venture capitalists and knowledgeable angel investors. In any case, the bottom line is you make a lot more money at exit if you can achieve a trusting discount rate instead of an untrusting one. Does that make sense?
Bottom line, your job when pitching — at least in the first pitch meeting, is to reduce fear and create trust. Old-style pitching, where you focus on what’s going to happen in the future, doesn’t do this. The harder you try to prove what’s going to happen in the future, the worse the situation gets – the more fear, distrust and disbelief you create in the mind of your investor. Fortunately, there is an alternative: to focus your pitching on yourself and your team. This helps your investor to bet on the jockey (you and your team) not the horse (the future of your business). This is called Story Pitching. I’ll dive into this subject next time.
- Old-style pitching is speculative; proving how the future will turn out
- This makes you sound like a salesperson.
- This triggers fear and distrust.
- This puts your investor into a state of disbelief and skepticism.
- This causes a high discount rate in their mind.
- This reduces the valuation they assign to your company, by a lot.
- Your alternative has more leverage: remove fear and distrust.
- This creates a state of confidence (in you) and belief (in your claims and projections)
- This causes a low discount rate in their mind.
- This increases the valuation they assign to your company, by a lot.
- The way to do this is to focus on you and your team, not the future.
- This allows your investor candidate to “bet on the jockey” not the horse.
- The way to do this is covered in coming blogs.