So if the entrepreneur is concentrating on sweat equity, what is the investor mulling over? We have an idea of what sweat equity means to the entrepreneur. But in valuation, different starting points are generated by the cavity between the entrepreneur's sweat equity and the investor's fear of gaining membership among the "living dead." Who are the living dead and what does the term mean to investors?
If you have a business and an investor invests in you, he or she becomes your partner. You are your own boss, having a wonderful time manufacturing your widgets—as any entrepreneur would. Things are fine with you. But if the investor can never obtain liquidity from the investment, a problem emerges. The business is doing well, and you are enjoying what you are doing because it is what you enjoy doing for a living. But to the investor, the investment is a failure because he or she cannot get money out at an appropriate multiple of the investment. The investor needs a liquidity event. As John Cadle explains, "If I'm looking at a deal, and I think I can get liquid in two years, I'll probably accept a lower rate of return, rather than accept a long-range development project that is not going to be liquid for seven years."
Liquidity can be achieved through a number of different mechanisms— for example, through a sale back to the entrepreneur, a merger, an acquisition by a public company, trading of illiquid stock for publicly traded securities, the sale of the company to other entrepreneurs, or an IPO. The investor has to keep in mind that very few of all venture-backed companies in the past several years have reached liquidity through IPO. Either the entrepreneur has to buy the investor out or some other situation has to occur that turns the investment into a return for the investor. In other words, the investor has to get money out of the investment sometime. If none of these alternatives works, we have an investor who has become a member of the living dead.
And while IPO is only one way—and not the typical way—to obtain liquidity, people are often fooled by the publicity generated by an IPO. The fact is that many more businesses are merged or acquired than experience an initial public offering. Perhaps this is the reason entrepreneurs often fail to realize how important it is to impress in advance on the investor what liquidity options are available out of an investment.
No investor wants to suffer in financial purgatory by being left in a venture without liquidity. For many investors, being a member of the living dead has been a dreadful financial experience—hanging in limbo, not wanting to slip backward, but unable to move forward. The money is in, but the investor has no way to get it out.
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