Sunday, October 9, 2011

Valuing Early Stage Businesses, Part III, Understanding Angel Math

This is the final article in a series on valuing early-stage businesses from the standpoint of the angel investor.  You can find the earlier articles at my blog, http://kevinlearned.blogspot.com.  Thanks to Mark Woychick, a participant in the MBA Honors Program for his assistance in preparing this series.
In the earlier articles we talked about the riskiness of an investment in your company and how lowering that risk will result in a higher valuation. We also talked about the importance of comparable such as the average regional deal value and similar businesses and about the value of the team.
In this article we want to present the math that most investors go through in order to validate a valuation.  It’s pretty simple.  Take these variables:
1.      How much money does the company need in this round?
2.     How much can the company be sold for and in how many years?
3.     What multiple of my investment do I believe I need to have the potential to earn to justify my taking the risk?
Given the answers to these questions, we can compute a preliminary valuation of the company.  For example:
1.     The company needs \$500,000.
2.     The entrepreneur and our own due diligence suggest the company can be sold for \$20 million in five years.
3.     Given the risk profile, we believe we need to have the potential to receive ten times our investment. Therefore we need to have the potential to receive ten times the investment of \$500,000 or \$5 million when the company is sold.
4.     If the company will sell for \$20 million and we need \$5 million of the sales proceeds, then we need to own 25% of the company at exit (\$5 million/\$20 million).
If we need 25% of the company at exit in order to meet our return objective, and IF the company does not need to raise any more funds between now and exit (admitted a tenuous assumption in that most companies will need to raise additional capital which will dilute our ownership), then we can compute the value of the company today as follows:
1.      Money raised, \$500,000
2.     Percent of company needed for this investment, 25%
3.     Value of the company after investment (the “post-money” value) must be \$2 million.  That is, with a value of \$2 million, our \$500,000 investment will purchase 25% of the company.
4.     This means the value of the company before the investment (the “pre-money” value) must be \$1.5 million (post-money value of \$2 million less investment of \$500,000).
Most investors will triangulate on a number of different approaches to valuing the company to substantiate the value.  In the above example, they will compare the computed value of \$1.5 million to what they believe similar companies in the region are worth.  They may adjust the value up or down depending upon the quality of the management team or the strength of the intellectual property.  They may run a discounted cash flow analysis on the pro forma projections to see how it compares.
Valuation of early-stage businesses is difficult and as much art as science.  In the end analysis, the value is what the investors and the entrepreneurs can agree upon.  But the well prepared entrepreneur will understand the different approaches and be prepared to negotiate with the investors based upon them.
In our consulting practice at the Idaho Small Business Development Center at Boise State we frequently work with entrepreneurs to help them set a value on their business before they go to the market to raise capital.  Our services are free and confidential.  Call the SBDC at 426-3875 for an appointment if you would like to discuss your company’s value with one of our counselors.
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Dr. Kevin Learned is a counselor at the Idaho Small Business Development Center (www.idahosbdc.org) at Boise State University where he specializes in counseling with entrepreneurs seeking equity capital. He is a member of the Boise Angel Fund, and is a principal in Loon Creek Capital (www.looncreekcapital.com), which assists angels in forming angel funds. He can be reached by email to kevinlearned@boisestate.edu.