This is my second article on the valuation of early stage businesses. These articles have been written from the perspective of angel investors in the hope that I can give some insight into this mysterious process for entrepreneurs who have to negotiate valuation with prospective investors. I have been assisted in preparing these articles by Mark Woychick, a participant in the Boise State MBA Honors Program.
The focus of these articles is valuation from the standpoint of the investor. I hope they will give entrepreneurs some guidance in how their businesses may be valued when they seek capital. I assume your business plan (e.g., business concept, market size calculations, competitors, use of investor capital, etc.) makes sense.
I should point out that in my opinion the traditional discounted cash flow method of valuing businesses doesn’t work for an early stage business. This method may be appropriate for a stable business with an operating history where you can have some confidence in the projections. But an early stage business has neither an operating history nor stability and therefore projections for such businesses are unreliable. In the many deals I have reviewed, I have never seen an investor do a discounted cash flow analysis.
Last time I discussed the fundamental relationship of risk and return, how the earlier in the business cycle a business is, the riskier the investment is likely to be, and therefore the lower the valuation of the business will be for purposes of seeking investment capital. Of course this is an important factor but not the only one. Here are some others that will likely impact the value of the company:
Average regional deal value. Sophisticated investors know the current valuation of deals in their region. For example, the Boise Angel Fund participates in a monthly phone conference with about ten other angel groups throughout the Northwest. We talk about the valuation of the deals we are seeing. This gives us a basis for the initial valuation of a local deal. For example, we know from this discussion that pre-revenue deals in the Northwest rarely have valuations of more than $2 million, and they are usually substantially less no matter how exciting the potential. So if you approach local angels for your startup company with a valuation of $3 million, you are likely to not even get to negotiations as your proposed value is completely out of line with what other deals are being done for.
Comparable businesses. If there have been other companies started in your space, then angels may want to use the valuation of those deals as a basis for the valuation of your deal. For example, many Software as a Service (SaaS) deals have raised capital in the last year. Generally well thought out SaaS deals are valued a bit higher than businesses which carry inventory and accounts receivable as they have the potential to be very capital efficient and to be highly profitable.
Team. All businesses are dependent upon the quality of the management team. A superb team with background and experience in bringing a company to market in your space is unusual and valuable. In my experience, all investors will increase or decrease the value of a business based upon their perception of the management team.
In the next article we will examine the most important, and most difficult component, which is projecting the exit value for the investors and then try to bring all these factors together.
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 email@example.com.