Valuing Early Stage Businesses, Part I: The Value of an Early-Stage Company is Related to its Riskiness

One of the toughest things to do is value an early stage business. Yet, in order to sell stock, the entrepreneur has to set a value on his or her company. Today’s article is the first of several on this topic. I’ve been assisted in these articles on valuation by Mark Woychick, a participant in the Boise State MBA Honors Program.

Risk and Return

Investors expect to be compensated for the risk they assume. The higher the risk, the higher the potential return must be to entice the investor to accept the risk. And early-stage investing is a risky proposition. Research suggests that around 40% of all angel investments in early-stage companies result in a loss of the investment, even after extensive due diligence. So investors must see the potential to make substantial returns in order to justify accepting the risk.

Business Stage

Risk is, in large part, correlated with the stage of the business. Here is a rough listing of risk, stage and returns expected in order to accept the risk.

Stage           Level of Risk           Return expected (compounded
                                                    per year)

Idea             Extremely high        100%+

Prototype    Very high                 75%

Initial
revenue       High                        50%

Multiple
customers   Modestly high            40%

Growing     Intermediate              25%

To put this in lay terms, if angels invest in a business that has started to generate some revenue, and if they expect a return of 50% (called the internal rate of return), then they are seeking to make about ten times their investment in five to six years.

Terminology

Most sophisticated angels use the concepts of “pre-money” and “post-money” valuation. The pre-money valuation of a company is the value that the entrepreneur and the investor agree the company is worth immediately before the investment. The post-money valuation is the pre-money valuation plus the amount of investment. If the entrepreneur and the investor agree that the company is worth $500,000 before the investment (the “pre-money” valuation) and the investor invests $250,000, then the company must be worth $750,000 immediately after the investment is made (the “post-money” valuation).

You can derive percentage ownership from the pre and post-money valuations as follows:

Pre-money valuation          $500,000        67%

Plus investment                  $250,000       33%

= Post-money valuation       $750,000      100%

After the financing the entrepreneur (and those who have previously invested) would own 67% of the company and the new angel investors would own 33% of the company.

Relationship of Risk and Current Value

The riskier your business proposition, the lower the current value of your business and the higher the proportion of ownership the angel will demand. If the angel is considering two deals, one which is only at the idea stage and the other is at the initial revenue stage, then, all other things (e.g. management, size of opportunity) being equal, the value of the company at the initial revenue stage will be higher than the company at the idea stage and the percentage ownership the entrepreneur will have to give up will be less. For example:

Stage:                     Idea                    Initial Revenue

Money needed         $100,000            $100,000

Value of company    $200,000             $400,000

% of company
to investors               33%                    20%

The lesson for the entrepreneurs is the further developed you can get your company before you seek outside capital, the more valuable your company will be and the less you will have to give up to investors.

Of course, valuation takes into account more factors than stage of business. We will explore other factors in subsequent articles.
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This article was originally published in the Idaho Statesman's Business Insider on August 10, 2011 under the title "How to set a value on your business so you can sell stock."

Dr. Kevin Learned is a counselor at the Idaho Small Business Development Center  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 Group which assists angels in forming angel funds. He can be reached by email to kevinlearned@boisestate.edu.