I thought my previous article was going to be my last for a while on the topic of valuation. But some germane new research has just been published.
In previous articles I discussed the concept of pre- and post-money valuation. Pre-money valuation is the value the entrepreneur and the angels negotiate before the angels invest. Post-money valuation is the pre-money value plus the amount of the investment, and it used for computing the percentage of stock the founders will retain after the investment by the angels.
In the second article on valuation I noted that one of the factors in setting pre-money valuations is the average regional deal value; that is at what value have other similar deals in the area been done? Since angels tend to invest close to home, the entrepreneur will have to compete for funding locally. Angels will look at the value of other similar deals in the area in deciding what value to offer or accept from the entrepreneur.
Bill Payne is a well-regarded angel investor in Montana. He is a member of the Frontier Angel Fund. The Boise Angel Fund and the Frontier Angel Fund have a close working relationship, from time to time investing in each other’s deals. Bill teaches classes on angel investing for the Angel Capital Association and has made more than 50 angel investments himself.
He just completed a survey of 35 angel groups in 26 states and two provinces. The complete results are available on his blog at http://www.billpayne.com/. His survey asks the question “What was the average pre-money value for investments made by your group in pre-revenue companies?” The average answer was $2.1 million, an increase of $400,000 from the previous year.
However, averages hide a lot of data. Valuations ranged from a low of $800,000 to a high of $3.4 million. Interesting for local entrepreneurs is that the Boise Angel Fund was one of two with the lowest valuation of $800,000. The other was Fargo/Morehead Angels, another group with which the Boise Fund has a relationship. In fairness, the Boise Angel Fund only did one pre-money deal in the past year, so that value was very specific to the deal that was done.
There are several implications for Idaho entrepreneurs.
1. Many Idaho angels have generally avoided pre-revenue deals due to their inherent riskiness. In order to entice investors to accept that risk, you have to offer a terrific deal, which means a low valuation.
2. While it is even more difficult to secure money outside of Idaho than inside, an entrepreneur with a truly exceptional opportunity may want to try to get the attention of non-Idaho groups.
3. Some valuations are skewed by the fact that bioscience and medical device deals typically receive higher valuations at the pre-revenue stage. Most Idaho angels will not do such deals.
4. Your pre-revenue deal will likely receive a lower valuation in Idaho than it might receive in a money center. The cure for this is to not seek funding until your company has secured its first revenue, thereby lowering the risk to investors. With a lower risk profile comes a higher valuation.
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 businesses 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.
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 which assists angels in forming angel funds. He can be reached by email to firstname.lastname@example.org.
Wednesday, October 26, 2011
Sunday, October 9, 2011
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.