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 kevinlearned@boisestate.edu.
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