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.
_____________________________________________________________
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.
Posts
Couple of comments/questions.
ReplyDeleteA. There are two metrics in your equation that are known... how much the start up needs in this round ($500k), and the return the investor wants (10x in five years). If the argument can be made that the company could sell in five years for $100M, and adjustments are made for future funding rounds, the valuation would be significantly higher. So, valuation is based on the expected return to the investor.
B. Second comment is that you use the word "region" several times. Yet, companies like bodybuilding, micron, mwi, winco, etc... are not valued based on the region they are in (or are they?). They are valued based on fundamentals and comparable valuations, independent of locale.
So, my question is, why do you hear from early stage investors in markets like Boise, that you simply cannot value a start up internet company at more than X$... it's simply not done that way here. I'm genuinely interested in understanding this dynamic between regions and valuations.
Jason
Jason, thanks for this comment, I apologize for being so late in replying. Yes, valuation from the perspective of the investor is based upon expected returns. That is, of course, only one side of the equation.
ReplyDeleteRegarding the companies you cite, they are all large, well established companies, now competing for capital nationally or even globally. But most angels invest within two hours of where they live, and when considering valuation they often compare to other local deals. In other words, early stage companies typically compete for capital locally.
I do believe typically valuations of internet start up companies are lower here than they may be elsewhere. This is likely due to the conservative nature of the limited angel capital that is available. I'd be happy to discuss in person with you. You can make an appointment to talk with me by calling my office at the Idaho SBDC at 426-3875. We can meet in person if you are in the Boise, Idaho area or by phone if that is not convenient.