Every seed investor has the following experience (or one like it) in
valuation. An entrepreneur delivers a professionally developed, spiral-bound,
four-color, business plan accompanied by a snappy Power Point presentation.
After a twenty minute discussion, the presenter states the investment opportunity
is valued at $30 million. The entrepreneur believes in five years company
sales will rise to dizzying heights, despite there being no sales to date!
AND for only a $5 million investment today, the investor can get 15 percent
of the action. This scenario happens much too often, and unfortunately,
both investor and entrepreneur have wasted their time.
This is why investors typically get to key questions early on: "How
much money do you need? What equity percentage are you offering? What are
you proposing to do with the money? How and when will the liquidity event
occur? What market pain does this venture cure? And, why is your product
the dominant solution?"
Yet another (and more frequent) valuation scenario is like the following:
the investor and entrepreneur have spent weeks in discussions only to discover
that the investor's analysis yields a $5 million enterprise valuation and
while the entrepreneur's estimate is $8 million. They are only $3 million
apart, but they might as well be $30 million apart. Here the investor's
logic is much like that used in buying real estate. The buyer compares the
property value to sales of similar properties in the neighborhood and sees
that the purchase price is above the highest range of properties sold in
the last six months. If it is commercial real estate property, the buyer
might (a) calculate that it will not generate sufficient rent levels to
reach a positive cash flow or (b) not appreciate in value over time to offer
an expected rate of return. The disciplined, sophisticated investor, who
never becomes infatuated with an opportunity, remembers there are always
more investment opportunities than there are investors and moves on.
Determining a realistic valuation for a given venture is a fundamental
requirement for seeking equity financing. In a sense the investor is "buying"
into the future value of the business after its potential has fully optimized
and then is "for sale" to the public or an acquiring company.
Investors take no interest in ventures without a realistic liquidity event
in its future. Liquidity events are what equity investing is all about.
Valuations of ventures are part art and part science, based upon mathematical
formulas, knowledge, experience, and negotiating skills. The more knowledge
entrepreneurs have about various valuation approaches, the more effective
they can be in developing realistic valuations, defending their logic and
negotiating terms.
Investors set valuations based upon rates of return they hope to achieve.
The rate depends upon the company's development stage and the expected time
to a liquidity event such as an initial public offering (IPO). Earlier stage
ventures and longer time to liquidity implies both greater risks and higher
expected rates of return. For example, an investor might expect to earn
a 10-times return (10X target multiple) on investment in a startup venture
projecting an IPO in five years. In contrast, a later stage company with
sales and three years from an IPO presents less risk and justifies a 3-times
(3X) return.
One Approach: using target multiples to first estimate the company's
value at the time of liquidity is one way to derive present valuation. Multiply
projected earnings in the year of the expected liquidity event times the
historical industry price-earnings (P/E) ratio. Make additional adjustments
and calculations for such factors as the expected IPO market, the risk factors,
and the expected rate of return. Example: assume that a startup company
is seeking $1 million from an investor who expects a 10X return on investment
(ROI) with an IPO. The company projects to have $5 million in earnings in
an industry with an average historical P/E ratio of 20. This calculates
to a post-IPO valuation of $100 million. The company also plans to raise
$40 million in its IPO, so the company's pre-funding valuation would have
a present value of $5 million (Calculation: {$100 million -$40 million
/ Expected ROI} - $1 million).
Startups are always difficult to value because they have no performance
history. Many investors apply rules of thumb for their investment criteria
based upon assessment of risk involved and the opportunity offered: Is the
founder a beginner or a seasoned entrepreneur with experience in the specific
market? Does the market opportunity offer sales above or below $50 million
in the fifth year? Depending upon a combination of factors, investors may
use a range of $500,000 to $3 million as the pre-funding value of the company.
These are but a few considerations in arriving at a valuation. Unless
you are valuation savvy and aware of the variables including market conditions,
don't try this at home! Find an expert. |
