An Investor Valuation can turn your ideas into actions, BUT pre-post valuations don’t work well for early stage companies.
Having an Investor in your company is a long-term commitment. It can be anything from 1-5 years, you need to be aware that you will be giving up part ownership.
By giving away equity in your company.
You will need to complete regular in depth financial reporting.
Are you ready for that?
Many entrepreneurs that I have worked with in the past have not been prepared to give up at least 20-30% of their company when it came down to the nitty gritty………. resulting in most opportunities never even getting past the first stage in the due diligence process.
I want to make sure that you are under no illusion
Fact – An Investor wants to make money
Fact – They want at least 10-20 x return on their initial investment.
So, make sure you are prepared to make this sacrifice before pursuing this route!
You need to ask yourself one question!
Do I really want an angel investor in my business?
Depending on where you are in the process you may also what to check out my articles
If you are just getting started this blog is just for you!
So, the first thing you need to understand, is how will an investor value your business.
First, let’s start with some key terms
1. Post- money valuation, the valuation of the company following the investment.
2. Pre-money valuation, the valuation of the company prior to investment.
3. Amount invested, the price the investor will pay to obtain a return.
Together they will determine the investor’s ownership, although it might seem like a quick equation, the difference of pre-money and post-money valuations can prove critical as a business scales and receives new investors.
For example, suppose you and a partner start a company.
The pre- valuation is £10 million, and the investment is £5 million the % of ownership is calculated as follows.
Equity owned by investor = amount invested/ (agreed pre-money valuation + amount invested)
So, equity owned by investor = £5million / (£10 million + £5million) = 33%
You are your partner now own 67% of the company between you
So, what does this look link in shares?
When you both started you issued 1,000,000 shares, to complete the transaction, you must issue new shares to the investor.
For the £5 million investment, the investor receives:
So now there are 1,500,000 shares outstanding, with you and your partner owning the original 1,000,000 shares, representing 67% of the company. Later you decide that you need additional capital.
A new investor now is willing to invest £10 million at a post-money valuation of £30 million, giving an implied pre-money valuation of £20 million.
If your company delivers as per your financial plan and hits its milestones sometimes the next investor maybe willing to pay a premium!
Using the same calculations, each share is now worth £13.33 before the investment (£20,000,000 / 1,500,000) and the company will issue 750,000 new shares (£10,000,000 / £13.33) to this latest investor.
Following this transaction, there are 2,250,000 shares outstanding with the 1,000,000 owned by you and your partner representing 44% of the company.
You will notice that when you secure more investment more shares must be issued. This means the original share value of the business owners reduces. This is what is known as dilution.
However, one thing to bear in mind is that every time new shares are issued the value of the share increases.
When additional funding is received all previous investors are also subject to dilution in share value.
However, as part of the original agreement some investors may choose to exercise the option to invest in subsequent funding rounds to maintain their equity stake.
It’s important to understand investor methods of business valuation
This is where it gets interesting and the fun begins! For startups with little or no revenue or profits, the job of assigning a valuation is tricky.
Most traditional corporate finance valuation methods do not work for early stage companies.
Yes, you heard that correct!
Why I hear you ask?
Discounted cash flow (DCF) is an appropriate methodology for established companies that have a history of revenues and costs.
DCF involves forecasting how much cash flow the company will produce in the future. Then is uses an expected rate of investment return to calculate how much that cash flow is worth.
A higher discount rate is typically applied to startups, as there is a high risk that the company will inevitably fail to generate sustainable cash flows. The trouble with DCF is the quality of the DCF depends on the analyst’s ability to forecast future market conditions and make good assumptions about long term growth rates.
However, these assumptions cannot be accurately approximated for an early-stage company, which makes the results questionable.
The next method Price/earnings (P/E) multiple, this method is not appropriate to most early-stage businesses as they are all mainly still losing money. Price/sales (P/S) may be used if a company has generated some sales for a few years.
Many (VCs) that are investing in startup companies will use these following two methods to establish a price they are willing to pay to invest in your company.
Market and transaction comparable
The VC will look at similar or comparable transactions, in a similar sector and stage as your investment opportunity. Many VCs are part of investment networks and through word of mouth will have access to recent valuations. Note global databases with information on companies backed by VCs and private equity can be found on databases such as Dow Jones Venture Source
However, it’s worth mentioning that transactions over two years old are not considered as the current market.
The potential value of the company at point of exit
Most VCs and private angel investors will already understand the company’s value at exit. This value will be based on similar merger and acquisitions. This will be from companies in the same sector.
The majority of startup investors will look for 10-20 times the return on their initial investment. Also, later stage investors tend to look for 3-5 times the return.
They are looking to make this return within 2-5 years
For example, let’s assume an exit valuation of £100 million.
The VC owns 20% of the company at the time of exit.
The VC would make £20 million on their initial investment at the time of exit.
If the VC invested £1million into the company, they stand to make 20 times their initial investment.
Using the post money valuation if the VC owned 20% for a million that they invested then the post money valuation was £5 million.
As you can now see, investors use the post money valuation to estimate the price an investment must command when they exit or sell the company.
Investors will have a maximum valuation based on their own view of the future valuation and perceived competitiveness for the deal.
However, they will always try to pay closer to the lower part of the range.
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What share percentage would you be willing to give away? but what would you want in return!