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Valuation of the Early Stage Company

Post written with examples and workshop taught by Rick Vaughn. Rick is the VP of Business Development at the Enterprise Center of Johnson County. Rick is also the managing director of the Mid-America Angels, a Kansas City angel group that has made 49+ investments totaling over $12 million in regional early stage companies. 

In order to obtain additional funding to grow and expand your business, you need to know what your business is worth.

But, how do you put a number to your hard earned sweat and tears?

It is important to distinguish between the value of a business and the price of a business. As Warren Buffet describes – price is what investors pay and value is what investors get. Valuation is the key element when determining the return for investors.

Key Factors that Affect Valuation

  1. Life stage of the company. Investors are willing to “pay” more for an established company because there is less risk; the company has established customers and financial statements. Investors assume more risk when investing in early-stage companies because there is a higher degree of uncertainty – projected financial statements translate to lower valuations.
  2. The business opportunity. The sweet spot for investors is 5 – 10 times return on investment in 4 – 8 years. After reviewing the business plan and pitch from the company, investors will reevaluate your numbers and determine if this investment makes sense for them – how much will they get back and how long will it take?
  3. Management team. Investors like to bet on the team as much, or more so than the actual business concept. Determine if you team has the experience, skills and knowledge to execute the business plan. If the management team isn’t fully formed, is there a plan to bring on members that bring the skills necessary to run the business – or is there a board of advisors that can provide the needed background?
  4. Unique Value Proposition. Determine what sets your product or service apart from competitors. Determine why customers will buy from you and make sure it is compelling and creates a sustainable competitive advantage.  Be sure to highlight how your business is protected (i.e. patents and barriers to entry).
  5. Customer Base. The bigger the existing and prospective customer base, the greater the likelihood of success. To determine market validation, a company needs to have spoken with at least 100 current or prospective customers – of those, how many have said they will buy?

Preparing for Valuation

Before a company can attached a value to itself, a few key components need to be hammered out.

  • Prepare a detailed business plan. Business plans should be 10 – 20 pages and contain information about the company, market and financials. Make sure the executive summary of the business plan contains the most important points of your business and is no longer than 4 pages.
  • Prepare for an Investor Pitch. Investors want to know the end game – how much money will they get back, how long will it take to get their money back and how will they get the money back. Check out the KCSourceLink calendar for “Pitching to Investor” classes.
  • Develop a term sheet. A term sheet that defines the key business elements of investment transactions. A term sheet is generally 10 – 20 pages and outlines the terms and conditions of a transaction.

Methodologies

Determining the value of an early stage company is more of an art than an exact science. The methodologies will differ based on life stage of the company and using two or three methods can provide a value range for your business. Below are a couple of common methods.

As you are using these methods to determine the valuation of your company, keep in mind that most angel investors like to invest at valuations of $1 - $3 million; typically for research and development, validation of business model and establishing time to market. Venture capital investors typically invest after product development is complete and companies are seeking to strengthen their balance sheets.

Rule of Thumb Method uses three key factors to determine valuation: size of the opportunity, experience level of the founder/management team and how risky is the company.

  1. Is your sales forecast under or over $50 Million?
  2. Determine if the risk level for investors is high (life sciences company) or low (internet or e-commerce based company).
  3. Does management have experience in the industry or with managing – have they been a general manager in a corporate setting?

Opportunity Size – Sales Forecast (Yr 5)

Under
$50 Million

Under
$50 Million

Over
$50 Million

Over
$50 Million

Risk Level

High

Typical

High

Typical

Inexperienced Management

$300,000

$500,000

$600,000

$1,000,000

Experienced Management

$600,000

$1,000,000

$1,800,000

$3,000,000

Using the answers to the questions, pick where you are on the chart – this is your valuation. Remember more complicated methodologies require more assumptions and are not always more accurate.

VC Back of Envelope Method uses five levels of development – each worth up to $1 million. 

  • Strong market potential, plus investment grade business plan  = up to $1 million
  • Complete and credible management team on board = up to $1 million
  • Beta tested technology = up to $1 million
  • Well protected intellectual property = up to $1 million
  • Actual customers and product sales = up to $1 million
  • There are several other methodologies:

  • Venture Capitalist Method
  • Burkus Method
  • First Chicago Method

When determining the value of your company, try to remove emotion from the process – remember, the hours you spent on your venture and how strongly you feel this will be a success are not factored into the final value. An entrepreneur seeks the highest possible value and an investor seeks to lower that value. Both sides need to be rational and determine a “reasonable” valuation.

For assistance with valuation in the KC metro, contact the Enterprise Center of Johnson County or the Small Business and Technology Development Center - UMKC.

 

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