Measuring your business for investment

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You need to set a ‘pre-money valuation’ before you seek equity financing.­­­ This is because the investor needs to know how much of the company he/she is going to own as a percentage of the whole company. For example, if you are raising £100,000 and your valuation is £1,000,000 then the investor will own 10% of the company. The investor will always hammer you down on valuation. If you are not yet making revenue you may struggle to be valued over £500k unless you have strong protected Intellectual Property (IP) or are in life sciences or deep tech (e.g. machine learning).

If you are seeking investment, Kent Investors Network welcomes you to get in touch. We’re also growing our investor base so if you are interested please contact christina@inen.global.

Roughly, what should I expect to give away?

Different investors value companies in different ways. Some look at the quality of the idea, assets, market size and management team. Some rely on financial projections. Some simply look for “big ideas” and determine their percentage ownership purely through negotiation.

A typical first round is:

  • Founders: 20 to 30 percent
  • Angel investors: 20 to 30 percent
  • Option pool: 20 percent

In a later round Venture Capitalists will expect 30 to 40 percent.

A high valuation is not always better. When you get a high valuation for your seed round, for the next round you need a higher valuation. That means you need to grow a lot between the two rounds. A rule a thumb would be that within 18 months you need to show that you grew ten times. If you don’t you either raise a “down round,” if someone wants to put more cash into a slow-growing business, usually at very unfavourable terms, or you run out of cash. It comes down to two strategies:

  • One is, go big or go home. Raise as much as possible at the highest valuation possible and grow as fast as possible. If it works you get a much higher valuation in the next round, so high in fact that your seed round can pay for itself. If a slower-growing start-up will experience 55% dilution, the faster growing start-up will only be diluted 30%. So, you saved yourself the 25% that you spent in the seed round. Basically, you got free money and free investor advice.
  • Raise as you go. Raise only that which you absolutely need. Spend as little as possible. Aim for a steady growth rate. There is nothing wrong with steadily growing your start-up, and thus your valuation raising steadily. It might not get you in the news, but you will raise your next round.

What will help bolster my valuation?

Early-stage valuation is commonly described as “an art rather than a science,” Several factors influence valuation, including:

  • Traction: Out of all things that you could possibly show an investor, traction is the number one thing that will convince them. So, how many users? 100,000 users will give you a good shot at raising £1M (that is assuming you got them within about 6-8 months). The faster you get them, the more they are worth.
  • Revenues: Revenues are more important for the B-to-B start-ups than consumer start-ups. Revenues make the company easier to value.
  • Distribution Channel: Even though your product might be in very early stages, you might already have a distribution channel for it. For example, if you have a Facebook page of cat photos with 12m likes, that page could become a distribution channel for your cat product.
  • Hotness of industry: Investors travel in packs. If something is hot, they may pay a premium.

What are the investors thinking?

  • Exit: How much can this company sell for, several years from now?
  • Long-term funding needs: Next they will think how much total money it will take you to grow the company to the point of exit. In Instagram’s case they received a total of $56 Million in funding. This helps us figure out how much the investor will make in the end. $1 Billion – $56= $940 million That is how much value the company created. So, everyone involved in Instagram collectively made $940 Million on the day Facebook bought them.
  • Ownership: Next, the investor will figure out what percentage of that s/he owns. If s/he funded Instagram at the seed stage, let’s say 20%. Let’s assume in the end, the angel gets diluted to 4%. 4% of $940 million is $37.6 Million.   $37.6 Million is the most this investor thinks s/he can make on your start-up.  If you invested $3 Million in exchange for 4% – that would give the investor a 10X returns. Only about a 3rd of top-tier VC firms make that kind of a return.

What methods are used for valuing a start-up?

  • Cost-to-Duplicate: considers fair market value of physical assets and how much it would cost to build an identical company. Only accounts for current state and does not include intangible assets such as patents.
  • Comparable Acquisition: indication of market valuation for a company based on recent acquisitions of similar companies. Requires comparable companies to be on the market with public information.
  • Venture Capital Method: Developed by Professor Sahlman, values the company on the eventual selling price of the company and divides the investors anticipated ROI to determine the valuation today.
  • Discounted Cash Flow (DCF): forecast how much cash flow the company will produce in the future, and, using an expected rate of return, calculate how much that cash flow is worth.
  • Valuation by Stage: designates a value to different stages of the company. An idea may be worth $250k-$500k. A strong team might push the valuation to $1m, a prototype to $2m, a customer base to $5m etc.
  • Scorecard Method: Payne’s (2001) method uses comparable valuations and then compares the company using certain factors which are weighted.
  • Risk Factor Summation Method: This method is similar to the scorecard method but it compares 12 characteristics rather than seven.

Ultimately your valuation will be set through negotiation with investors. You do not need to pay an adviser to set your valuation, I can tell you now, an early stage start-up without revenues will be valued between £500k-£2m. Only companies with rich IP will secure the higher end of this. If your company is valued less than £500k, it’s probably too early for you to raise money. Go back and talk to your customers and distributors, try to gain traction. If you have revenue, you could be valued at 5x your revenue, but it may not be this high if your company is not defensible (i.e. competitors could copy it overnight). Equally, it could be a lot higher if you are highly defensible and a genuine original business solving a real problem. Crowdfunding platforms will give you a higher valuation than Angel investors but then you risk having a down round when you go to raise again. You will also have hundreds of small investors who all need updating with your progress and all have rights to ask questions.

My advice, is don’t get hung up on valuation. If you find the right Angel Investors, then that could be the difference between your company being mediocre or a raging success. You may lose 5-10% more than you wanted to but if your company becomes worth £200m instead of £20m then you’re coming out on top!

 

Christina Mackay
Managing Partner, InEn Global LLP
CEO, Kent Investors Network

Read Christina’s previous articles here:

Getting your new venture off the ground

Giving up the day job

Where are all the women investors?