How to value a startup is a vexed issue for start-ups and investors. If either side get it wrong we risk losing the deal or creating a structural impediment to growth in the future.
It’s also something that pops up on TEN’s Shark Tank Australia, pitch after pitch, with the expectations of entrepreneurs veering from overly-conservative to wildly exaggerated.
On last Sunday’s episode, entrepreneur Dave Smith presented a great idea: an electronic device that turns surfboards into shark-repellents. I’m not exactly a surfer myself, but I liked Dave’s story and what he had already achieved.
What we couldn’t agree on however, was what his business was worth. Dave wanted a six-figure sum for 5 per cent equity. Based on where he was at with his business, I wanted a hell of a lot more of his company for that type of investment. He refused to negotiate, and walked away from the deal.
The truth is, valuing a start-up is as much an art as a science. It is almost impossible to accurately determine how much a business is worth before it’s making sales or attracting users.
So how do investors like myself look at start-ups and decide how much of an ownership stake we want for our cash?
The skill and entrepreneurial determination of founders aside, it comes down to potential. The founders must be the right people, with the skills and the right head screwed on their shoulders.
If it’s a bricks and mortar business – something that sells things or products, it generally comes down to a multiple of profits, either what they are today or the opportunity for future profits. If an entrepreneur wants a good valuation, they must be able to demonstrate real traction and growth.
If it’s a tech-start-up that could capture a global market, then it’s more complicated. You need to look at the risk profile: to look at the markets they’re targeting, the competition, and how they’re already going with their first few customers.
For any start-up, you need to look at the founders: do they have the track record, the subject-matter expertise, and most importantly, can they execute their plans? You need to look at the premium you’re willing to pay, and putting a dollar value on the risks associated with the founders’ skills and abilities.
A typical early stage investment can range from $100,000-$500,000, which will help an entrepreneur build out their product, acquire customers, or use it to hire more people. The exact amount needed relates to the point in time when the business generates more cash, and how much investment you need to reach this point.
When deciding the percentage of the company that I want in return for my investment, I generally follow three rules:
RULE 1: I’M NOT BUYING A BUSINESS. I’M INVESTING IN ACCELERATION.
I don’t desperately need more assets ticking over at a steady rate of return. I want my money to help the entrepreneur put the foot down, and take their start-up from 0-100 in 4.2 seconds, not 60 seconds. So I’m looking to put the funds needed to get a start-up to a point more quickly – be it judged in revenue, customer/user numbers or the next stage of funding.
RULE 2: SHARKS MAY BE PREDATORS, BUT I DON’T DO PREDATORY INVESTMENT.
There’s no point in taking too big a bite out of an entrepreneur’s business. It’s better to have 5% of a billion than 50% of a million. The entrepreneur’s blood, sweat and tears are going to help fuel a company to global growth – they need skin in the game. I never leave an entrepreneur with so little equity they question their commitment to growing their business.
This matters most in terms of the end game – growing a business is a long journey which will usually require further investment. This investment is usually at a different valuation than the one you’re investing at and if it is for less than previous rounds then you have a problem. Many investors have built in protections that can see founders stripped of their equity in these situations, but if you lose the entrepreneurs (the driving force and experts in that business) then the business is at serious jeopardy, along with the money you’ve put on the table.
RULE 3: THERE’S A SCALE OF SCALABILITY.
I invest on a sliding scale depending on how big I think a business can be. Look at the big picture, and work backwards. A good valuation gives an entrepreneur the capital they need to get to the next milestone, while allowing enough room for future fundraising.
When approaching an investor, the best thing an entrepreneur can do is show more than just how the money will be spent. The best investment pitches are built around a tangible future goal. It needs to be succinct. From a statement like: “We will be turning over $100 million in five years in the online consumer market” the plan flows, the need for investment will be clear and the scene is set for a great ride in business.
This article first appeared on Business Review Weekly. View the original here.