The value of a company is important because it is the basis for determining the “cost” of the new capital when seeking equity additions to the capital structure.
Jargon busting
Simply put, a company with a valuation at $1 million (pre-money) and no debt, seeking fresh infusion of capital of, say, $1 million, would be worth $2 million (post-money valuation) after the investment. The old owners would own 50 per cent of the new $2-million company (for their contribution of the old company with a $1-million value), while the new investors would also own 50 per cent interest for their contribution of $1 million cash.
Generally, a valuation considers four questions:
1) How much is the company worth today?
2) How much is it estimated to be worth in the future?
3) What is the estimated time value to create that future worth?
4) Does the company have a viable business plan to reach that future state?
While there are a number of different methods used to value start-ups, in the final analysis it is a whole lot subjective.
It depends on how well you have sold your vision and how much the buyer has bought into it and is willing to pay. While there may be well laid down discounted cash flow spreadsheets and market multiples to EBDITA, finally it depends on a number of factors such as:
(i) Have similar deals been done in the industry, if so at what valuations?
(ii) What stage are you in right now?
(iii) How attractive is the opportunity – is it the flavour of the day?
(iv) Does the promoter have a track record of delivering; there is no better factor than if someone else has made money out of you?
(v) More importantly, who else is in the fray to do the deal?
In our case, the angel round was valued by a third party appointed by the angel investor and while we had submitted projected financials the final valuations were completely subjective and done through a process of negotiation. So was our ‘Venture Capital’ round, for which we arrived at and accepted the valuations over a drink. The bigger the funding the more intense the negotiations and our later round saw weeks of negotiations with multiple parties where multiples of EBDITA was the basis of the valuations.
Identifying potential VCs
As the business grows it becomes increasingly complicated to get the right partner to fund the business. In my opinion, the best way is to hire a merchant banker who can help you with fine-tuning the business plan, position the company, brainstorm with you on likely venture capitalists, who’re on the prowl, and arrive at some reasonable valuation expectations and help you tailor the right pitch to the VC’s. More often than not you can negotiate a success based fees and the money paid (normally 1.5 – 2 per cent) of the capital raised is well worth it. This is more than compensated by the likely higher valuations and the options that the merchant banker helps bring to the table.
How do funders evaluate an investment opportunity?
Here are a few of the things that funders look for when evaluating a business opportunity:
(i) Market Opportunity – What is the growth potential of the market that the company has identified? What is it now and how does the company propose to growth that market?
(ii) Timing – Is the opportunity window right? Why?
(iii) Competition – What is the existing and likely competition?
Porters theory of competitive advantage is probably a model that can be used to evaluate the market and competition.
What are the entry barriers , new entrants, suppliers, customers, substitutes , etc.
(iv) Business / Revenue Model - How will the business make money. Is it viable and sustainable? What factors can impact revenues.
(v) Scalability – Funders love scale. How scalable is the opportunity, is the business process oriented or person dependent and can the process be easily replicated across geographies and /or markets
(vi) Strategy – What is the strategy proposed? How is it different from competition? What is the key value proposition? What are the chances that the company can effectively deliver on this value proposition.
What pain points does the opportunity seek to address and how effectively?
(vii) Return on Investment – How much and what time scales? What is the risk level? Evaluation of IRR based on realistic projections.
(viii) Team – How good is the team. Is the Team exemplary, have they been there, done it. What is their track record? Are their skills complimentary and is there any proof of commitment. Also the personal level of comfort once the VC’s have met the promoters and the team.
(ix) Exit – Normally investors have a 7 year window with a possibility of a 2 year extension. What life cycle of the fund are they in just now and the likelihood of an exit determines how interested a VC would be. Whom will they sell to, another larger VC or a strategic investor. In our case the angel investors sold out to the VC and the VC sold out to the strategic investor.
(x) Co -Investment – Are their other co-investors already on board or are there others interested in investment. VC’s like it when there are other co-investors also on board so that the risks are shared.
Areas of Joint control
Once you take external funding there are also areas that you give up total control. Most commonly, as borne out from my experience, these areas are the following:
(i) Overall capital expenditure budgets
(ii) Entering new geographies / cessation of business operation of the company
(iii) Hiring / firing key employees – at least employees who are one level below in the hierarchy
(iv) Infusion of additional equity capital
(v) Any action that changes shareholding pattern / rights of shareholders
(vi) Declaration of dividends
(vii) Any increase in the number of directors and mutual consent for third party directors
(viii) Any material change in the nature or scope of business
(ix) Approving any mergers and acquisitions
The entrepreneur must ensure that control on the above mentioned critical areas are not given away completely to the VC and he/she retains at least joint control in decision making.
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