Why Your Valuation Is The Key To Raise Money
Guest Post by Dennis V. Valenti
Many Entrepreneurs don’t understand valuations, and why you can’t raise money until your valuation or profit is high enough. Or why you’re ability to raise money is ALL centered around your pre-money valuation. This is a tough one to dissect because it’s like sitting at an eight sided table or more; depending on where you sit at the table you may view and calculate the valuation differently for many reasons.
Because of this, your pre-money valuation does not have an exact formula. The important key for a start-up is to understand the different few view points of the table, and what you can do to create a strong bottom line, or a case for one. Understand this, and you’ll understand what you need to do to appeal to investors in the start-up phase. I’m spilling my guts here for free, so pay attention 😉
Let’s start with understanding everyone’s motives at the table:
Who Else is Sitting at the Table
Once you start really taking on external investors, you’re no longer the only person at the table. Each person sitting at the table will have different reasons why they are there. You potentially have a seller, buyer, financer, buyer/seller broker/agent, consultants, business partner, employees, family, litigation attorneys, etc. I can’t go through all of these so I’m going to take the few most common and frame them for you.
Why You are Fundraising
“Why” you are at the table is extremely important. It will influence your perception and actions, but no matter where you sit some of the same basic principles will apply. First, income and bottom line numbers are key. These numbers will help validate and find the valuation. Within these numbers profit will be paramount, this is technically called an “Income Approach” but I will not explain it technically since you probably don’t have income yet.
Everyone will view profit differently at the table because they all want to use it differently. For example, the entrepreneur looks at it as “my income/earned money” and doesn’t want to lose it. And rightfully so.
You’re probably shaking your head right now saying “that’s the problem…I don’t have income”. You’re right, and we’ll get to that in a minute.
Why the Investor is at the Table: Profit or Exit
The investor looks at your business as a way to get paid back… with a huge interest rate. He/she probably already has your potential exit/acquisition in mind; and probably already knows someone.
So the investor’s going to look at it from the acquisition point of view if your start-up lacks immediate profit. Who does he know that would want to buy this company? Think of an investor as a middle man who gets you from point A to point B. Point B, commonly misunderstood, is not your ultimate lifestyle dream business destination. Point B is acquisition. That’s where he gets paid.
The Proof is in the Numbers (but you don’t have numbers yet)
Most investors/bankers will look at the past two to three years and begin to make predictions for the next three to five years as how they start to receive on their investment. Well, if you’re a start-up you don’t have bottom line. That means you have to do 10x more prediction and market analysis needed to support your business case. Unfortunately, bankers and investors typically don’t like to play the “what if?” game. They want more concrete, proven results on money in, money out.
That’s why it’s so important you get these things right, even if they’ll likely change. You can’t expect an investor to take you seriously unless you’ve done your own due diligence, and you’ll have to present one hell of a strong case to get funded pre-revenue.
EZ Numbers provides a tool for depth financial projections, prints out some pretty cool reports for investors, and automatically calculates taxes, insurance, etc.
Understanding the Pre-Money Valuation
If your pre-money valuation isn’t high enough yet, the angel investor can’t invest without reasonably taking most of your company. And that’s when you’re going to have a fit. So they’ll tend to stay quiet until that point.
Here’s where most people ask about using the multiplier and what multiplier should I use. Also, where does the pre-money valuation multiplier come from? Slow down trigger, it’s coming. Understand the multiplier is a “rough shortcut” for valuation. Most of the multipliers are derived from industry “average” sales and purchases of “like” businesses. You take the profit and multiple it by the multiplier value and have an “approximate” valuation. How accurate your research of “average sales of like businesses” could put you in a good valuation “range”.
Not exact science here. But if you’re looking for generalities my experience has been if you are buying clients or a “book of business” the ranges from 1 to 2.5 based on the business. This multiplier mostly holds true if you’re valuing a service oriented business like lawn care or hair stylist. If you’re buying more specialized book of business like financial services or doctor’s practice it may be on the higher-end or more. If you have a retail front or manufacturing business you may use a 3 to 5 time multiplier depending on what industry you’re in. Alternative energy has governmental interests and possible tax advantages that may fetch a high multiplier. And why so many are flocking to an internet business, is because no conventional thought has been established on how to get a tech multiplier. The general multiplier has been in ranges from 5,6, or7 all the way up to 12 and beyond…..some internet companies have sold for multimillions without having any profit. So, “how do they do that”, you ask? Great question.
Market Based Valuation Approach
Aside from bottom line profits, revenues, before taxes, after discretionary expenses, whatever you want to use; entrepreneurs and investors may use what’s called the Market Based Valuation Approach. This one is tricky and subject to much scrutiny from everyone at the table. I can say this is probably in the top 3 of reasons why buyers, entrepreneurs, and investors have trouble seeing valuation on the same level; and there is a vast disparity of valuation once this approach is applied. The market is what industry are you in, who is the target market, what product or service are you offering to this market and at what price, where are the business and customers located (locally /regionally/internationally), what’s the life cycle and positioning of the company or product/service, market trends, competition, etc. Again, with a start-up you only have market analysis, and if the market is not proven the risk is high and potentially lowering the valuation. Are there investors that don’t mind high risk? Certainly, but those are extremely hard to find. That information will be in the upcoming blog post: How to Find an Investor.
Asset Based Valuation Approach
Lastly, the easier and more calculated pre-money valuation technique is the Asset Based Approach. Simply put, calculate the positives and negative, and get your final number. This approach can be more complex when you start adding equipment and real estate amortization and depreciation. Include non-tangible assets; like internet traffic, branding, intellectual property, patents, databases, strict no competition territories; and “poof” you can quickly get misaligned on valuation. Here’s where some of the tech businesses have blown the roof off of their pre-money valuation.
There’s no one right way to place a pre-money valuation on a business, but there can arguably many ways to do it wrong if you pay too much . You might use these techniques, a combination of them all, or other more detailed approaches that other business professionals use. The important questions to answer are; “why am I valuing a business” , “how much is it worth to me”, and “how much is someone willing to pay for this business”. From here you can make a strategy about what you’re trying to accomplish with the pre-money valuation.