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Authored by Bryan Springmeyer Bryan Springmeyer is a California corporate attorney who represents startup companies and investors. The information on this page should not be construed as legal advice. |
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Million Dollar Idea? Business valuation for startups.
In any private equity transaction, the biggest issue is going to be business valuation. In a priced seed round, the issue of valuation often becomes even bigger, because normal metrics of valuation, such as earnings and revenue are non-existent. Entrepreneurs often value their company at what they believe it will become. Investors value the company at its current worth.
If, for instance, an entrepreneur made an offering of $1 million in securities representing 25% of the company post-transaction, the offering would value their company, before any significant development, at $3 million (pre-money). Could your idea and your commitment to seeing the idea through really be valued at $3 million?
Within the realm of startups, there are different levels of development prior to revenue: concept, proof of concept/product in development, prototype, product developed. An idea, no matter how great, is at the earliest level of development, concept. Most likely, it would be your commitment to seeing an idea through rather than the idea itself that would peak investor interest. If that commitment were sufficient to spark investor appeal at the concept stage, investors would likely seek an exponential return on investment.
Business valuation in venture capital transactions determines a present value of a future business. The method is called discounted cash flow (DCF) and discounts future earnings and residual business value upon the company's exit to a present value, based on a percentage that accounts for the interest rate the investors could get in a risk free situation plus a risk premium for the endeavor. The risk premium for a startup is high, because of the uncertainty involved and the high percentage of businesses that fail.
Venture capital firms and angel investors who tend to operate like VC firms might want 70+% risk premium to account for the risk of investing in a pre-revenue, concept-only idea. The risk comes from the fact that the concept has not been proven to be feasible or useful, its development costs are uncertain, and the ability of the founders to develop it is unproven. There is also a threat that a more mature company could take the idea and develop it faster than the startup. The 70% premium means that a five year plan should include a 14 fold return, requiring a $4 million (post-money) company to become a $56 million company in 5 years. If you approach the investors without any employees or management, or without substantial development, the premium could be even higher. Certain industries will also require a higher risk premium.
Even at the low end estimate (of 40% risk premium), your $3 million idea will have to result in a company whose cash flow and residual value at the end of the five years is $21 million.
Not all angel investors will engage in a discounted cash flow analysis to value your business and/or may not require such a high rate of return. Some angels are looking to mutliply their investment by a certain number in a certain number of years. This may not be too much different than a DCF analysis, minus the formulaic approach. There are even some real "angels" out there that will simply like an idea and then decide what they want to put into the company. The corresponding equity stake has little to do with any analysis of future earnings. However, most angels are going to take some look at the risk factors, acquisition prices for similar businesses, and profitability and revenue figures for those businesses, before they sink a large amount of personal capital into your venture.
Negotiating business values is often a disappointing endeavor for entrepreneurs doing their first venture capital transaction. There is some legitimate undervaluation that investors may propose to get a good deal. They are also expecting an inflated valuation, so the plan should reflect that. However, even the "fair" values use a risk premium that challenges the entrepreneur's ability to succeed. Be prepared to support your revenue projections and argue for a lower risk premium to increase valuation, but be prepared to accept a valuation that reflects the risk involved with startup capital if you decide to go the VC route.