This is the question that crops up most when chatting to technology entrepreneurs. The answer is “What someone is willing to pay”. So how do investors or buyers work out how much to pay?
Firstly, investors will have in mind a rate of return on their money which substantially outperforms the stock market. History shows that only 2 out of 10 companies which had serious potential will make it. So this will be factored into the investor’s expectations as to rates of return. Your financial projections therefore need to show growth and returns which will exceed these minimum expectations.
All business plans I see have the usual graph showing the hockey-stick-shaped growth curve. However, it needs to be substantiated.
Most investors will assess a company’s potential by considering the market and working backwards from there – and so should you. The size of the overall market; market demand for the product; likely market share; timeframes before sales into the market; internal and external risks before having a robust market-ready product; barriers to entry for the competition following launch of your own product – all these will have a bearing on what an investor would be willing to pay for a slice of your company.
Whilst every investment proposal is different, I could probably predict, based on statistical evidence, what share of your company you are likely to have to give to investors on each funding round. I could also predict the average timescales for securing your investment – which have progressively lengthened each year since the dotcom bubble burst (along with timeframes for likely exits). Combine the statistical evidence on likely dilution on each funding round with the timeframes for raising money – you soon realise that you should be trying to raise as much money during the funding round as may be required to achieve your objectives. You should certainly be ensuring that you are raising enough to fully fund your business plan or at least hit significant milestones, with some margin for error. The most common problem is raising money to see your business through a minimum period without considering whether (at the end of that period) the value of the company will have been enhanced by the achievement of key objectives, either in terms of product-development or market penetration.
Coming back to valuations, it may be that your investor is sceptical about your ability to meet your business plan objectives – hence is suggesting a lower valuation than you believe your business plan justifies. One way of bridging this valuation gap is to agree to disagree on the initial valuation. Give the investor his share of the company based on his valuation, on the understanding that (if your assumptions turn out to be correct) the shareholding will be re-balanced so as to give management a greater share of the overall pie. This is a win-win situation where management are incentivised to perform and investors have the comfort of knowing that they have not overpaid at the outset.
Ultimately, no-one (be it management, investors, founders) will see any returns unless the team brings the company over the finishing line. This might be a sale of the company to a competitor or customer; floating the company on the financial markets; selling your key technologies. That will be the true test of whether the original valuation assumptions were correct.
On July 20, 2010