What’s on Second

Valuation is in the eyes of the beholder,  or in our case… the investor.   As we illustrated in our previous Blog, the more you move through the Capital food-chain,   the more proof-items you must have to mitigate investor risk.    The Capital “drill” is real.    It is like Baseball.   Only a rare few go from high school ball to the Biggs.  The rest of us must work our way through the minors and/or college ball – maybe both.

The challenge historically has always been…”what’s my napkin worth?”   Today, we live with a very concrete set of proof items required for each level of funding.

Valuing Visions and Brite Ideas.   Step one is to launch that  “great idea” into a new business complete with developing a sellable product or service.   Funding comes from founders, partners, plus friends and family.   Banks fund small business that are “real” and that are fully secured with pledged assets.   In most cases,  this risk requires spousal consent which is often beyond high risk.    Later, when you have momentum,  executives with checks can be recruited that will invest AND take an active role in building the business.     Their ownership is based on the mutually agreed valuation and ownership percentage.   No science – just a number both parties agree enabling them to work together to build the business.   Third party participation, investment and credentials help drive subsequent investor valuations and ownership.

Pre-Rev Valuations.    More snake oil please…   I read a recent Tweet from ATV owner David Cummings that I thought provided a much needed framework for early stage companies who have a built a business and have product/service,  prototypes, Alpha, Beta and possibly non-paying customers.   This represents some form of a “proof-of concept.”

David’s premise was… valuations are usually $1 to $2 MM for companies with a proto-type and a handful of non-paying users. (Beta or Alpha)     Investors place $300K to $500K for 20% to 25% of the Business.

Exception 1.     Highly experience management team – comes from the industry, exited from a successful entrepreneurial venture before and/or highly regarded prior employer.     This enables the entrepreneur to get pre-money valuation premium in the   $3M to $4M range.

David ask in his Tweet for other exceptions and that takes us back to the “beauty” question.   The following exceptions  come to mind that I believe are worthy of consideration.

  • Founder/Team invested Capital
  • Founder/Team Sweat Equity at discounted rate
  • IP   Patent (pending and issued)
  • Strategic Partner Market Makers who have bought-in and can drive a channel market
  • Founder Technology – Owned and part of the technology solution suite

Post Revenue  Valuations.   Earn $1 from a legitimate customer and you have just achieved a major milestone.  It is called “proof of concept”   You have arrived – well sorta.   However, you have now entered a Capital round that is less subjective and emotional.   You must now deal with valuation of your company based on five year projections of Revenue and/or EBITDA and/or Members.   One or more are used to value your company at exit that is based on a recent industry exit multiple of a company in your space.   You will be challenged  on your 5 year revenue forecast – by channel and supporting 5 year ICS proforma    From this projection – the investor exit price vs their buy price are estimated to project the investor ROI.  The investor ROI is based largely on the amount of risk the investor perceives with the investment.  More risk – higher return – lower buy price.

However, at this stage you must now deal with accredited Angels, Angel Funds, and Angel Pools who have a track record making deals on “their terms.”   He who has the gold sets the rules.    They have a very defined set of selection criteria based on their “sweet-spot” and existing portfolio of funded companies.    They know what works for them in their portfolio, what risks they are comfortable with and at what terms.    Some may want to lead in the deal.   Others may want to have someone else lead, complete the due diligence and evaluate risks based on their success track record.

For me, this is THE KEY – What is their Sweet-Spot?   What is their return expectation?   Do they lead or follow?    Understanding the Customer “Needs” is essential in making any sophisticated SALE.     You have to know what is the customer buying and why?      In raising capital funds,  the customer is the Investor (Angel, the Fund or the Pool).     The Seller is the Entrepreneur.     Alas…..the customer knows more about the product and value than the Seller.    How’s that model working for you?

Second, they are not buying a PRODUCT.   They are buying a BUSINESS that they hope to grow and  sell at a profit in five years or less.   Buy low – sell high    It is called an Exit.   These are two major fundamentals 80% of the companies coming through the Ritz Group just fundamentally miss.

Third, no one is buying the HOME RUN post 2002.   Yet, how may entrepreneurs continue to believe  they have the next Facebook or Snap Chat and, thanks to their eXcel skills, they can blow the doors off in five years.      Right!     All they need is $100K and they will be $100MM in five years.    Really?   $100 million in five?

Do you have any idea how hard it is to build a $1Million dollar company from scratch?   I can attest that Investors know…. and they have long been out of the pipe dream business.

So what’s the answer – besides GET REAL?     Maybe what is needed is a fresh approach to managing shareholder expectations in a privately held company.   That is the subject to our third Blog titled “You want to do what?   A fresh approach to managing shareholder expectations.