: tools & methods for small businesses

You’ve gone way beyond having a business idea that gets a  “wow” from people who aren’t related to you.  You’ve actually bought in some outside help and you have the beginnings of a real business – abeit your Wunder-Teknology is still residing in peoples’ head and in long Word files of various laptops.

BUT, the entrepreneurial life is nothing like you imagined it and you’ve decided to sell.

The grand question is for How Much.  Classic valuation doesn’t help much.  You’ve got no revenue.  Assets are limited – maybe – to a handful of lapops, some second-hand Aeron chairs, and hollow-door-on-file-cabinets work tables.  Intellectual property?  Mostly in your head.

So, how DO early-stage investors value such companies?  Let me talk about two methods here.

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METHOD 1:  Shopping for Comparable Terminal Value


The first bit of spit-and-windage number we need to determine is something called the ‘terminal value’ for the company — a value at some point (say 5 years) in the future. In 5 years, one assumes, there’ll have been a ‘liquidity event.” (IPO, or acquisition) And if that DOESN’T happen, this 5-year horizon’s got to be a point where your company will – finally – be making a profit. The easiest way to do this is to look at a comparable company. So – find a company in a similar offering space that’s gone public or was acquired and use that value as a kind of proxy for the guesstimate we’re looking for.

Simple.  Painless.  Full of potential hazards…

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METHOD 2: A ‘QUANT-JOCK’ TECHNIQUE: ‘I’ll invest if I think my return is sufficient.’

Lets say you determine that the barrier between your bright idea and a profitable company is about $2M:  enough to hire two part/time PhDs, a marketing person who can double in sales, and a whole lot of outsourced software development talent.  (to make the math simple, assume you think a one-time, $2M investment is all you’ll need).  OK – investors know this is a high risk bet and in such a case, they might reasonably ask that their $2M will – at the end of 5 years – give them a 50% annual rate of return. 

This means in year-5 the investors share of the now-profitable company must be worth (1 + 0.50)⁵ x $2M = $15.2M.  

Now – in order for this $15M’s worth of shares to be somewhat reasonable to the person selling the company, the investor works backwards.  Guessing and trying numbers in a simple spreadsheet.

A pound of flesh is one thing – asking an entrepreneur to give up 90% of their ownership a whole ‘nother.

In this case – the valuation guess (given the loan and the risk) – FOR FIVE YEARS HENCE – works out to about $45M and so, the investor’s ownership is 15.2/45 = 34%.

Note: This 50% return on investment isn’t nearly as arbitrary as it might sound.  It’s called the Discount Rate – and it’s a reflection of the risk involved.  Placing money on nothing more than a bright idea is extremely risky.  Placing that same bet on a company that’s already successful and is expanding – dramatically less so.  There are rules of thumb for discount rates:

Seed stage: 80%+

Startup: 50-70%

First-Stage: 40-60%

Second-Stage: 30-50%

Bridge/Mezzanine: 20-35%

Public Expectations: 15-25%