Valuation raises its head as a subject after an investor has determined that the business is worth looking at. It is not the first thing that an investor will look at. In fact, considering the number of business plans that don’t get read past the executive summary, it is something which business owners spend far too long dwelling over.
Having said that, once a plan is actually being considered, it becomes an important factor.
There are two sides to the valuation.
For a business owner, it controls the “cost” of the funding that they are seeking ie how much they need to give up (in equity) in order to get money into the business.
For an investor, it controls what they get for their money.
An investor buys into a company (and its potential) so that it can earn some money and then get that money out again. The mechanism is generally an exchange of funds for a percentage of the ownership of the company. This means a calculation must be made about what the company is worth, and what the business owner is prepared to give up to get the funds.
In addition to the valuation question it’s a complex negotiation that has many factors involved:
The valuation of the company, and the method used for this
- How much the owner is willing to give up and how much the investor wants
- How much the investor needs these particular funds
(if cash is low, and there are no other sources, the investor will probably negotiate a better deal)
- How the deal is structured – debt or equity, a mix, or debt that converts to equity.
- What else the investor is putting into the deal – expertise, contacts etc (“Smart money” is better than just money)
A valuation that is too high, and by implication represents a higher cost of entry to an investor, means someone might walk away from a deal. A valuation that is too low means the owner is underpaid for their asset.
At the heart of this are two opposing forces. Generally the owner will want to give up as little as possible, and the investor will want to take as much as possible. With all other things being equal, and hoping that the owner isn’t out of cash (which means the investor will pretty much get whatever he wants!) then the valuation provides a mechanism for structuring a deal.
There are many methods for valuation. Some are explained here.
None of these is completely accurate, and in fact they may give wildly different valuations.
At the end of the day, the business owner has to decide if what he gives up is worth the cost (in equity). So, often the right question is not to look at what you have now, but to look at the potential you can have with this investor on board (with the benefit of the funds, plus the advice).
A few years ago there was a great show on Seven called Dragon’s Den which had budding entrepreuners pitching their ideas to four succesful Australian business people. The question that was often asked, and was foundational to the negotiation was “would you rather have a smaller slice of a big pie, or a big slice of a small pie?”. Venture Capital in prime time was great viewing, and there were some instant lessons on how to pitch and negotiate.
This remains as the question to you as well… what are you willing to give up to get to where you want to be?
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