During this week’s read of Winning Angels: the 7 Fundamentals of Early Stage Investing, valuing a business was the topic of interest. As it turns out, the authors mention that there are 5 approaches to valuing a company: Quick and Easy, Academic/investment banker, professional venture capitalist, compensated advisor, and value later.
The quick and easy approach is used when time is of the essence (146). If an investor needs to act quickly so the entrepreneur can take their product/service to market quickly, the quick and easy approach would be most applicable. The academic/investment banker method uses tools and calculations to determine the value of a company (146). The professional venture capitalist method uses multiplier and discounted cash flow to determine the value of a business (146). Compensated advisor method gives the investor an upside to investing in the business (146). Last, but not least, the value later method is used to get capital sooner, but the valuation will come later when a business reaches a certain milestone (146). Of these five approaches, there are 12 different methods used to figure out how to value a business.
These 12 methods are: the $5m limit, Berkus method, rule of thirds, $2m-$5m angel standard, $2-$10m internet standard, multiplier method, discounted cash flow, venture capital method, virtual CEO method, advisor method, Pre-VC method, and O.H. method (148).
I have narrowed my interest down to 5 of the methods.
The $5m limit method, basically, means not to invest in a company that is valued at $5 million or higher (149). The reason this is the case is that not all businesses can be built up to be a $50 million business. If you, as the investor, are trying to get a return on your money and only 1 in every 10 businesses in your portfolio grow to a massive scale, you’d be losing a ton of money!
The Berkus method was developed by Dave Berkus and places an added value if there are certain measures in place (150). For each of his five measures (sound idea, prototype, quality management team, quality board, any sales) an additional $1 million will be placed on the valuation of the business. This method typically values a business between 1 and 6 million dollars. This method requires sound judgement and is usually a fair deal.
The Rule of thirds method simply divides the value of the company into thirds between the founder, the capital providers, and the management team (150). The book mentions that a con is the founder typically places a high personal value on themselves. Coming from an entrepreneurial standpoint, I’m inclined to say the value a founder places on themselves is just. If they didn’t step up and take their product or service to market, it wouldn’t exist for anyone to profit from.
The $2m-$5m angel standard method uses entrepreneur asking valuation to help make a gut decision (151). The “sweet spot” is $2.5 million. Anything under $2 million may mean the business is not making any progress and anything over $5 million may mean that the entrepreneur is too ambitious or they require venture capital.
The venture capital method builds on the multiplier and discounted cash flow methods to figure out how much of a company an investor would need to own to get the returns they are looking for. Determine the future value of a company at a certain point in time, figure out how much return you need to get for the investment to be worth it to you, then divide that number by the value of the company at the predetermined point in time. That number will be the percentage of the company you should own.
In the end, as an investor, I would invest the time and use the venture capital method. It seems like a very calculated, and fun, way to determine what percentage of the company you should own to make the investment, personally, valuable. Maybe the founder offers a higher percentage than you would need, so the initial offer is a great one from the beginning. As an entrepreneur, I would prefer a quick turnaround and would want to work with investors using any of the other four methods. No preference between the other four, with a (very) slight bias against the rule of thirds. It can help, but can hurt the valuation as well.
Amis, David and Howard Stevenson. Winning Angels: the 7 Fundamentals of Early Stage Investing. Pearson Education Limited, 2001.