I am a keen viewer of BBCs Dragons Den, the show where entrepreneurs pitch their business in order to secure an investment from the dragons in return for company equity.
On the show the typical scenario is: entrepreneur A will ask the dragons for, say £100,000 for 10% of the business.
What gets me is the dragons will protest that the valuation is absurd and would only invest if they can have 40%.
The dragons usually say something like (all made up numbers) “you have only £10,000 of stock and have turnover of £80,000 in the last 6 months, how on earth do you value your company at £1 million”. The entrepreneur usually responds with forecast figures and “potential”, but this doesn’t sway the dragons opinion.
I imagine myself in this situation, having developed a cancer cure from sunflower seeds, but I need Investment to buy a field, harvesting equipment and run a marketing campaign. Now I would value my company at around £100 million +, just because I see massive potential for a cheap guaranteed cancer cure. Would the Dragons (or any other investors) argue my company is only worth a couple of hundred pounds (for the sunflower seeds I have in stock)?
It’s hard to put a value on a company that hasn’t really started. Most of the valuations that I’ve read about were based on a multiple of annual revenues, with the multiple being dependent on the type of business.
Yeah, I’m going through a round of investment funding right now for my firm and we used a multiple of annual revenues. Since we’re still in early startup (just past the year one mark) it’s all a little hazy but it worked.
No one is going to give good money on ‘potential’, though. There’s a LOT more to investment than the idea. There’s also the market potential, potential competition, track record, and the proven ability of the entrepreneur to run a firm and grow it. You might have the greatest idea in the world but with no track record of being able to run a company investors don’t know if you know how to bring the idea to reality and are much less likely to toss money your way. Also, if they do drop some dough it’ll be at a higher risk level so they’ll want more for their money than they would if you were Warren Buffet or someone else who knows how to get the job done.
The classic method of valuing a business is by adding the value of actual assets held (stock etc) to an amount derived by dividing the income by a rate of return on capital.
So you may say that at present a reasonable return on capital is, say 10% per annum. You may decide that a business has (based on market value) $10,000 in assets, and calculate that it has an income of $10,000 per annum. Divide that by 10% and you would arrive at $100,000 plus the $10,000 assets, and there’s your total value.
Here’s the difficulty though: you need somehow to build in risk and this is done by varying the rate of return you expect. High risk business? You expect a fabulous rate of return. Long established stable and boring business? You expect a low rate of return.
For a startup, it is impossible to scientifically evaluate the risk. It’s guesswork. If you take your example (but change “turnover” to “profit” because turnover means nothing in earnings terms) the current rate of return is only 16% (160,000 pa/990,000) which is too low to interest the dragons, and they are little swayed by the projections which they know (statistically) are likely to be crap. The dragons are just taking a hard nosed attitude.
The entrepreneur “knows” that his idea will be wildly successful, so to him the sky is the limit for the value of the company. The dragons know that may be right, but they also know that, on average, it isn’t.
Those responses make alot of sense, especially the track record. I guess if I ever do come up with a sunflower seed cure for cancer I would make more money selling the invention rather than the business it could be.
I’d say each industry probably has its own rough measures like that. Certain investors, the ones that are more spreadsheet oriented, will use those sort of calculations in determining the price to offer for a business. Other, more strategic investors, will have other factors involved.
Real World Example! Torn straight from the pages of my life!
Two weeks ago (a bit more) I agreed in principle on the purchase of another regional magazine. Simple enough. Going over their old books I see these numbers:
Revenue: $103,000 for 12 months
Expenses: $99,000 for 12 months
Debt load is about $15,000
It’s an established pub with a 7 year track record. Well and good, but it’s barely breaking even so to a financial investor it might not have a great value. In publishing, using a strict 4x formula a financial investor might pay $10,000 for it.
They claimed to have had a media firm do a valuation on it and came in at $120,000. I laughed, silently, at this.
But there are other factors in play.
The demographics of the pub compliment my existing pub very well.
It has an established advertiser base.
In going over her books I got competitive bids for many things. I can shave 50% off the printing, 70% off the staffing, and 25% off of delivery costs. I can do all of these things by extending my current contracts for these things and getting some economies of scale AND because it appears that he isn’t a particularly good vendor negotiator.
It also has title to a local media and marketing event that I can roll out aggressively.
So I ended up offered $45,000. It took them a while to get there but they eventually accepted. Now we’re down to looking over the books and doing due diligence and such.