Every investor has had the following experience.
An entrepreneur delivers a professionally developed, spiral-
bound, four-color business plan accompanied by a snappy Power Point
presentation. After 20 minutes of discussion, the presenter states
their investment opportunity is valued at $30 million. The logic for
the valuation is based upon the entrepreneur's belief that in five
years the company will have sales of a "cazillion" dollars in spite
of the fact that there have been no sales to date and for only a $5
million investment today, the investor can get 15 percent of the
action. The end result is the investor wasted an hour of time.
This scenario explains why investors typically get to the
following key questions early on: How much money do you need? What
equity percentage are you offering? What are you proposing to do
with the money? How and when will the liquidity event occur? What
market pain does this venture cure? And, why is your product the
Another more frequent and realistic scenario is one where the
investor and entrepreneur have spent weeks in discussions only to
discover that the investor's analysis leads to an enterprise
valuation of $5 million and the entrepreneur's estimate is $8
They are only $3 million apart, but they might as well be $30
The logic is very much like buying real estate. The buyer
compares the property value to sales of similar properties in the
neighborhood and determines that the purchase price is above the
highest range of properties sold in the last six months. If the
property is commercial real estate, the buyer might calculate that
it will not generate sufficient rent levels to reach a positive cash
flow nor appreciate in value over time to offer an expected rate of
return. A disciplined, sophisticated investor, who never become
infatuated with the opportunity and remembers there are always more
investment opportunities than there are investors, moves on.
Determining a realistic valuation for a given venture is a
fundamental requirement for seeking equity financing. In a sense the
investor is "buying" into the future value of the business when it
has fully optimized its potential and is "for sale" to the public or
an acquiring company.
Investors take no interest in a venture that does not have a
realistic liquidity event in its future. Liquidity events are what
equity investing is all about.
Many entrepreneurs fail to realize that arriving at a venture
valuation is part science and part art, based upon mathematical
formulas, knowledge, experience and negotiating skills. The more
knowledge the entrepreneur has about various approaches to arriving
at a valuation, the better they are at developing realistic
valuations, defending their logic, and negotiating terms.
Investors set values based upon rates of return they hope to
achieve. The rate depends upon the stage of the company and the
expected time to an initial public offering. Earlier stage ventures
and longer time to an initial public offering implies greater risk
and a higher expected rate of return. …