Financing Your Small Business

Valuation

The subject of valuation has elements of science and art. There are for - mulistic models for valuation that are quantitative and other models that are qualitative. The qualitative general factors include (roughly in order of importance):

• quality of management;

• size of the market;

• strength of the product;

• possible market growth;

• competition;

• stage of development; and,

• relevant industry.

In an early stage company, a quantitative valuation has less relevance since there is little hard financial information. If your company is on the fast track for launch, the longer you wait, the more you increase the valuation. You should at least have a passing familiarity with a quantitative model for valuation.

F Figure 7.3: ENTREPRENEURIAL VALUATIONS

Tarby Bryant, Chairman and CEO of Anasazi Capital Corporation (Www. gatheringofangels. com), provides the following guidelines on entrepreneurial valuations.

Proper valuation of the entrepreneurial business is the seminal event in the corporate maturation process, and it becomes an absolute requisite when the entrepreneur wants to raise private or public capital. Once the company is properly valued, then the entrepreneur can determine how much of the company can be sold for the capital injection provided by the investor or venture capitalist. Valuation is highly subjective and is art and not science. The return that an investor requires is commensurate with the perceived risk and his investment objectives.

Let's imagine that Terabyte Technologies, Inc., a New Mexico high tech start­up, is projecting that by its fifth year, it will earn $1,000,000 after taxes on sales of $10,000,000. Suppose that the initial funding request in their busi­ness plan is estimated by Terabyte management at $800,000 and that the interested private investor requires a 50% annual compounded return on investment (ROI).

Anasazi Capital's suggested methodology of valuation is as follows:

The private investor will estimate the value of the company in the fifth year based on a multiple of earnings for companies similar to Terabyte's. We will assume that similar companies are selling at approximately 15 times earnings. This would give Terabyte a value in year five of $15,000,000. (15 x $1,000,000).

Employing this earnings multiple and the required 50% rate of return, one can calculate the present value of the company using the following formula:

R, . i future valuation Present value = :n

(1 + i)n

Where future valuation = total estimated value of company in five

Years

I = required rate of return for Private Investor n = number of years

The present value of Terabyte Technologies would be calculated as follows:

Present valuation = T15,000,000 = $15,000,000 = $1,975,000 (1 + i)n (1 +.50)5

Based on the initial required funding of$800,000, the private investors' share of the Terabyte Technologies' equity would be 41% which is calculated as follows:

Initial funding _ $800,000 _ 41%

Present value $1,975,000

Valuation of the entrepreneurial company has as many variables as noted above. The more accurate the revenue and income projections, the higher the valuation of the company, and the lower the private investors' share of Terabyte. The early private investor should require dilution protection on his stake as a first round early stage investor.6

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At the premoney stage of your company, do not spend endless amounts of time on valuation. It is more important for you to demonstrate to investors your strategy to bring your product to market, rather than showing them an arbitrary assignment of value for your company.