If the company is already trading shares on a public exchange, then its valuation is done for you. Just multiply the number of shares issued by their price and you have its value. But what if the company is not being publicly traded and you have to work out what it might be worth?
People buy businesses for their future, not their past. Whilst the past gives a good indication of future financial performance, the future is actually about guesswork and estimation. And the world is awash with 'experts' prepared to sell you their opinions. But at least they've usually something to work on.
However, when you are considering the value of a start-up who by definition does not have a past, the future is very hard to calculate. So it's pointless trying to apply the same sort of science that experts apply to companies with a history of trading, you have to use a more artistic approach. Quite simply you have to work out what both the buyer and the seller of shares thinks is a fair price. And that can be either incredibly easy - you both guess and your guesses aren't too far apart - or incredibly difficult - your guesses are far apart.
But even if the company itself does not have a history, there are some things you can find out from the past. You can look at what companies operating in similar markets have managed to achieve. You can look at the track records of the principals. You can possibly buy research about the market or perform your own to apply predictions based on trends. But at the end of the day you're usually left with these factors:
- The business will have produced a Business Plan. In it you will find a graph or spreadsheet that looks like a hockey stick. It will start with a tiny number and end up with a massive one. The tiny number is the only one you can rely on. Ignore the big ones on the revenue side and look only at the expenditure numbers. These are not guesswork and can/should be pruned dramatically. From this alone you can work out how long the company can survive on a sliver of revenue plus your investment before it decides a) to find more investment, b) to struggle on (because they still believe there really is a way to make money, which is unlikely since the evidence is weak), c) to give up.
- The founders will have spent a certain amount of money already. This includes modest wages that they haven't taken as well as other contributions from useful people like software developers who probably will have exchanged what they should have charged for what is known as Sweat Equity. The amount already invested will not be a large number compared to what the company is probably now seeking, but the founders are the ones who took a massive risk with their careers and savings by starting the business in the first place. By the time they approach investors, they've probably already re-mortgaged their homes, maxed their credit cards, tested their marriages and borrowed to the hilt. One type of start-up investor you won't see these days is banks. Early investors in start-ups are usually known as the 3Fs - Family, Friends and Fools. All of this early investment symbolises personal hopes and dreams. You cannot, and should not underestimate its equity value. But it clearly wasn't enough otherwise they wouldn't be asking you for a lot more now.
- Inevitably you will find that some of the original founders will have parted company with the business - either because they couldn't put any more money in and needed to start earning a living again, or because when that hockey stick didn't materialise, founders started blaming each other. So when you meet the business, the remaining principals will still need to be incentivised to carry on, and their erstwhile partners will probably need to be paid off to release their equity. Don't forget the principals left in the business will have been through hell to get to the point where they're asking you for money. Most businesses, especially tech, don't start with a plan to raise money. Most think they'll grow organically without outside help. Few will of course.
b) If it does, can it be sold for a lot within 10 years?
c) If a) and b) are Yes, then how much can I afford to lose if I’m wrong?
d) What’s the biggest percentage of equity I can achieve without becoming a disincentive to the principals?
e) Once involved, how can I use my experience and connections to increase the chances of a) and b)?