A. Robert Copping writes:
It isn’t easy for an investor and an entrepreneur to agree on the present valuation of a young business, as projections of future profits can only ever be uncertain.
One way is to work backwards from a target exit point. Let’s take an example where the investor and the entrepreneur agree projections that show a business valuation of £2.5m in three years. They also agree that a reasonable annual return on the injection of funds should be 40%. Discounting the £2.5m business valuation back over three years at a rate of 40% would value the business now at about £900,000. So, an investment of £250,000 would justify a shareholding of 27.5%.
This method removes the laborious negotiations around whether or not the entrepreneur has already created sufficient value in the business to agree a shareholding for the size of investment required.
The discount rate can be adjusted to reflect the risk of a particular investment opportunity, which may relate to how far the proposition has already been proven.
The exit valuation can be adjusted to reflect how attractive the business is likely to be to a potential buyer.
The negotiations will reflect reward and risk, and the challenge is to find a balance that makes both parties feel duly rewarded for their input. A refinement of this method is for the investor’s share of the equity to float depending on the exit valuation actually achieved.
In our example, the investor’s share could be set at 45% for any exit valuation achieved below £1.5m, giving the investor greater protection of return to reflect the risk. However, if the business performs to the higher end of expectations, the investor’s share could be reduced to 25% for any exit valuation achieved above £2.5m. This allows the entrepreneur a greater share to reflect due reward for skill and effort. A compromise would also be negotiated for any exit valuation achieved between these points.
This allows both parties to share in the reward and risk without feeling despondent as the final outcome unfolds. The more robust your projections, the more likely you are to achieve the valuation you desire.
Robert Copping runs business planning specialists Sightpath. He is the author of The Heart of Business Success – How to Overcome the Catch-22s of Growing Your Business and e-book, The 7 Essentials to Attract an Investor for Your Business, which can be downloaded free. http://www.businessinvestorrequired.com/