It's a valid question. Your innovation is going to require money in order to advance from development to commercial launch. Whether your total capital needs are $3 million or $30 million, the needed money can trickle in via smaller increments or in tranches of millions of dollars—depending on how you ultimately structure your funding request. But, independent of such incremental amounts, you must establish and validate a valuation for your business. In other words, how much of your company (i.e., stock or ownership) will an investor get for their investment?
You may recall that in our previous article, we talked about the importance of raising funds after the accomplishment of meaningful milestones. If you missed that, click here to read it because the timing of fund raising is a key to your company valuation. But, for now, let’s focus on calculating what that $100,000 investment offer might mean in terms of company ownership.
Begin with your sales forecasts.
You and your team must work diligently to estimate sales using a “from the ground up” approach—in other words, starting with the most basic sales activities, rather than offering a top down 1%, 2%, 10%, etc., of market approach. Ground up means figuring out who would sell your product, and how they would do it. Will you hire your own sales force incrementally over time? Or will you engage a distributor with a major salesforce already in place? How many potential customers can one sales person call on in one day? And what is an estimated success rate per call? One out of ten calls will purchase? Maybe one out of 20 or even 100 is more realistic? Does your product merit repeat orders, or is it a one-time sale? Does your product include consumables that must be reordered?
All of these elements must be carefully factored into a sales forecast as your company gradually ramps up sales over a period of years. Aim for a five-year forecast. That “five year” will be crucial, as we will see. And be prepared to defend the rationale behind your forecast, including your “from the ground up” assumptions. When you are fundraising, if this rationale is not sound and convincing, you may end up giving away more of your company than you had expected.
Research the M&A activity in your space.
By “space,” I mean similar technologies or markets. Specifically, we want learn about (1) the most recent purchase prices for companies in your space; and (2) the acquired companies’ annual revenues at the time of their acquisition. Yes, a fair amount of digging will be required to uncover this information; in the end, you may only have estimates and incomplete information. Try to put the pieces together for four or five prior (but as recent as possible) M&A cases. Examine each company’s annual revenues and the total price, including payments of both cash and stock, for which they were acquired. Divide the purchase price by the annual revenues to find the multiple of annual revenues, on average, for which the company was acquired. Chances are your numbers will cluster around two to three different multiples, perhaps all within a range of 3x to 10x of revenues.
For example, if an acquired company had approximate annual sales of $20 million and was purchased for $60 million, the purchase multiplier would be 3x. If the purchase price had been $100 million, then we are looking at a 5x multiplier. Your research may indicate, for example, that four companies in your space were acquired at multiples of 4x and 5x of their annual revenues.
Got it, so far? We have credible forecasts going out five years, and we have an understanding of purchase price multipliers. How do we use this to understand how much of our company we exchange for that $100,000 investment?
Input a few assumptions.
As a general rule of thumb, early investors will expect, roughly, a 10x return on their investment in an approximate five year period from time they put the money in. Truth is, however, five year cash-outs, in today’s world, often end up extending to six, seven, eight or more years. In any case, set that fact aside, and stick with a five year horizon for our purposes.
So, if your investor puts $100,000 into your company, and you need to show a 10x return in five years, that means the investor will be looking for, approximately, a $500,000 cash-out. How much stock would he need to get now for that $500,000 return in five years? Well, let’s see what the estimated value of the whole company, five years out, tells us.
Remember the sales forecasts that you and your team have worked hard to create? They can be substantiated through your ground up approach, right? Good. Pull them out and look at your expected revenues in year five. Then, as you may recall from our last column, we had arrived at some comparable M&A activity that was 4x and 5x the annual revenues of those acquired companies. Let’s apply this information.
Assume that you forecasted revenues of $25 million in year five. If similar companies have been acquired for 4x their annual revenues, then that means your company should be worth 4x $25 million—or $100 million in five years. If a $100 million value must support a return to the investor of 10x, that means today’s value for your company has to be 1/10 of the $100 million—in other words, $10 million ($100,000,000/10 = $10,000,000). Easy enough, right?
Do the math.
Therefore, a $100,000 investment in your company, which has a value today of $10 million, should be exchanged for approximately 1% of the business. The exact figure is calculated by adding the current $100,000 investment to the $10 million “pre-money” valuation (the valuation prior to receiving the investment) and applying the $100,000 investment as a percentage of the $1,100,000 “post money” valuation ($100,000 / ($10 million + $100,000) = 0.91%.
Bring on those investors. You got this.