By Dave Berkus, Chairman Emeritus, Tech Coast Angels
Financial History and Projections
Let’s start with the basics. If you are investing in a going business with a track record of revenues, then the importance of accurate current financial statements cannot be overstated. If there is no record of revenues, see the “The Berkus Method” available with any search query for valuing the business before revenues.
And your entrepreneur should “know your numbers and be able to defend them” during early meetings with candidate investors. At the least, historical numbers must include the latest income statement and balance sheet, showing activity through the latest period. If the business is not a startup, expect to supply income statements for the past several years as well, to emphasize trends in revenue and costs.
Projections for the future
You should expect to review detailed projections for the next 12 months as a basic minimum. Beyond that, ask for projections for two additional years, but not necessarily in account-by-account detailed format. Sophisticated businesses will also create a cash flow projection for the same period, showing cash used and remaining at the end of each period. And note that projections showing “unbelievable” rapid growth are always suspect. Careful about “hockey stick” forecasts.
How much money can an early stage company expect?
Well, here is a question with a circular answer. To grow their business to a size that will be attractive to a VC or angel making an investment now, they’ve got to show that the business will be large enough at the time of the investor’s liquidity event (cashing out) to make the investment attractive at all.
Most VC’s look for a 10x opportunity – that is – a ten times increase in the valuation from investment to liquidity event. Later stage investors sometimes look for less, since the business has already proven its capability to stay in the game and has already completed its product development cycle, eliminating more risk for the investor.
So, play with the numbers to determine the entrepreneur’s expected level of comfort. The more they ask for – the more equity they give up. Completing this exercise often leads you to lower your expectations about the amount of money to be raised.
It is also a factor that early stage investors don’t want a controlling interest in the company. It is a disincentive to entrepreneurs and a burden to you as an angel investor. “Engineer” the deal if possible so that you give 20-35% to investors on the first professional investor round.
Here’s a valuation example for you based on amount to be raised
Try this example: The entrepreneur wants to raise $2,000,000 today. The projections and the analysis we’ll undertake below lead to a possible valuation of $40,000,000 in five years, assuming that they meet the plan, and allowing for a 50% discount to the projected numbers during the investor’s evaluation. That means – using the investor’s 10x expectation for return – making the business worth $2,000,000 today at best. To raise $2,000,000, the entrepreneur must give up 50% of the post-investment equity (the current value of $2,000,000 plus the investment of $2,000,000). The post-investment value would be $4,000,000. When multiplied by 10x, the target valuation at exit would be the $40,000,000 quoted above. It is a fact that very few businesses reach the $40,000,000 valuation hurdle. And it is probable that the company will need more money to reach that target, muddying the calculation and reducing the investor and entrepreneur equity percentage.
Remember employee option allocation
Potential investor will include the full number of shares reserved for the present or future option plan – usually 15-20% of total equity – making an entrepreneur’s personal equity 20% less when calculated as “fully diluted,” or including a reserve for options. Therefore, in the example above, the entrepreneur would control less than 50% of the company at funding if they received $2,000,000.
Given an entrepreneur’s strong desire to keep controlling interest in the early stages of growth, the amount that can be raised must be lower than $2,000,000 in order to accomplish this goal.
So, the circular reasoning exercise returns. Raise the projections (and sell us investors on the increased projections as a result) or lower the amount of capital to be raised in this round. Future rounds should be at higher valuations if the company meets its plan, making dilution of equity less onerous at that time.