This is the last in a series of posts on the numbers an entrepreneur needs to know when preparing startup financial projections as part of a pitch for TV programs such as Shark Tank and Dragons’ Den.
The previous posts in this series have dealt with the following:
- Part 1: Unit retail price, selling price, and cost of the product.
- Part 2: How the income statement can be used to find details relating to the revenue, gross profit and net income of the business.
- Part 3: How the balance sheet can be used to provide additional information relating to working capital and funding.
This final post deals with the startup valuation placed on the business and the offer made to the panel of potential investors during a shark tank or dragons’ den pitch, and aims to show how this offer must relate to the numbers already provided for the pitch to be credible.
The Offer Startup Valuation
During every shark tank or dragons’ den type pitch the owner of the business will set out what percentage of the equity of the business they are prepared to offer in return for the investment. For example, they might offer 10% of the business in return for 150,000.
In making that offer, the entrepreneur fixes the startup valuation they place on the business after the money has been invested (post money valuation).
The calculation is as follows:
Equity % offered = 10% Investment = 150,000 Startup Valuation after investment = Investment / Equity % offered Startup Valuation after investment = 150,000 / 10% Startup Valuation after investment = 1,500,000
In this case, offering 10% of the business for an investment of 150,000 means that the entrepreneur has placed a value on the business after investment of 1,500,000.
If this is the valuation after the investment, then the valuation the entrepreneur came into the pitch with before the investment (pre money valuation) is given by:
Startup Valuation before = Valuation after - Investment Startup Valuation before = 1,500,000 - 150,000 Startup Valuation before = 1,350,000
This means that before any investment the business has been valued at 1,350,000.
The Counter Offer Startup Valuation
The panel of potential investors will now consider the offer in the light of the pitch and numbers provided and make a counter offer. Perhaps in the example above they are prepared to invest 150,000 in return for say 40% of the equity. The startup valuation they have placed on the business is then as follows:
Equity % offered = 40% Investment = 150,000 Startup valuation after = Investment / Equity % offered Startup valuation after = 150,000 / 30% Startup valuation after = 500,000 Startup valuation before = Valuation after - Investment Startup valuation before = 500,000 - 150,000 Startup valuation before = 350,000
In the blink of an eye the startup valuation placed on the business before any investment has gone from 1,350,000 to 350,000.
How did the Investor Value the Business
Valuations are very subjective and a matter of negotiation, ultimately a business is worth what someone is prepared to pay for it. For a business listed on a recognized stock exchange the valuation is simply the current share price multiplied by the number of shares in the market place. However for a private business seeking investment there is no recognized market share price, and a number of different methods have evolved to provide an estimate of the value of the business. These methods usually involve multiples of profits, turnover, assets or discounted cash flows, and are more fully discussed in our company value article.
On of the main techniques used in shark tank and dragons’ den type pitches is the PE multiple value. Using this method, the investors will apply a multiple (based on their industry knowledge and experience) to the earnings of the business discussed in part 2.
For example, if the income statement for the business shows a net income of 70,000 and the investor decides that for this type of business the appropriate multiple is 5, then they will calculate the percentage they require along the following lines:
Earnings = 70,000 Industry multiple = 5 Startup valuation before investment = Earnings x Multiple Startup valuation before investment = 70,000 x 5 Startup valuation before investment = 350,000 Startup valuation after = Valuation before + Investment Startup valuation after = 350,000 + 150,000 Startup valuation after = 500,000 % Equity required = Investment / Valuation % Equity required = 150,000 / 500,000 % Equity required = 30%
Credible Startup Valuations
It is important for the entrepreneur to make a reasonable estimate of multiples used within their industry. Unless they have access to private industry data to see what similar businesses have sold for, it will be necessary to use PE multiples from companies in a similar industry sector quoted on a recognized stock exchange and adjust these as necessary to allow for the fact that the business is a private (more risky, less liquid) company.
In the above example, the investors used a multiple of 5 which they consider to be standard within the industry the business operates in. On the other hand, the entrepreneur (whether they know it or not) has in fact used a multiple of 1,350,000 / 70,000 = 19.28 which is way above the value the investors consider reasonable.
In any negotiation there will always be a difference in the startup valuation placed on the business by the investor and entrepreneur. However, if the difference is too high the investors will either conclude that the entrepreneur has no understanding of the numbers involved or that they are deliberately trying to overvalue their business. Either way, it will harm the entrepreneurs credibility and probably contribute to a failed pitch.
Our startup value calculator available for free download, allows you to enter the investment and the percentage, and then calculates the before and after investment valuations.
Other Posts in This Series
- Product price, cost and gross margin.
- Income statement numbers, revenue, gross profit and net income
- Balance sheet numbers, assets, liabilities and equity.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.