Over my entrepreneurial life, I have started dozens of businesses, some needed cash from an outside angel investor or bank and some did not.
For the ones that did need outside capital, being a new start-up usually meant an angel investor. Many of those have been private individuals but some have also been professional angel investors. It doesn’t really matter what type of investor you bring on; they will all want a piece of the business and usually in the form of common shares.
Most entrepreneurs over-value their companies in the start-up stage and either ask for more than they need, can afford or, they offer less shares than what is reasonable. To complicate matters, most informal angel investors are new to this game and when an entrepreneur offers a value for their company and shares, many will accept it as they too lack the insight.
Then you have the sweat equity factor in the equation (where the entrepreneur says they have just spent x time in developing their business project), how will an angel investor verify this?
How dare someone tell an entrepreneur their time is not worth what they say it is! These are tricky waters but you know what, as Donald Trump says:
‘It’s not personal, it’s just business!’
It is indeed just business and you need to keep reminding yourself. However, I am not so sure “The Donald” is the best person at trying to find the correct understanding and balance between how much someone is offering vs what they are willing to invest.
So, is there an answer? Absolutely not. However, understanding business valuation is the crucial foundation for both entrepreneurs and informal angel investors.
A pre-investment start up or early stage valuation is definitely the most difficult to value (vs an established business) but there are some rules. For example, at the very minimum, a business is worth at least 100% of the invested capital.
£100,000 cash invested = 100%
You can dilute from there keeping the same percentages as post money starts to come in. On the other extreme, one can make an argument that a business is worth what it “should” generate through future earnings. For example, if an entrepreneur makes the argument that their business will generate £1 million in sales and £250,000 in profit each year over the next 3 years (or any number of years), and an angel investor comes in at £250,000 for 50%, they will see a return of 50% per year based on their investment.
Will it happen? That’s the tough part, maybe and maybe not but that is speculation and all part of the game. In the middle of all this is some estimate of cash invested, future earnings, sweat equity, future rounds of finance and so on. It can get very complicated and subjective.
My rule is to look at and base things on the initial cash investment from the entrepreneur (plus anything they have personally guaranteed because they are on the hook for this as well), allow them 20% of this for their sweat equity, but be VERY cautious about future earnings because if they happen, they happen because of your investment and if you are taking common stock in the company just like the founder. You will both go up and down as things move along. If you can bring other things to the equation such as physical involvement, industry contacts and leads, overhead infrastructure, etc. start deducting this from their proposed equity offering.
As we are all learning, sometimes we win, sometimes we lose but if we learn a little each time and have some basic rules to follow, the losing will become less and the winning will become more!