The higher the value of your business, the less stock you have to sell to get your business funding.

But, how do you determine the value of your business when it doesn’t have a history of cash flow, a book of customers or any other criteria that are typically used to establish value?

Valuing an emerging business for purposes of venture capital financing or angel investors is based on two factors:

1.) The rate of return required to compensate for the risk of investing in the enterprise; and

2.) The expected enterprise value at the time of the “exit event.”

The first factor depends on the general investment climate and the fact that investing in a start-up is extremely risky.

Today, professional investors would expect at least 10X return on investment over a 5 year period. This is much higher than it was a few years ago because the risks of investing have increased.

As a result, for each $1.00 of investment, you’ll be expected to return $10.00 to the investor in the fifth year. The money to pay the investor is generated by an exit event.

There are three types of exit events: liquidation, initial public offering (i.e. “going public”), and sale of the enterprise.

Liquidation is usually a bad outcome. The company’s assets are sold, creditors paid and the remainder is distributed to the shareholders. Goodwill – the portion of value that makes the company worth more than the sum of its tangible assets – is usually lost.

Since 2002 going public hasn’t been a viable exit strategy for most growing companies either. Because of changes to federal laws, the process has become too burdensome for most emerging enterprises. And, given the economic situation in the United States today, there is little appetite for relatively small public companies.

Therefore, the only exit event available today is the sale of the enterprise to a larger enterprise.

Sometimes entrepreneurs erroneously believe that they can buy out their investors at some point in the future. However, because, as you’ll see below, the enterprise value is based on cash flow and that cash flow would be the way to pay an investor, it’s almost never feasible to buy out an investor.

For this reason, you should view all potential investors as true financial partners – you’re getting married economically to them.

This also means that, by bringing on financial partners, you’re agreeing to sell the enterprise in about five years.

Enterprise value for a sale exit event is generally based on a multiple of the EBITDA (earnings before interest, taxes, depreciation and amortization).

EBITDA is essentially your business’ cash flow. And the multiple is similar to a P/E (price to earnings) ratio in the public market, although a multiple is usually much lower than P/E for various reasons.

So there are two values that must be “determined” to arrive at enterprise value at the time of the exit: EBITDA in the fifth year and the appropriate multiple to be used.

This is where the emerging business valuation game is played in the investment capital world.

Your EBITDA estimate for year 5 is based on the financial projections (guesses) and assumptions in your business plan. There are always points of contention that will make the investor’s opinion of EBITDA in the exit year different from your opinion. But, your assumptions must be reasonable and must be specifically stated so your projection can be properly evaluated and defended.

Likewise with multiples. Multiples are a reflection of the risk of the enterprise going forward: a higher multiple means less risk. Multiples vary quite a bit by industry. You can increase the multiple (and the value of your company) by eliminating risk, such as, for example, by having paying customers or proving that your technology is commercially viable.

Putting it all together, let’s say, for example, you’re looking to raise $1MM. Your business plan financial projections show an anticipated EBITDA in year five of $5MM. Based on your research you believe that private companies in your industry area typically are valued using a multiple of 6. And you know that your investor will typically look to received $10MM in year 5 through the exit.

Based on your EBITDA and multiple estimates, the enterprise value in the fifth year should be $30MM. This means that, in order to receive $10MM of the $30MM sale price, your investor would have to hold 1/3 of the equity interests to achieve the desired return.

Therefore, you would expect to sell 33% of the common equity interest of the company for $1MM in the current year and the post-money valuation is $3MM.

Of course, this isn’t a science and opinions as to EBITDA and multiples will vary. To be taken seriously, you have to make an informed and reasoned valuation case.

Furthermore, professional investors will also include downside protection so that, if things don’t work out, they’re first in line to recoup their investment. As a result, they’ll purchase a preferred stock that provides these and other protections over and above the common stockholders.

So what happens if you don’t have sufficient cash flow to justify an investment? This just means that your business probably isn’t a candidate for venture funding or that you have to consider a different business model.

An accurate basis for valuing your emerging company will ensure you sell stock at a fair market price and don’t give up more equity than necessary to raise capital and it will tell you if your company is qualified to secured venture funding.

The above is provided solely as general information. It is NOT provided as legal, financial or other professional advice and should NOT be construed as such. DO NOT rely on the information in any way. You should NOT take any action or refrain from taking any action based on the above information. Rather, you should consult an appropriately licensed business lawyer for your particular situation.

Author: Edward Alexander
Article Source: EzineArticles.com
Provided by: Digital Camera News