Start up businesses – how do you value them when you are looking for equity?

There are many ways to value a company. Some people use a multiple of normalized earnings. There are different multiples for different types of businesses and different locations of businesses. A business may have a higher multiple in a big city vs a town.

The multiple also changes depending on what part of the country you are located in. Some investors use discounted cash flow, others look at liquidation of the assets if real estate is involved. There are many different ways to value a business but none are applicable to a start up company.

You have a start up business which needs money to get to the next stage. Unfortunately, this is the most expensive type of financing because this stage of financing is very risky. The investor may not get his money back, there is no guarantee that the venture will be successful and there may be no liquidation value in the assets of the company if it does not succeed. Since this is risky, investors are looking for large returns. A person who will invest in this stage of business may be called an angel investor or venture capitalist.

They are typically looking for a 25% ROI. They play the numbers game, for every 10 investments they do, 8 will fail and 2 will be a home run. The return on the 2 will more than compensate for the loss on the 8 bad ones.

Since the investor knows that you have no options, they often may require control of the company. As a result, if this does not succeed, you may lose the company to the investor. Many people will try to finance the business to get it to the profitable stage, where the company is making money, not just about to make money. The risk of the business at this stage of the life is considerably less when you have cash flow and are profitable then when you are still incurring losses.

Your business plan and the amount of money that you need must be calculated. The more you ask for, the less you retain in the company. If you have no hard cash in the company, only sweat equity, investors will leave you with little equity in the business because they will argue you have nothing to lose, only time, not money. You need to ask only for what you think you need, if you are short, then you may have trouble raising more equity the second time unless you have negotiated with the investor, I need $X now, if I need more later, get them to commit to put in more later for a predetermined amount of equity. Often these investors will lend the business the money and want to control more than 51% of the shares of the business. If you ask for too much money, then you gave away more equity then you needed and you will not be able to recover the excess equity which you gave away.

If you have multiple smaller investors, you may be able to retain more than if you have one large sophisticated investor who will try to get as much as possible. Often venture capitalists and angel investors tell you what they are looking for if they want to invest in the business. You then have to decide if you like their offer or not.

This may sound very unfair for the entrepreneur but you have a choice, own a little of something large, if it is successful or own 100% of something that does not work.