The following is a guest post by Dan Smith, MBA, a Business Coach, Consultant, and Project Manager at Fusio Solutions. He works with a lot of small businesses trying to raise money from investors. He hears all sorts of pitches and has done his fair share as well, so we asked him for his insight on what a business is worth and how to value a company.
The entrepreneur turns to the Angels in the room and says, “We are looking for…” the amount, basic terms, and timeline are confidently presented by the entrepreneur. Slightly puzzled looks sweep across the investors faces but for the most part they remain poker faced. One Angel asks, “What is your pre-money valuation?” The entrepreneur, without fear responds, with a double-digit million-dollar valuation for his company. She follows up by reminding the investors that with his conservative estimates he will make them independently wealthy. The business seems interesting, the presentation even refined, but the investors are left scratching their heads wondering what planet the valuations came from. They ask, “How did you do value your company?”
Angel investors have heard the same confident projections many times before, but few entrepreneurs deliver. Potential investors do have some belief in your concept or else they wouldn’t be listening to your pitch, but after you leave the room, Angels talk openly saying: “Where in the world did they get that valuation from?” This is not a war of optimism versus pessimism, but a real difference between realistic valuations and the numbers many entrepreneurs come up. When it comes to startup valuations, it seems that entrepreneurs continue to struggle to get anywhere near the correct galaxy regarding what their fledgling business should be worth.
I have some insight on both sides. I remember when I did my first investor pitches. Like so many failed entrepreneurs before me, I decided how much I wanted to raise, how much equity I was willing to give up. Magically the company had a value just high enough to support the desired raise and desired give. Like so many others, I thought this made sense, but in reality, on this planet, savvy investors will keep their wallets closed when they sense this kind of rationale.
As an entrepreneur, you are sold on your business and believe it will be worth millions! Rightfully so, to you this is your concept and you should be all in; however, you need to reign in the numbers while keeping your enthusiasm. After many missed investor pitches and now working directly with angel investors, I realize how much entrepreneurs need to bring in the numbers a little closer to Earth. Remember, to an investor an idea without proof of concept it’s just an idea.
Real “proof of concept” happens when people paying your business money for your products and services. Any money you need to get past this stage is going to cost you the most equity. There are many valuation models and formulas that can be used once your company is generating revenues. So until that time, the risk is greatest on the person putting up the cash. The more revenues or contracts for future revenues you have, the more your business is worth, and the less you will have to give away to get the funding you need.
If your company has no revenues, no customers, no contracts, no real proof of concept, and your money slide of your investor “pitch” is touting a valuation north of $1-2 million dollars, then you need get Earth back into your sights. It’s important to know how to realistically value your company.
If you can get some friends and family to put money in at first or you can cash flow your business current growth until you have a few million of revenues on the books. Then you may reasonably justify a multi-million dollar valuation. Until that time, stay a bit more grounded reality, and accept that you will have to give up a lot to get a little at first. Increase the chances of getting that investor check by at least being in the same orbit on your businesses value.
Related: How to find ideas for a product
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