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Start-up Business Dilemma 101: How to Value a Company That Has No Revenues Yet? article

Source: http://angelinvestornews.com/ART_acenet2.htm

 

The books on how to prepare a business plan usually prescribe a discounted present value of cash flows approach to valuing a start-up business. Entrepreneurs develop a three-to-five year projection of net operating cash flows (inflows, generally from sales, less outflows for production and other operating expenses, interest payments, and taxes.)  Then, they add those flows and discount them using an interest rate in line with the risk/reward parameters targeted investors are looking for - 20-25% returns.

 

 For example, say a business expects to generate $25 million of net cash flows over the first five years of operation, growing from zero for the first year, then $2 million, $5 million, $8 million and $10 million in the next four years, respectively. Discounted at the 25% rate, that pattern of cash flow’s net present value is a bit below $13 million.

 

 But, is this value real? We would argue that it is virtually devoid of reality, especially since the start-up company has no revenues and the valuation is based on expectations of future outcomes that are highly uncertain.   Furthermore, this value – or some other – will be a cornerstone in the process of determining how much company ownership the entrepreneur will give up to the angel investor, given the amount to be invested.  No matter how many potential customers have raved over the business concept, until cash is actually in hand, it has virtually no value.

 

 Our advice to entrepreneurs is that they avoid trying to place a value on start-up company offerings, allowing for discussions about this further down the line when they have attracted serious attention from potential investors and are at the stage of negotiating an agreement.  Even discounted at a fairly steep interest rate, as in the example above, these kinds of projected cash flows have little credibility, something the hopeful entrepreneur cannot afford.  Savvy investors simply won’t believe them, so they make the entrepreneur look naïve, at best, or egomaniacal, at worst.  While angel investors appreciate the enthusiasm with which entrepreneurs promote their business concepts, angels invest - first and foremost - in people, not numbers.

 

 In this second part of a three-part series devoted to the special business planning needs of entrepreneurs with business plans for start-up businesses seeking angel investor funding, we discuss the reasons for not attempting to value the deal for as long as possible. 

 

 In my previous article for the March AIN newsletter, I addressed how entrepreneurs can develop pricing strategies to obtain the highest prices available for their products and services.

 

 The reasons for developing estimates of cash flows for the 3-to-5 year investment time horizon attempts to pinpoint when the start-up might reach the break-even cash flow point for the first time and when it will subsequently break-even cumulatively. In the final part, we will discuss a critical factor in cash flow planning, how to optimize the process of pricing the start-up’s new product or service.

 

 For more information on ACE-Net or to contact Mitchell, visit www.ace-net.org