Many advanced R&D firms will need equity investment to bring their technology to market. The first round of funding, also known as seed money, was most likely provided by the company founders and friends, supplemented by SBIR awards, and was used to conduct high-risk research and development.
Once these development efforts have met with success, attention more urgently shifts to seeking other sources of funding to complete the commercialization process and bring the new technology to market. It is not uncommon for young R&D companies to have little experience with the investor community and investor expectations. The purpose of this article is to clarify their expectations and provide guidance on how to prepare for success in obtaining financing.
Of fundamental import is conducting an opportunity assessment for the technology or product. This starts with identifying customer needs that can be uniquely addressed by the company’s technology. The opportunity assessment should touch upon:
This assessment is at the heart of the company’s business plan, developed to show the commercialization road map and used in approaching investors. A good business plan is based on a rigorous assessment of your assumptions. An investor expects that a company will do the hard work involved with segmenting and sizing the opportunity. Company representatives must be intimately familiar with the source of information substantiating every detail of the entire business plan. Investors see the business plan as a reflection of the company and the commitment and drive of management.
It is important to note that investors do not wish to meet with companies that do not have a complete business plan ready for their review. While a venture capitalist (VC) does not expect company leaders to be experts in all fields, they do expect the management team to have answers to their questions. Bear in mind that statements made in the business plan should be substantiated as much as possible and that overly optimistic projections can raise many questions. This isn’t just about selling a financial plan to investors, but the company’s vision and future goals need to be well presented, as well as the way the management team will assist the business in achieving its potential. The venture capitalist will want to know exactly how much money is being requested and how it will be used. They also want to clearly understand how the investment will be repaid and what the exit strategy will be.
What does it take to have a complete, impressive and effective business plan? As to the actual length of the report, it depends on the complexity of the business and may be as many as 20 to 30 pages. When beginning the writing process, start by including all of the relevant details of the company’s past and a list of its key players. There should be a concise description of the five year plan, making certain to mention key problems and the plans to overcome them. Now is the time to be honest and open. Investors do not want big surprises down the road, especially if they could have been avoided.
It is also important to be realistic and reasonable about the amount of money needed to attain the company’s goals, with the thought in mind that it often takes more money than initial estimates predict. When considering the valuation of the company and the contributions made by each team member, do not cut corners. As for forecasting, again, be realistic. The VC is going to be conservative, so back up estimates and explain any assumptions being made.
Remember that a business plan has a five year horizon. The detailed outline below is organized in a way that will assist in building a logical business case for both internal and external use.
The company’s Pro Forma Financials (i.e. projected cash flow and income statements) should extend a minimum of five years out, which is often the time period an investor looks to for an exit scenario.
Because venture capital is extremely expensive, startup companies will have lower valuations and often have to make significant concessions in getting their first round of funding—especially if initially funded by VC’s. Due to this circumstance, entrepreneurs should negotiate with multiple providers of capital, which could either raise a company’s valuation or speed up the process—bringing a final deal, amenable to all parties, to the table more quickly.
Investment Returns and Percent Ownership Required So, what do venture capitalists expect for returns and what percent of the company will an entrepreneur have to give up in exchange for this investment?
The answer depends on the stage of investment and the time to exit. The chart above shows the expected returns for each stage of investment. Another question is how much equity in the firm will need to be relinquished in order to receive this investment? This is where Pro Forma Financials become important.
One valuation method, called the Venture Capital Method, bases the valuation on net income projected in the last year of the exit (typically the fifth year). This approach discounts optimistic future earnings to present value, at a subjective required rate of return specified by investors. A typical Venture Capital Method approach contains the following steps:
The following example shows that the company’s value in year
five, when sold, will be $30 million based on a Price Earnings
Ratio of 15X. For an investment of $1M, the percentage of the
company required to earn 10X, or $10 M, would be 33%.
Many investors use EBITDA rather than net earning to value a company. EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation and Amortization, strips out the affects of leverage and accounting assumptions regarding write-offs of investments. When used, the Price Earnings Ratio is replaced with the EBITDA multiple—the Enterprise Value of the Company (equity plus debt) divided by EBITDA. The multiples tend to be lower than P/E ratios.
The disadvantages of the Venture Capital Method are:
Because of its simplicity and the fact that the technique strongly benefits the providers of capital funding new ventures, the method is widely used. Thus, entrepreneurs need to be prepared to counter its use with more accurate valuation methodologies and understand these alternative approaches. In the next edition of this magazine, some of these alternative methods will be discussed. ♦
Literal use of this valuation technique by a founder will almost certainly increase the valuation gap between the investor and the founder, and that increase may preclude obtaining otherwise available financing. Founders expect to be the next Microsoft; investors expect that they will write-off or break even on 90 percent of their startup and early stage investments—including the promising ones—and the odds are worse when the founder has the “I am the next Bill Gates” disease.
Investors see founders who are improperly fixated on “How much of my company am I giving up?” The more relevant questions are: “How do I successfully commercialize it and what does it take?” and “How much can I make off it?” Ninety percent of a failure is worth less than 10 percent of a success.
First, the investor will dramatically discount the projections by assuming slower revenue growth, higher costs and lower margins— all of which result in a lower exit value occurring later. Remember, few successful companies implement their original business model and even those that do are usually behind schedule and over budget.
Investors expect insightful, rigorous planning reflected in detailed projections, but they use them to evaluate the business acumen and realism of the founders, more than to estimate the value of the company.
Second, for startup and early stage companies, investors focus on time investment earned much more than IRR (internal rate of return), usually expecting ten times the investment. The investor does not expect a liquidity event for these companies for four to seven years, so the pay off will be over ten times.
IRRs have serious limitations above a 20–30 percent annual return, especially for valuing individual companies. They are useful for comparing portfolios, and even then, they have serious limitations, especially the re-investment and timing assumptions.
Thus, using this method, with the optimism embedded even in “conservative” projections, the founders are likely to value the company at several times what the investor will value it.
Companies, like any investment, are valued by the lowest of three methods:
Since investors are seeing many investment opportunities (dozens a week) and they usually have the opportunity to invest in other equally promising companies well below the valuation derived by this valuation technique, the comparables method will often limit the value. Even where the investor sees a higher return possibility, it will be reflected more in a desire to invest, perhaps at a slightly higher valuation or in other deal terms. Rarely, will it actually set the valuation.
High-quality projections are necessary to get the investment, but won’t usually drive the valuation.