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:
The baseline technology being used to address the
needs of targeted customers. Then the shortfalls
presented by the current technology, the magnitude
of the necessary improvements needed and the
customer’s sense of urgency for finding a better
solution should be determined.
The value proposition, which indicates the magnitude
of improvement and the economic benefits and also allows a customer to justify the purchase of the
The size of the market opportunity. Indicating the number
of potential customers and confirming that the
group is large enough to justify a commercialization effort
that offers an attractive return on investment.
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.
Make Sure the Plan is Complete
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
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.
The Making of a Good Business Plan
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.
Company & Technology
Marketing / Sales Plan
Human Resource Plan
Plans for obtaining investors or strategic alliance
Pro Forma Profit & Loss statements
Pro Forma Cash Flow projections
Pro Forma Balance Sheet
Plan for the Exit Scenario
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.
Valuation—The VC Method
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:
Estimate the company’s net income at the time the
investor plans on harvesting. This estimate will often
be based on the sales and profit margin projections
provided by the entrepreneur.
Determine the appropriate price to earnings (P/E)
ratio, by studying current multiples for companies
with similar economic characteristics.
Calculate the projected terminal value by multiplying
net income by the P/E ratio.
The terminal value can then be discounted to find
the present value of the investment. VC’s use discount
rates ranging from 35 to 80 percent to account
for the optimism typically present in the cash
flow forecasts of entrepreneurs.
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:
Company value is linked to a single year of company earnings.
Other sources of capital may have a lower cost of capital.
Comparable companies for deriving the P/E ratio are frequently
not truly comparable.
Typically applied before new ventures have reached stable
cash flow growth.
The investor f the envelope” approach
and thus can be used by virtually anyone.
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. ♦
The Venture Capital Method: An Investors Perspective
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
The income they are expected to produce
(the method used here),
comparables (the valuation for other promising companies
in which the investor can invest), and
replacement cost (what does it cost a competitor to duplicate
the product, management team, etc. and work
around IP protection).
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.