When backing any sort of business, to ensure that there is every prospect of making an acceptable return on exit, it is absolutely vital that you do not pay too high an entry price.
If the company you are proposing to invest in is a five year old business with growing sales and generating its second year of trading profit in an established sector, it’s not particularly challenging to get the entry pricing right. An experienced investor would look at the company’s operating profit (EBITDA – an accounting term which equates to what profit (earnings) the company makes before deducting any interest on any loans it might have, any corporation tax liability and any accounting costs related to depreciating or amortising any assets it has purchased) and simply apply a multiple to the earnings to establish a fairly scientific valuation for the company. The multiple used will be what other investors have recently used to value similar businesses in the same sector – easily established through online research or by taking advice from a professional corporate finance adviser. In the absence of any available guidance from these sources, experienced investors will typically look at the profit multiples which are used to value similar companies on the Stock Exchange, and use the sector average multiple discounted by around 25-30% to reflect the fact that private company shares are less readily tradable than shares in listed companies.
In the above scenario, the only real issue to consider is at what point in the company’s financial year you are investing. Do you apply the sector multiple to last year’s profit or to the forecast profit for the current year? And, what if last year saw a profit of £100k, but the forecast is for £400k for this year?
These questions require the investor to do a bit of lateral thinking. If you are investing, say, just two months after a year end, you’ll be more mindful of using last year’s profit – whereas, if you are coming in two months before the year end, the forecast profit for the full year is much more relevant. And for a business looking to quadruple profit against last year on the basis of a credible plan, it would be folly to try to negotiate an entry price with any professional management team based on just applying the accepted sector multiple to the much lower profit for the previous year. In this instance, if the sector multiple was, say, 10, even if investing early in the year of the forecast quadrupling of profit, an investor might value the company at 5-7 times the forecast profit.
So, so far so good. And not too demanding!
But, how do we value a new company with no sales and no profits – as scientifically as we possibly can?
Benchmarking is one possible approach. If the new company is in a sector where other ventures have recently raised funding, it is possible to look at how other investors have valued similar ventures, with similar growth plans, and use this market data to derive a fair valuation.
So, if our new company has a not dissimilar business model to an identified recent entrant, and this player is projecting sales and profits of around 50% of that forecast by our even more promising entrant, it could be reasonable to look at valuing it in the region of twice the price paid by other investors to back the earlier competitor.
But let’s assume we are considering an investment in Start-up X, a venture in an established commercial sector and can’t find any benchmark valuation data. The business projects several years of start-up losses, but £5m sales and £500k EBITDA by Year 5. The initial funding requirement is £250k. An experienced investor would not expect to be offered the prospect of anything less than 6-7 times money on a successful exit.
If the company operates in a sector where valuations are based on an 8 times profit multiple, and the company sells for 8x £500k in Year 5, it would be worth £4m. So, our investor would need to acquire a shareholding at the time of investment of at least £1.5m/£4m = 37.5%. This would imply that the investor placed an initial value on the business of £667k (£250k for 37.5%).
Again, all well and good, and still with something of at least a partly scientific feel!
But, what if the company you wish to invest in is a completely new start-up in a nascent sector.
In these situations investors can really only look to the future – and, specifically, to a reasoned expectation for the value of the business when it is sold at exit and work backwards.
We can obviously ditch any benchmark approach, and there are no profits to which we might apply any relevant multiple.
Any investor prepared to back a completely new venture in a totally unproven sector would be well advised to be targeting a prospective return of in the region of 10 times money.
So, the investor needs to approach this very high risk scenario by taking a conservative view on the ultimate possible exit value. This is likely to involve a degree of “finger in the air” thought, coupled with having an eye on recent valuations applied to first or early movers in remotely similar sectors.
Whatever the view taken, the investor has to apply exactly the same principles as with Start-up X to ensure that a 10 times money return is a feasible outcome – i.e. work backwards from the assumed exit value to get the entry terms as right as they can be.
As a footnote, all of the above does not take account of the array of tax incentives which are available to private investors under the Enterprise Investment Scheme (EIS). The scheme offers 30% income tax savings, tax free profits on exit and loss reliefs if a start-up investment was to fail. In simple terms, this means that a 45% higher rate tax payer is only risking 38.5p in every £1 invested in a qualifying company.
Investing in start-ups can be incredibly rewarding, but the risks are high. By being focused on getting the entry pricing right, an investor is adopting the right approach.
Note: The contents of this article are the author's opinion and have not been approved as a financial promotion.