Start-up companies can be excellent ways to enjoy a massive capital return if they succeed. The problem is that investing into” the next big thing” is tricky and in some cases, downright financially dangerous. Remember, that as the company has not yet floated, there can be many transparency issues. Although the managing directors may claim that their business is worth £10 million pounds, is this the truth or merely a sales tactic to attract crowdfunding firms and punters? This may be difficult to answer and it is critical that a realistic valuation of the company takes place. But how can this be achieved?
1. The Problem of Subjective Valuations
It only stands to reason that ANY firm looking to attract investors must portray itself in the most financially attractive right. Unfortunately, this can lead to valuations which are much more “optimistic” (to put it nicely) than they are realistic. Although this could be an accident, many companies tend to value themselves based on their projected gains as opposed to their current status. This is one of the main reasons why investors only receive an average of 12.4 per cent equity for what are very large sums of initial seed investment. For an untested company, such valuations can be dubious at best.
2. Looking at the Big Picture
Determining the potential value of a start-up company is as much of an art form as it is a science. In other words, there are no “sure things” with such a process. Still, it is always wise to look at other factors, which may affect the success (or the lack thereof) of the firm, into the future. Some major metrics to evaluate are:
- The demand for the product or service that is being offered.
- The current state of their niche sector or market.
- The reality that the company will be able to raise enough capital, not just to start up, but for continued growth and success.
- The desperation of the company to secure the necessary funds.
Having said this, it can be argued that the single most important determinant is the state of the market that the company intends to enter. However, we are not only referring to today’s condition. We must also take into account how today’s condition may impact the future.
3. Risk Versus Reward
The ultimate goal of anyone who becomes involved in a start-up is the ROI (return on investment). What level of return do you expect and will this outweigh the potential risks involved? What is the time frame that you hope these returns will be delivered in? If you hope to make a return of 50 per cent over the next two years and a company is currently valued at £5 million pounds, the firm will need to be sold for no less than £7.5 million pounds during this time period. This can be a tall order; particularly if the company is promoting a relatively unknown product or service.
4. The Power of Objective Valuations
Objective, realistic and transparent valuations are critical before making any type of financial commitment. Let us not forget that a sizeable portion of start-ups fail within the first few years. The only way to avoid being caught up in such an undesirable scenario is to do your due diligence from the very beginning and question valuations. A bit of research and foresight can go a long way.
Tim Aldiss writes for Shadow Foundr: don’t just follow the crowd, follow experienced investors.