… and Why Pigs Fail to Fly
By Jack Lander
Inventors and entrepreneurs who produce and market hot inventions soon find the need for money – lots of it. Tooling, inventory, marketing literature, etc., are all essential to get the typical startup off the ground, and all are expensive.
Enter the angel.
Angel investors and inventors, at least on paper, make for the perfect couple. Angels are willing to take a financial risk on innovations that emerge from individuals or startups. But angels aren’t charities. They look to the potential of your startup to repay their invention with interest – lots of it.
The rate at which your sales are growing, and the profit your sales are earning, largely determine whether the angel will invest, and if so, how much he or she will invest. The combination of sales growth-rate and profit determine the nominal value of your business, which, in turn, sets the amount an angel will invest for a given percentage of ownership.
On an episode of the television show Shark Tank, an inventor asked for $500,000 in exchange for 25 percent of his company. The investors called the inventor a pig because he had valued his company at more than four times annual sales.
We might forgive such insult from the sharks, but I felt that they owed the inventor at least a brief explanation for why his multiple was far too ambitious.
So, what is a fair multiple of annual sales as a value for your business? Not easy to say. First, the practice of using a multiple of annual sales as a means for valuation is misleading for businesses based on an innovative product or service. Profit growth should be the basic criterion of value, not sales. But annual sales is the common denominator of all businesses, and profit can be a variable that is much more difficult to pin down.
For valuing a gas station, a hardware store, a convenience store, etc., annual sales provide an easy first approximation. A startup business based on innovation, however, is very different than a routine retail business.
The difference lies in its potential for exceptionally rapid, and virtually unlimited, growth – not merely growth of sales, but growth of extraordinary profit, often due to limited competition based on a patent. To get to the logic of an appropriate sales multiple as the value of an inventor’s business, we have to start with the investor’s perspective.
Typically, investors want an annual return on their investments of between 30 and 35 percent. Considering the high failure rate of startups, the investor is justified. Startups are high risk ventures, and the angel must cover past and anticipated losses in his target return-on-investment or ROI percentage.
Furthermore, investors want to compound their money. For example, a 30 percent return compounded over five years is 1.3 x 1.3 x 1.3 x 1.3 x 1.3 = 3.7. This means the typical investor wants to approximately quadruple his money in five years. Most angels consider five to seven years as the likely period that will be required to bring a startup to its best sell-out potential.
Let’s say that the inventor/entrepreneur wants $100,000 for 50 percent of his business. What is the implication for the business’s earnings? The typical business sales dollar is allocated something like this: 60 percent for marketing, 20 percent for product cost, 10 percent for overhead, and 10 percent for profit. And let’s say that sales are expected to double every year. Assuming that the business will earn 10 percent, here’s how the first six years will look:
1st year sales: $100,000 profit: $10,000 (Owner’s profit; no angel involved.)
2nd 200,000 20,000 (Angel-investor and owner share 50-50.)
3d 400,000 40,000
4th 800,000 80,000
5th 1.600,000 160,000
6th 3,200,000 320,000 “
Total profit $630,000
Less owner’s 1st year profit $10,000
Net profit to be split 50-50 $620,000
Net profit to investor $310,000
The investor’s goal is 3.7 times his initial investment of $100,000, or $370,000, as against $310,000 net profit. Thus, even at a consistent sales growth rate of doubling every year, the investor fails to earn his target return.
But by reducing his investment to $83,800, the angel arrives at his target return of 3.7 times (3.7 x 83,800 = $310,000) or (310,000 divided by 3.7 = $83,800).
If the inventor agrees to yield 50 percent of his business for the reduced investment of $83,800, the total value is $167,600 from the angel’s perspective. This approach to valuation assumes the inclusion of intangible assets such as a strong patent, a repeat-customer list, and good will. Tangible assets, such as inventory, equipment, and accounts receivable add to the value.
Although the calculated approach provides at least an understandable rationale for valuation, angels may be more impressed by the experience and drive of the inventor than meeting an exact numerical target. In other words, gut feel may count as much as arithmetic.
The lesson for inventors and startup entrepreneurs is this: Be realistic about the present and the potential value of your startup. Appreciate the angel’s perspective. Do the math. Successful negotiations may depend on it.
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Ediors’s note: This article appeared in our January 2010 print edition.
