What attracts investors and drives the value of startup companies?

Starting a business can be an exciting but stressful endeavor. Founders often hear about the risk in creating a new business or trying to get a novel idea off the ground. You’ve weighed the risks and forged ahead, but you need funding to get started or continue growing. That funding could be in the form of cash or in-kind services. Many startups will give out an interest in the company in exchange for funding, but how are these interests in your startup valued?

Value is driven primarily by risk versus return. As your risk decreases, your value grows. As your expected future returns increase, so does value.

Future earnings for startups with no revenue or negative cash flows is difficult to forecast and highly speculative, as value requires economic substance. An idea has value if it can be monetized at some point in the future. Your startup likely has value even if you are not currently producing returns.

How stages of development impact risk

An investor’s perceived risk of your startup depends on your enterprise’s stage of development. Brand-new companies have an idea but not much else. Companies in earlier stages are focused on product development and generally have no revenue. Later-stage companies have established sales but still have negative cash flow. The latest-stage companies are typically at break-even or positive cash flows and are nearing a sale or IPO.

These stages affect your earnings potential and the financing available to you. The earlier the stage, the higher the risk of achieving results, which impacts the required return an investor is looking to receive. Investors typically require around a 50% rate of return for brand-new startups, while a 25% return is generally required for companies in the latest stage, since the probability of success is much higher. The required rate of return is directly tied to the riskiness of each stage.

Quantifying risk and determining value

Risk is not only impacted by earnings. Investors will also look at factors that will predict future success. Investors will analyze the quality of your concept, its market potential, costs, and the management team’s ability to capitalize on the idea.

Finding investors in your startup is only half the problem. Once you have interested investors, you will need to know what your company is worth. If you give a 10% interest to an investor, how much is that 10% worth? Or if you’re looking for a $100,000 investment, what percentage interest does that equal? Value can change daily and can be impacted by many different actions.

That’s why it’s essential to work with someone experienced in valuing business interests. Valuation specialists consider future income, growth, and risk relative to achieving prospective results to estimate the value of the potential investment.

There’s a lot more that goes into arriving at a reasonable value for an interest in your startup. We’ll dive deeper into how that value is estimated — as well as the different financing options for startups — in our presentation on Feb.17. Register now: http://events.greatergbc.org/sbaweb/events/events.asp?details=true&cale_id=2349&month=1/28/2021

Blog provided by:

Lisa Cribben, CPA/ABV, ASA, CMA, Partner, Wipfli LLP
Zachary Liermann, Consultant, Wipfli LLP