Following on the heals of last week’s post from Andrea Belz, we have another guest blogger, Bob Aholt. Bob is a Director and long-time member of the Pasadena Angels, has been investing in early stage companies for 5 years, and has been held numerous “C” level positions at private and publicly traded companies. Bob also teaches graduate level finance courses at Antioch University.

  By Bob Aholt

To set the stage, as an early stage investor, I look to invest in a “perfect storm” company.  That is, I’m looking for a great Entrepreneur, a great product and a great deal.  I’ll leave the discussion of what comprises a great idea and a great people for another post, but here I’ll give my rational behind what constitutes my version of a plausible deal.

It all centers around Return on Investment, or otherwise known as ROI.  The higher the ROI the better the investment – brilliant eh?

Now for some details.  Lets start with the definition as presented at Investopedia.com (one of my favorite resource sites).

For this conversation, I’m going to focus on gains exclusively from a sale and forgo a discussion on ROI from cash flow.  Not that it’s irrelevant or infeasible, just that early stage investments are generally more exit strategy centric.

So for an example lets assume a $500k investment in a company with a $600k pre money that professes to have an exit plan that will garner a $5m sale in 5 years.  The investor ROI on this is 355%.  [Gain = $5m *$500k/$1.1m], [Cost = $500k].   The gain divided by the cost of the investment is often referred to as the multiple.  In this case 4.55.  Typically, I hear the “multiple” referenced more than ROI in Investor presentations. Since they are derived from the same parameters, they are rather synonymous, but as the ROI calculation includes the time parameter, it’s more relevant to me.

Two other statistics that also come up are Net Present Value (NPV) and Internal Rate of Return (IRR).   Excel quants will be able to calculate these fairly simply, and in this example come to $828k (at 10%) and 35% respectively.  However, from my point of view, really only the multiple or ROI are necessary.  That’s because all these numbers are all based on a rather large set of assumptions.  That’s where I’ll turn my attention next.

Assumptions:  everyone knows how the game is played.  All Entrepreneurs say their projections (from revenue, to expenses to exit values) are conservative.  All investors feel they are, at best, an educated guess.  From what I’ve seen, and what I appreciate most, are a couple of different scenarios – best case, worst case and expected case – with the parameters and assumptions clearly laid out.  If I can buy into a plausible scenario where the exit is approximately a  400% ROI or a 5x multiple in 5 years then I’m willing to go further along in the conversation.

As someone looking for funding, lay out your case as to why your company will be bought for $5m in 5 years (in the above example).  As an Investor, I understand that 5 years out is an eternity for an early stage company, and the scenario has a better chance of being wrong than right, but I need to know the Entrepreneur has thought through the process and that the scenario is realistic.  Sure there’ll be adjustments, course corrections and outright changes to the business model, but my end goal is still a high ROI and I need to know the company understands that perspective.

In the financial part of a presentation, I’m also looking at the company’s validation points.  From inkling to viability my list includes:

- idea – is this all the company has at the moment
- beta – is there a proof of concept to show
- customers – is someone using the product
- sales – have the customers agreed the product has value
- gross margin – can the company make the product for less than its sold for
- operating profit – can sales cover the cost of doing business too
- positive cash flow – a going concern

If the company can present a timeline showing each of these milestones, or at least the ones that get it to the exit point, the story becomes much more plausible.

Since an investor is focused on ROI, the implication to valuation now becomes clear.  All else being equal, the lower the valuation the higher the (potential) ROI.  Using the example above, if the pre money were $1m instead of $600k, the ROI drops to 233%.

A note about subsequent raises and dilution.  If the company is going to need more capital than Angels can supply, that’s ok.  There are plenty of examples of Pasadena Angel companies that have had multiple rounds of funding and provided quite good returns to the investors.  The Entrepreneur needs only reflect the smaller ownership percentage of the initial investors in the ROI/multiple number. Usually the follow on funding is presented in a scenario where the exit amounts are higher, so mathematically, the results could be a wash.  Again, for me transparency, plausibility and clear assumptions are most critical to persuading.

So to sum it all up, an investor’s ROI depends on three things: exit price, the length of time to the exit and the percent of the exit received by the investor.  The first two – sale price and duration – are heavily influenced by the quality of the idea and the people executing (not to mention luck).  Valuation (and any subsequent raises) are casual to the percent of the sale received by the investor.  And valuation is the only variable in this equation that can be controlled at the time of investment – that’s why it becomes such a critical negotiation point.

Hypothetical Example
THE RAISE
Investment    $500,000
Pre Money    $600,000
Post Money    $1,100,000

OWNERSHIP
Founders    55%
Investors    45%

EXIT
Sale Price    $5,000,000
Time    5 years

INVESTOR RATIOS
ROI    355%
Multiple    4.55x
IRR    35%
NPV @ 10%    $828,000

 [Editor’s Comment] In a previous post, we mentioned recently meeting Dr. Tom McKaskill (aka Dr. Exit) and were impressed with the vast knowledge and wisdom he’s shared over the years with entrepreneurs and startup companies around the world. Beginning with today’s post, we’d like to welcome Tom as a regular contributor.  Check out his website at www.TomMcKaskill.com.

I am continually amazed at how little entrepreneurs know about building value in their business as part of a process of selling their business. Not that I should be that surprised having spent many years now educating business owners on how to best prepare their businesses for sale and how to generate a premium on sale. But the thing that constantly amazes me is the fact that their professional advisors and business brokers know little better.

Fundamental to the sale process is understanding the value which the buyer will extract from the business. Without question, this comes in the future not the past. That is, the value of any investment is derived from a future stream of income. That being the case, why is it that advisors and brokers force business owners to use past profits to value a business – normally using an industry EBIT valuation model which is more guess than science.

When you think about this a little more seriously you can see that a business which makes the effort to provide the buyer with a different, more positive, more profitable future for the business being sold, should get a higher price than simply a multiple of past earnings. This can lead to two possibilities: the buyer can extract more from the existing business than the seller or the buyer can utilize the assets and capabilities within a much larger business thus exploiting the underlying assets and capabilities much more than the seller could.

Clearly, the process of extracting value is to find a buyer who can exploit the business better than you can. The objective is to create future potential for the business way beyond the current owner’s capacity and capability. By finding multiple potential buyers who can generate greater value in the business in the future than that which could be generated by the current owner, the seller can readily achieve a premium on the sale.

If you are a business owner, you need to break away from the past and concentrate your preparation on what the future of the business might look like in the hands of a much more capable and better resourced buyer. Then go find those buyers who can best exploit the potential in your business. By setting them up in a competitive bid, you will be able to extract the best price for your business.

However, a word of warning. Make sure your buyer can deliver on the potential – otherwise you won’t be believed and their lawyers will come after you wanting to get the money back because they (and not you) failed to deliver on the potential.