These days there is an explosion of startups seeking funding for their ideas, concepts and plans. And there are a lot of investors with money looking for places to put it to work. You’d think the matchmaking would be easy. So why isn’t it? Here’s an example that best answers that question.
Suppose an entrepreneur has started and grown a business with exciting prospects, and she wants to raise some equity money to help it realize those prospects as soon as possible. She values her business with its exciting future at $5 million and wants to raise $2.5 million more. She reasons that a third of the value (2.5/7.5) should entitle the investor to a third of the business, or 33%.
An investor, however, with less attachment to the business and its yet-to-be-realized prospects may only think the business is worth $2.5 million today, given the uncertainty of realizing its full potential. His view may be that it will only be worth $5 million after he has made his investment. Thus by his logic he should be entitled to 50% of the business for his investment.
Who’s right? Neither, or both. It all depends. Oh, yeah, I said that up front. But that’s the rub. Because business valuation is at best an estimate of future events, and especially when there is no consistent pattern of such events, e.g. an established pattern of profitability, the level of uncertainty makes any negotation a highly subjective exercise. This subject is covered in more depth in Chapter 12 of my book, Finance for Non-Financial Managers, McGraw-Hill 2003.
What do you think? As always, your comments and suggestions are welcome.