Tern Insight Guide

Attracting and securing investment: three models

Running a start-up or an SME? Whether it’s already crucial to your development plans, or merely a quiet hope in the back of your mind, it’s likely that you’ve at least considered the question of attracting and securing investment.

And little wonder. Injections of investment cash, whether from venture capitalists, crowd funders, angel investors or more traditional financial institutions can be the engine for a wide variety of actions. They can power the development of new products or services, and the expansion into new markets. They can enable small businesses to finally move to premises or purchase equipment that will match up to their growth plans. They can introduce new expertise and experience to small teams, enabling start-ups to learn from the track records or benefit from the contacts enjoyed by industry stalwarts. Investment, in short, can be the difference between standing still and becoming the next great success story.

As such, it is vital that any start-up or SME with half an eye on the future is both positioned as attractively as possible to potential investors and valued accurately.

How?

Three valuation models

The truth is, there is no hard-and-fast scientific method for valuing businesses of any size. Start-ups and SMEs, which tend to be changing and growing very rapidly, and don’t have a track record of many years of performance behind them, can be even more difficult to place a price on. And the technology industry, with its enormously rapidly pace of change, can make things more difficult still.

Nevertheless, there are some general principles which any business owner can follow. Broadly speaking, there are three general business valuation models: asset-based, market-based, and income-based. Organisations may follow just one, or straddle two or three, but the principles remain the same.

Model 1: asset-based

This model focuses above all on the physical assets within your business. Add up their value, take away your current liabilities, and you have an asset-based idea of the value of your business. The asset-based model is, therefore, particularly suitable for businesses which incorporate a large volume or particularly  high-value physical assets, such as manufacturing equipment, vehicles, or even a large amount of physical stock. Meanwhile, if you are interested in selling your company outright rather than securing investment, then you will probably need to follow an asset-based model as a matter of course, so as to determine the asset purchase agreement.

Asset-based valuation models are often complex, expensive and time-consuming to develop. They require specialist skills in asset and liability valuation, and a keen understanding of the equipment you actually have in place.

Model 2: market-based

This model takes a future-gazing approach, focused on estimating future earnings. It does this by looking outwards, examining similar companies and the transactions and earnings they have recorded. By generating an accurate picture of performance in the market in general, this model aims to place the company in question within that market, and compare it sensibly with similar organisations.

Market-based models face complex challenges in terms of sourcing and analysing pertinent data. Actually identifying companies which provide a reasonable comparison can itself be difficult, and then accessing the relevant data can be difficult again, particularly if those competitors are small. From there, you need to deploy pricing multiples, which allow you to estimate business worth in relation to business performance.

 

The advantage of a market-based model is that it contextualises your business in the wider marketplace, which often helps to reassure investors that you have carried out a comprehensive competitor analysis and considered your own USPs.

Model 3: income-based

The income-based model, like the market-based model, takes a future-gazing approach. However, in this case the focus is on future earning potential, through measures of economic benefit such as discretionary cash flow or net cash flow. It is obviously appealing to potential investors in that it provides the clearest picture of potential return, and it is often considered to be the most accurate of these three approaches. Nevertheless, it also requires some complex calculations in terms of either discounting or capitalisation of business earnings. 

Mix and match?

In most cases, the best course of action is to blend two or even all three models, ensuring that you properly take into account your physical assets, the growth potential of your sector and the competitors you are up against. It is almost always worthwhile bringing consultancy on board to advise on the best blend, the data you will need to collect and the calculations you will need to undertake.

One good rule of thumb to follow is that if the valuation process seems quick and painless, the chances are that you have overlooked something important or taken too light an approach. Business valuation is a complex procedure; it will usually feel complex.

 

How much investment should you request?

This really is a ‘how long is a piece of string?’ question. Every investment pitch is different, just as every business is different. The stage your business is at in its development can provide a rough ballpark, however. Have you merely developed a minimal viable product (MVP) and put together a business plan, or have you already got your first revenues in place and a cohesive, highly-skilled team? 

Very broadly speaking, organisations tend to seek up to around £500k when their initial minimal viable product (MVP) is complete and a business plan is in place, up to around £750k once a working prototype has been developed and the first customers are in place, and up to £1m once the proposition is clearly very attractive to investors with a strong market full of potential. Investments of over £1m are generally reserved for businesses which are already earning revenues and have both an exceptional financial track record and forecast.

Looking good: positioning your business attractively

Selecting the most appropriate model for valuing your business and a ballpark figure you are seeking are, however, just two pieces of the puzzle when it comes to attracting and securing investment. Given that having an attractive proposition is also key to establishing an investment value, you also need to think carefully about you to position your business as attractively as possible for that investment. Business value, of course, is not merely about financials.

 

Here are some points to consider:

 

Business plan and financial forecasting

Obvious? Perhaps. But it is so fundamental that it is still worth emphasising. Any business seeking investment to help with innovation and growth needs to have a very clear trajectory in mind for the coming months and years, and needs to be able to communicate that planned trajectory to potential investors. Whilst business planning always necessitates a certain amount of educated guesswork and ambition, there is still a wealth of guidance available to help develop the most accurate plan possible.

Team

People are the lifeblood of any business. You don’t necessarily need to have a complete team in place to secure investment; many businesses seek investment precisely, so they can develop their team, or draw on third party expertise. However, you do need to be able to demonstrate why every individual within your business is there, demonstrating the value they add and their commitment to the future success of the organisation. Recruitment and retention can be costly challenges for start-ups and SMEs, so it is a huge bonus to be able to demonstrate how you have them under control.

Prototypes

If you are in the business of selling physical products, then having an engaging prototype in place is non-negotiable. Very, very few investors get involved on theory alone. Whether you are an early stage start-up working with an MVP, or a more established SME with an active product line, you need to ensure that the samples you share with investors are as compelling as possible.

Energy and personality

These elements are often overlooked. But investors look for people they can work with as well as product or service ideas they can generate return from. Many organisations fail to secure investment not because the underlying idea and plan was unsuitable, but because the leaders fail to understand the communication and collaboration involved in bringing investors on board. Positioning your business attractive for investment also means positioning yourself attractively as an investee – as someone with drive, ambition and business nous, but also someone who is willing to listen, learn and adapt where necessary.

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