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What will an investor expect in return? 28 July, 2006

Posted by varoom in Business Plans.

Some thoughts on what shareholding potential investor will ask for in exchange for an investment

The criteria for investor participation in your business are wide and varied. But it continues to surprise me that many entrepreneurs are shocked when they see the share holding requested by investors. There is a simple calculation you can do yourself, based on figures in your business plan, which will tell you the shareholding you will have to give up to gain an investment.

Firstly you should understand that the investor is looking for a return on their investment over a certain time period, lets say 5 years. The return could well be in the order of 10 times the original investment. So an investment of 100k in your business today should yield a return of 1Million in 5 years.

How could they get that return on investment? Well many ways; firstly the company could be floated and the shares owned by the investor sold to get the return. Secondly the company could be sold in a trade sale to another company in a similar business. Or finally a sale back to the shareholders or management buyout.

When reviewing your business plan the investor is trying to build up a picture of the business potential, the investment risk, the product risk, the market growth potential and an assessment of the people involved in the business. He will use this assessment in the valuation of your business.

How do they value the business? One important factor is the business size in 5 years time. They look at the Profit forecast in year five and multiply this with a figure which is typically in the range of 5 to 10. The lower number will reflect a more risky business and a higher number reflects more confidence in the business. This number is driven from their own risk assessment of the business proposal.

Another important factor in this evaluation is the business value today.  If no development has been done so far, or no investment has been made, or no market demand is clearly demonstrable then this will undermine the future valuation. If you have a working prototype, existing customer demand or even sales, then you have a stronger justification for the future value of the business.

Now the take the original investment which must yield a 10x return and divide that into the valuation of the company to get a rough shareholding needed to provide that return. For example:

If your projected profit in year 5 is 500k and the investment required today is 100k then the investor will take their assessment of risk (lets say 5x multiplier) and this will yield a company valuation of 2.5Million in 5 years time, so in order to get a 1Million return he must have at least 40% shareholding of your company. No doubt he will try for more than 40% to get increased reward for the risk.

If the investor has some concerns about the risk there may be more requirements on your business set by the investor to mitigate those risks like having other investors join in, specific board members or recruitment of Chairman or Marketing director.

The above simple calculation is NOT the only factor considered by investors, but it provides a good estimate of the range of shareholding likely to be requested by a potential investor assessing the business.

Notable exceptions tend to be special cases like Business Angels or VCs who specialise in a particular class of investment. But the rule of thumb above is a good guideline.




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