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Valuation - like beauty - truly is in the eye of the beholder.
The business partners are asking for an investment of £225,000 at a £3,750,000 valuation. This is calculated by dividing 225,000 by 6% which is the stake that they are willing to sell. At £3.75 million, in US dollars, the valuation would be pegged at $5.951 million.
Online Dragon Julie will write updates of Den activity throughout the 2010 series.
This episode shows a lot of the issues that entrepreneurs and investors face when the founder of a business has his or her own means to invest.
Michael Ehrenreich has invested $1.3 million of his own money [£820,000]. It's hard to know what the real picture is, but based on what we saw on last night's programme, my personal guess is that his aggressive valuation is due to the fact that he trying to preserve the value of his own stake bought with cold hard cash.
Four years ago, he raised capital at a $4 million valuation, but he has only $40,000 in the bank with substantial losses.
There are many ways to value a business. Ultimately in the marketplace of investors and entrepreneurs, what one is willing to pay trumps everything.
With cumulative losses, and, in their own words, only $400,000 of revenue over the past twelve months, not to mention the small amount in the bank, not only is the business not worth £3.75 million in a conventional way, but the company's future doesn't look great either. We don't have eyeshot of the Net Current Assets of the business found in its Balance Sheet, but it's difficult to imagine that it has the liquid assets to cover the current liabilities. Paying your current [defined as this year or over the next 12 months] liabilities is the most common definition of solvency.
So in this type of situation, business owners undergo what is known as a down round - as the valuation goes down from the last round despite the fact that the company has been trading longer, and so should have a higher valuation.
While it is typically a positive thing when entrepreneurs invest their own money into their business, it tends to elevate the valuation.
There always is a "banker of last resort" in any firm. That may be the Royal Bank of Scotland or Barclays, or it may be outside investors, or the Chairman. In this business, it is Michael. He is looking to share the risk, but he can't have it both ways. The business hasn't yet met his projections, and he doesn't want to accept any penalty for that. What we don't know is what he'll do now as he hasn't raised cash from the Dragons. Personally if I were a betting woman, I would bet that he puts more of his own capital in. It didn't sound like he had the ability to go back to the other outside investors from the way he described the meeting he had with them.
It's worth stating the obvious that projections are important. Part of how investors judge your general management abilities is by whether or not you do what you say you are going to do. Better to low ball your forecasts and over deliver, then to miss them, and make excuses. If this is the case though, why don't more people forecast conservatively?
Well, entrepreneurs are basically optimistic, glass two times full people. They tend to overestimate their abilities to control and execute. The main reason though why they don't forecast more conservatively is back to the overall framework for valuation. If the forecasts are lower, then the valuation is lower, and their stake is worth less.
And round and round we go....
So if you are an investor assessing a company, and you have a gut feel that the forecasts are ambitious, then dig into how solid the assumptions are on which they are built. You can usually quickly see whether the forecasts are aggressive because the entrepreneur wants/needs them to be to bolster his valuation expections, or if there is some reality to them.
One way of governing a situation where you want to invest or you want an investor to come in, but genuinely hold a different view of the valuation or ability to achieve the forecasts, is to put a ratchet in place. That provides for a situation where projections are not made or are exceeded and a claw back of equity happens accordingly.
Overall, it is very important to establish a positive architecture for a company. This requires a shared view of all of the major assumptions and how all parties anticipate events to roll out.
Steven and Michael didn't win the Dragons over as they didn't bring the Dragons onside early. When there is no meeting of minds about the overall proposition, valuation quickly descends into a battleground and just a symbol of why the pitch didn't succeed.
Last updated: 10th August 2010
These are the views of Julie Meyer, not those of the BBC
Each week in the 2010 series Julie Meyer and Doug Richard offered their take on some of the key moments from the TV Den.
Week 1: Kirsty, the Best of Britain
Week 2: Called to account
Week 3: Where pitches go wrong
Week 4: A school for entrepreneurs
Week 5: Why evaluation matters
Week 6: When coup de foudre happens
Week 7: The role of an early investor
Week 8: What finishes a pitch
Week 9: Unlocking an investment
Week 10: Lessons from the Den
Missed any action? Watch, read, rate and have your say on the class of 2010.
Other entrepreneurs from this episode:
Missed any action? Catch up and find out more about the Online Dragons.
Apply to enter the Dragons' Den.
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