This is part 3 of a series. Links: (Part 1) – (Part 2)
Now that you have taken the first steps necessary to bring early investors into your company, you know that they will be looking for the answer to the question: “What return can I get by investing X amount in dollars in your company and when can I expect it to be at that value?”
It’s our experience at LDFH that when you are raising money it’s best to use a combination of debt, such as Small Business Administration (SBA) loans, and equity, giving up some of your company in return for growth cash. However, this is where things can get a bit complicated because Main Street debt financing and equity financing through Family and Friends rounds have different valuation expectations and require some expertise to put together. Unfortunately, this expertise is normally very expensive and found in places like Wall Street and Silicon Valley.
LDFH, through its platform and special processes, are bringing the Wall Street tools to Main Street at an affordable price.
So, the first step at LDFH is a financial analysis of your company. This is normalizing the historical earnings, analyzing the economic and industry conditions and forecasts, and evaluating the company’s internal and external risk factors in order to estimate the future benefit stream. This benefit stream will be used to determine what is a realistic value to put forward given your growth plans as well as the analysis that will allow you to see what it would take to qualify for SBA loans.
Lender’s Considerations
It is important to realize that SBA lenders don’t really value your company the way investors do; they underwrite the loan. Underwriting means the Small Business Administration is guaranteeing a portion of the loan and not providing the direct funds. Direct funds are provided by participating banks. The SBA’s role is to assess the creditworthiness and risk of a small business loan application. They want to make sure it meets the agency’s standards before guaranteeing it for a participating lender. The idea is that the lender’s risk will be less making it easier for small businesses to secure financing.
This type of debt funding is based on Cash flow coverage, collateral and the track record of the business. Cash flow coverage asks can the business service the debt in its existing state? Basically, SBA lenders look at something called the The Debt Service Coverage Ratio (DSCR). A lender will look at your financial statements and see if it shows your company’s ability to pay its mandatory debt payments, including principal and interest, using its net operating income or EBITDA.
It is calculated by dividing the Net Operating Income (NOI) or EBITDA by the total debt service (principal + interest payments). A DSCR greater than 1 indicates sufficient cash flow for debt payments, while a ratio below 1 suggests a potential risk of default. An SBA loan usually requires a DSCR greater or equal to 1.25. The also look at any hard assets for the business and sometimes require personal guarantees for collateral. They also look at the track record of the business as to whether it has revenue stability and whether you pay you existing loans on time.
The SBA side is not about negotiating valuation — it’s about proving repayment capacity. The lender doesn’t care if your company is worth $2M or $5M, they care if you can cover loan payments.
Investor’s Considerations
The second part of the equation is where valuation matters. In our experience it is best to use a hybrid approach which can make investors feel protected and you not undervaluing your company. At LDFH, we typically anchor on a current revenue multiple. We compare our revenues with similar companies in your industry then we use our growth projection and land somewhere in the middle. For example, if we have $500k currently in revenues and use a 2 to 4 X Industry benchmark multiple that equals a $1 million to $2 million valuation as our baseline. Then we use a growth project of say 10 X revenue growth in 5 years. That means we will have $5 million plus as our target revenue in 5 years. If we look at comparable exit multiples being 2X to 3 x revenue there is an implied future value of $10 to $15 million.
We then use a small business/ private risk discount of 25 to 30% annually on this future value which gives us a present value of $2 to $3 million. This means a Pre-Money Valuation (before any investors put money in as about $2.5 million. We would have to raise $X (equity) + SBA loan leverage. So, an investor Entry Point would be fair midpoint between “current multiple” and “growth potential”.
What this would mean for an investor is if he or she gives a $25 thousand investment today at $2.5 million valuation they will receive a 1% ownership. If a company grows to $10 million valuation in 5 years that a 4X return. If it grows to $15 million its a 6X return.
The messaging to family and friends would be: “We’re already doing $500 thousand in sales. At industry multiples, that’s a $1–2M company today. With our 10× growth plan, we could be worth $10–15M in five years. By setting valuation at $2.5M today, we’re being fair.
Our Negotiation tool helps you to structure the Family and Friends Round by helping you understand current value and future value, and the effect of debt on this structure.