I am starting a new company and looking for seed capital. Let’s say my projected total income is A, my gross profit is B, my net profit is C and my start-up costs are Z, and I have a five-yearly projection.
How do I calculate the company’s worth and how much money I should ask for, given the percentage of investor shares as equity in the company?
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Congratulations on taking the exciting step of starting your own company. Entrepreneurship has such an important role to play in the Australian economy and I believe it should be encouraged and supported.
You may have heard that companies that fail financially can actually be profitable; they only failed because they ran out of money to run the business and pay bills.
This is a key fact to pay attention to and will help explain my comments further about working capital.
When you calculate how much working capital you need (be it a mixture of your own equity funds and some seed capital, it doesn’t matter), the most important factor is how much money you need to operate the business. This is, in fact, not related to the profit you are projecting.
You need to calculate the value of the assets you will have to fund in the business, which is usually stock, debtors, expenses like staff, etc.
For example, even if you are going to sell $100,000 worth of product a month, you may actually need to have $300,000 worth of stock to achieve this. This could be because of lead-times, minimum buys, etc.
So in this example you need at least $300,000 as a working capital fund. Then you need to consider what your payment terms will be with your suppliers and when you will get paid from your customers to calculate what funds you need for the net of your debtors and your creditors.
This could be a further $100,000 if you are paying 30 days but receiving debtors 60 days.
So, in summary, the formula for working capital or funding is about money to operate the business and you should factor at least three months’ working capital as a minimum requirement to give yourself a buffer if something doesn’t go to forecast.
In terms of the value of the business, the market uses a multiple of EBIT (earnings before interest and tax) usually taking the last three years average, but this is difficult if you have no track record.
So your investors will have to believe in your business plan and invest on the basis of what you are forecasting rather than actual results.
The multiple of the EBIT depends on the type of business, the risk profile, the exit options and the dividends forecast.
Most businesses today would be working on a multiple of between four and 10 as a guide, which is very broad, I know, but difficult to narrow without knowing more about the business.
But the most important message is don’t run out of cash. Even if you are profitable you can run out of cash and effectively go broke if you don’t have enough working capital as set out above.