It is not impossible to come up with a calculation method that can be used to determine whether an investor is worth putting money into a startup. To do this, we need to know the investor’s objective. There can be two main objectives.
1. To take a percentage of the profits each year, as much as the share the investor holds in the startup.
2. At the exit of the company, to receive much more than the investor has invested.
Let’s look at these two cases separately!
Profit sharing
Let’s state the objective of an investor is to get his or her share in the profit. Let’s say the investor wants to triple his $100,000 in the next three years. Let’s say he or she gets 12% of the company for his or her money! Then we have to check whether at the end of the 3rd year 12% of the total profit of the three years will be $300,000 or not. In this case, the profit must be $2,500,000 in 3 years.
Since the profit is the result of the income-expenditure operation, if we know the unit price of the startup’s product and how many times the users pay this unit price in 3 years, then we know how much the income will be. We can also estimate the expenses. Let’s say that the expenses are 8% of the price paid by the users. So, for the profit to be $2,500,000, the income must be $2,718,000.
To calculate whether it is possible to earn $2,718,000 in 3 years, we need to know 3 things. 1. What is the highest possible price that users are willing to pay? 2. How willing are potential users to change their habits for using the product? 3. How many users can you acquire in 3 years? And these are the questions we can answer using my method.
Exit
If the seed investor’s goal is to receive 12% of the purchase price when the startup is finally sold, then he or she is interested in the company being worth as much as possible at the time of sale. Then formulate your goal as follows: in five years, 12% of the company’s value should be five times my invested money. In our case, $500,000 should be 12%, so the value of the company should be $4,167,000. The correct calculation of a startup requires a perfect prediction of future revenues. Revenue depends on the number of paying users. And here we are: we should know the answer to 3 questions. 1. What is the maximum price that users are willing to pay? 2. How willing are users to change their habits? 3. How many users can be acquired in the next 2-5 years? And in this case, we should not forget: will the costs change or not?
If you are interested in the answers to the 3 + 1 questions, bookmark this blog post and come back later. I will be back in 14 days.
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