Put another way – how are they going to get out of the company when they either get bored, or have realized enough value that it becomes more worthwhile to sell it on (or shut it down and dispose of the assets accrued) than keep it ticking over.
The most clinical approach is to build the exit into the business plan, and use that as a way to see (indeed, test) whether the whole venture is actually viable. If the exit strategy is to sell the whole company on as a going concern for a value of 1 million pounds (Euros, dollars, etc.) in five years time, it becomes relatively easy to work backwards through the numbers to test for feasibility.
Other exit strategies also include going public (selling shares on a stock exchange) or selling the company purely on the basis of its value to a competitor or related business – think of Google’s acquisition of YouTube, or Twitter buying TweetDeck, for example – where the classic measures of revenue, profitability, etc. don’t really apply.
However, these are subject to specialist knowledge, market awareness and probably a healthy dollop of good luck, so to provide an empirical example, we shall assume that the business valuation is designed to provide value to an investor – be it 100% (disposal) or some fraction thereof (to garner investment, or when going public.)
This kind of valuation is usually based on current performance. Examples of companies valued on potential performance (the most famous being PayPal) can also be found, but these are relatively special cases : for those that manage a PayPal, there are many, many, successful serial entrepreneurs who never see that level of IPO success.
On the other hand, many start-up investors will also be looking at potential. However, given that it has to be grounded in the figures that reflect believable performance, the discussions about exit strategies also apply here.
There are many, many approaches to valuing a company:
- Wikipedia : Business Valuation
- How to value a Business on BusinessLink
- ‘How to Value a Young Company’ by Martin Zwilling (Forbes.com)
A common measure is to take three to five times profit, and use that as a nominal value to establish targets for exit or investment. From the other side of the table, so to speak, if an entrepreneur needs 10,000 pounds (dollars, Euros, etc.) investment, for a 20% stake in their company, the investor will be expecting to be able to see at least 50,000 pounds worth of company value, as well as a return of 5-10% (using a better than bank rate) on their investment.
Using these techniques, it should be relatively easy for budding entrepreneurs to appropriately value their business idea, and potential of their start-up company.