7 Deadly Sins of Startups from a Valuation Perspective: No Risk/Return Analysis

One of the most difficult considerations for an entrepreneur is the risk/return analysis of the potential business venture. An incomplete or poorly-reasoned risk/return analysis on the part of the entrepreneur may lead a savvy financial investor to turn down a potential investment in the business in favor of an apparently less risky opportunity.

Even in a world with the global financial system and markets turned upside down, there is a relatively clear relationship between risk and return. An investor in a higher risk investment should be compensated with a higher return. For example, an investor in a risk free asset such as US Treasury bonds would expect a return of roughly 4%. An investor in a publicly-traded, blue chip company (a utility company, for example) may expect a dividend yield of 5-6%. Corporate bonds have returns of 5% and higher. A well diversified investment portfolio may have a return in the 6-12% range. “Junk bonds” have returns of 12% or higher. Venture capitalists expect annual compounded returns anywhere from 30% and up for “risky” equity investments in startup ventures. Entrepreneurs should recognize that owning their own business involves significant risks. As such, any investor (whether it is themselves or a financial buyer under the fair market value standard in business valuation) would expect a return significantly higher than that on Treasury bonds, a diversified portfolio of publicly-traded stocks, etc.

For example, suppose an entrepreneur invests $500,000 of his or her own money into their business. For the first two years, they expect losses which they finance with external debt. After three years, they are projecting a net cash flow to equity of $20,000, representing actual cash available for distribution as a dividend at year end. The return in this case is only 4%, which is hardly enough to compensate for the level of risk. A financial investor would likely opt for any one of a number of other potential investments that offer a higher projected return for an apparently lower level of risk. For the entrepreneur, however, the investment in the business only makes sense if they factor in their $20,000 net cash flow along with their projected salary and benefits of $50,000, for a total return of $70,000 or 14%, in year three. The financial investor will receive no salary, so the return calculation is not as attractive for them.

 

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