Investing in a start up, how to determine the value?

I'm considering investing in a company that a friend of mine has started, as a means to help him bring his plans to fruition quicker, and hopefully making a decent profit.

The start up company is a board game company. Three games are currently published, with more on the way.

I'm guessing that about half of the value of a game is in the initial investment, and half of it is in the cost of the manufactured goods (And artwork and other capital costs), although I see that ratio might be skewed somewhat towards giving more value to the labor. Thus, I feel like taking the total cost of all of their costs, multiplying by a factor between 2-2.5, and using that as the assessed value of the company.

Is there a reliable method to determine the value of said company without having it assessed by a business broker of some kind?

Also, if I own a small portion of the company, should I feel obligated to put forward some of my time to ensure the success of the company, equal to the portion of the company that I would own?

This sounds like a pretty traditional business that can use the revenue or profit multiplier model for an evaluation.

You need to figure out the time horizon for your investment and then figure out revenue or profit growth over that time. You then discount it via Net Present Value back to today and then add some multiple.

For example, let's say you have a 5 year investment horizon. Take the projected revenue for those 5 years and take the NPV using a discount rate you could get for your money elsewhere (say a CD rate or something like that). This will give you the projected value of the company in 5 years.

Next, you can then multiply that by some multiple (say 1.1 to 2.0) for the upside growth potential or you could use a higher discount rate (e.g. say 10% as opposed to 5% because it's risker).

The other way to do it would be to look at comparable companies in the same space of the same size. That's usually a good comparison as well.

This sort of thing is amazingly difficult to do for small businesses due to lack of comparables that can be used to justify the valuation. The NPV method mentioned above is one way of estimating the value, though it is generally done on a cash-flow basis rather than a revenue or profit basis. The reason for the cash-flow basis is the essential question of where you should invest your money. In the simplest investment scheme, you put in some present value (your investment) for one or more future cash flows (payments to you, either in principle, interest, or both). In the simplest case of a savings account, you put money in the account and the bank promises you interest payments on that money at an agreed upon rate. Other types of investment (like savings bonds) have an initial investment and promise to pay a fixed amount in the future, which effectively pays an accumulated interest plus the original principal.

So when you look at investing in a stock or a company, you try to answer the following question: what do I want my return on investment to be? You might answer this by looking at your next best opportunity to invest your money, and assert that the opportunity you take must at least match that opportunity. So if you had an alternative investment that could yield a 9%, you might insist that your return from your potential investment at least match that rate. However, depending on how risky you felt the potential investment was in comparison to the alternative, you might adjust that rate higher or lower.

There are several NPV calculators on the internet, this one is pretty simple to use:

[http://www.datadynamica.com/irr.asp][1]

 

It's nice because it indicates the Internal Rate of Return and the Net Present Value so that you can judge whether the opportunity is worth your time. Remember that these are cash flows, either as investment into the company, or dividends or payments out of the company. Using this tool, you can use the future cash flows of the company overall to calculate its current NPV, and then use that number to determine how much of the company to ask for in exchange for your investment.

Please note that this is the most amazingly simplistic way to answer your question, but more sophisticated methods are probably going to require more research, and in the end your friend (depending on his background) has to be comfortable about the valuation method, especially if you want to keep them as a friend going forward.

To answer the second part of your question (whether you should put in time to insure success), it really depends on the dynamic of working with your friend. The best way to address this issue is to work out some sort of agreement on how to deal with "sweat equity", whether it be a conversion rate of hours worked to number of shares, or some sort of fixed distribution based on a commitment to put in a defined level of effort. The most important thing is to work it out in advance, and then stick to it faithfully.