Understanding the Valuation of Your Startup

The two most common mistakes founders make when valuing their startup business are:

1. Pointing west and saying “that company, doing something similar, just raised 50M on a 300M valuation!”

2. “The market size is X Billion all we need is 1% to be a multimillion dollar revenue company”.

The formula for determining the value of a pre-revenue company has more variables than equations and it is nearly impossible to use comparables, because in most cases, if you have a direct comparison you’re late to the game. Without a steady concrete cash flow, it is difficult to give a hard value to a growing company, however there are a few non-scientific methods that may help a founder value his business.

Value, in this sense ultimately is based on negotiations until both parties come to a agreeable number. Investors want a reasonable pre-money valuation so their investment buys them a higher ownership position, while founders believe their company is usually worth more and seek to retain control and ownership.

It is first important to understand valuation as a term. When we talk about equity, there are two types: pre-money and post-money valuation. A pre-money valuation is what a company is theoretically worth without any investors, whereas the post-money value is calculated with the inclusion of investments. For example, if your company has a $2 million pre-money valuation, after a million dollar investment, the post-money valuation would be $3 million. Pretty simple. The existing shareholders/members (founders and maybe early investors) would own two thirds of the company and the investors would own one third of the company.

Discounted Cash Flow (DCF) models are used to determine the value of a company based on future cash flow or earnings. The basic theory is this; make a reasonable estimate of what your company will have for free cash flow across some period of time, say 5 years, apply the reduction for the time value of money and start layering on the risks to attain (discounts) and shazam, you have a number.

For a fundamental technology businesses I like a decision tree based valuation… if there are several critical regulatory or technical hurdles between now and profitability, lay them out in a decision tree fashion and estimate the likelihood of each being in your favor. Multiply these together and apply this to your baseline prior to adding discounts in the DCF model.

Of course you can always look at comparables… but that is risky business… because the well funded companies and VC backed are easy to find. If you look at comps, just make sure you look all the way down the value range (where data is sparse and unreliable). Don’t be fooled by the business that was funded by a “relationship” or “track record” and likely has little bearing on your value.

To offset the risk of investing in an unproven startup, professional investors such as venture capitalists will want their *potential* return to be generally 10x their initial investment. For example, if you believe that in 5–7 years you reasonably believe you can sell your company for $20 million, and you need $1 million in financing to continue your company’s development, it’s probably safe to say your pre-money valuation should not go above $1 million.

When it comes down to actually creating the number, realize that valuing an emerging growth business is more art than science. You also must understand that your company is only worth what someone is willing to pay for it; again, the basics of supply and demand. Maybe in this case you have assets or accounts receivables in excess $1 million, but if no one else is willing to value you over $1 million, then the (small) market has spoken and that is the price your company is worth. Just because your friends or relatives bought shares from you at $20 per share does not mean your company was valued correctly. In the eyes of the investor market, it was probably overvalued and thus, the price your original angels paid for shares should not be a benchmark for a future offer.

On the flip side, the market will tell you what your company is worth based on the information you have told them. A properly presented Problem, Solution, Market, Model and Team will do wonders for your valuation. The more knowledgeable you are about your company’s particular space and your ability to execute on your plan, the easier it will be for you to determine if an investor valuation is fair.

It is also important to have comprehensive financial projections to determine your company’s value. Although a tedious process, it is a necessity if you are seeking to raise capital through a formal private offering. Investors will take into account your projections and interpret them as they wish which will help influence your valuation. Investors will ultimately expect that your forecasts for revenue are wrong… but when looking at your financials a savvy investor will apply a series of litmus tests to see if your overall sense of the potential is sound.

The most important factor in increasing your valuation: profitability or the promise thereof. A business is not worth very much unless it is ultimately profitable. If you own a business that earns a profit, and you are seeking a valuation, make sure that fact is apparent and leverage it as you seek the best method of raising capital.

In the event of an exit, there will be limited buyers for a non-profitable business, unless it has hords of social momentum… If you aren’t profitable, as most startups aren’t, base your valuations on the future and when you expect to start becoming profitable.

All in all, pre-revenue valuation is a tricky subject. There is no completely ‘correct’ way to pin a price to a growing company. There are certain metrics which can help, but it also requires blending these metrics with the intangibles and the future of your company. Get multiple opinions, consult professionals, listen hard to investors, and educate yourself as much as possible. You have worked hard to grow your business, and the more knowledge you have about how professionals will value it, the more respect you’ll elicit as you negotiate.

If you have a startup that’s ready for funding and/or are looking to invest in emerging businesses visit VENTURE.co to get started.