How to find the right value for your startup?

Having started my career in the legal profession, the mechanic of startup valuation was something rather foreign to me. Then I studied equity valuation while preparing for the CFA. But the technic I learned then seemed quite difficult to apply to early-stage business. It is only after reading a number of books on the topic, including Startup Valuation by Stephen Poland and Term sheets and valuations by Alex Wilmerding, that I stated understanding valuation cuisine. Here is an overview of the basic principals. I will look at individual valuation method in greater details in later posts.

The first rule of startup valuation is that your startup is worth whatever you and the investor agree it’s worth. This is the beauty of freedom of contract: the right consideration for an agreement is the one the two parties agreed to.

Therefore, it is your job as the startup founder to develop a reasonable valuation range that investors will accept.

Before outside investors get involved, founders own 100% of the equity in the startup. The investor will buy a part of that ownership via the invested cash.

For example, if the investor agrees to invest $1 000 000, how much ownership (equity) does that buy?

You can calculate the answer in a simple sequence:

1. Assign a value to the startup before the investment dollars are injected. This value is called the pre-money valuation.

2. Add the investment amount to the pre-money valuation. The result is called the post-money valuation.

3. Divide the investment amount by the post-money valuation to give the equity percentage owned by the investors. This percentage is also called the founder’s dilution amount.

Pre-money valuation + Investment amount = Post money valuation

$2 000 000 + $250 000 = $2 250 000

How to calculate from there the investor ownership percentage (or founder dilution)?

The percentage equity owned by the investor after the funding round closes is expressed by this simple equation:

Amount raised / Post money valuation = Investor ownership

$250 000 / $2 000 000 = 20%

So from here, the big question is how do you find the per money value of your startup?

There are several methods avail which all have there pros and cons. This is why it is important to use different approaches to justify your valuation.

Here are the most relevant methods:

The Market Comp Valuation Method

One of the quickest ways to establish a valuation is to compare your company to another that has already closed a funding deal and therefore negotiated its valuation with the equity investors.

Step Up Valuation Method

The Step Up valuation method is inspired by the Dave Berkus approach. The original model created by Berkus avoids the need to rely on, or debate, a founder’s financial forecasts, but instead, it loosely qualifies other major factors that strongly influence a startup’s valuation and its chances of success.

Risk Mitigation Valuation Method

The risk mitigation method assigns dollar values to the accomplishments and validations of the startup in four categories of risk mitigation: Technology, Market, Execution and Capital.

Exit Valuation Method

This valuation method was originally described in a case study by Harvard Business School Professor William Sahlman. The method centres on the idea of deriving what your pre-money valuation needs to be to satisfy the expected return on investment required by the angels or VCs you are negotiating with.

Discounted Cash Flow Method

The DCF method is the most “scientifical” approach used to estimate the attractiveness of an investment opportunity. DCF analyses use future free cash flow projections and discounts them, using a required annual rate, to arrive at present value estimates. A present value estimate is then used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.

Again, startup valuation is more of an art than a science so I recommend that you use several of these methods to justify your valuation. I will present these different methods in greater details in following posts.