Once you have a potential investor excited about your team, your product, and your company, the investor will inevitably ask “What is your company’s valuation?” Many entrepreneurs stumble at this point, losing the deal or most of their ownership, by having no answer, or quoting an exorbitant and indefensible number that convinces the investor that you don’t understand basic economics.
Let’s consider a hypothetical example. Two founders of a new health-care web site company named NewCo have spent $200K of personal and family funds over a one year period to start the company, get a prototype site up and running, and have already generated some “buzz” in the Internet community. The founders now need a $1M Angel investment to do the marketing for a national NewCo rollout, build a team to manage blogs and other resources, and maybe even pay themselves a salary.
How much is NewCo worth to investors at this point (pre-money valuation)? What percentage of NewCo does the investor own after the $1M infusion (post-money ownership percentage)? Well, if the parties agree to a pre-money valuation of $1M, then the post-money investor ownership is 50% (founders give up half interest, and lose control). On the other hand, if the pre-money valuation is $4M, the founders ownership remains at a healthy 80% level.
So what magic can the founders use to justify a $4M valuation (or even the $1M valuation) at this early stage? Here are a list of tips and techniques that I recommend to every startup:
1. Place a fair market value on all physical assets (asset approach). This is the most straightforward valuation element, often called the asset approach. New businesses normally have fewer assets, but it pays to look hard and count everything you have. Sometimes founders forget to include all the computer equipment they bought or upgraded to get the business started.
2. Assign real value to intellectual property. The value of patents and trademarks is not certifiable, especially if you are only at the provisional stage. Yet the fact that you have filed is very positive, and puts you many steps ahead of others who may be stepping into the same area. A “rule of thumb” often used by investors is that each patent filed can justify $1M increase in valuation.
3. All principals and employees add value. Assign value to all paid professionals, as their skills, training, and knowledge of your business technology is very valuable. Back in the “heyday of the dot.com startups,” it was not uncommon to see a valuation incremented by $1M or every paid full-time professional programmer, engineer, or designer. Don’t forget to include the “sweat equity” for unpaid efforts of founders and executives.
4. Early customers and contracts in progress add value. Monetize the value of existing customer relationships and contracts, even contracts which haven’t yet been signed. Highlight any recurring revenues, like subscription fees, that don’t have to be sold from scratch each time.
5. Use discounted cash flow (DCF) on revenue projections (income approach). In finance, the discounted cash flow (DCF) or income approach describes a method of valuing a company using the concepts of the time value of money. The discount rate typically applied to startups may vary anywhere from 30% to 60%, depending on maturity and the level of credibility you can garner for the financial estimates. For example, if NewCo is projecting revenues of $25M in five years, even with a 40% discount rate, your NPV or current valuation comes out to about $3M.
6. Multiple of discretionary earnings (earnings multiple approach). If you are doing well, you can estimate your company’s valuation by multiplying earnings before interest, taxes, depreciation and amortization (EBITDA) by some multiple. A target multiple can be taken from industry average tables, or derived from scoring key factors of the business, and averaging the results, with the final average called the “multiple”.
7. Calculate replacement cost for key assets (cost approach). The cost approach attempts to measure the net value of the business today by calculating how much it could cost for a new effort to replace key assets. If NewCo has developed 10 online tools and a fabulous web site over the past year, how much would it cost another company to create similar quality tools and web interfaces with a conventional software team? $2M might be a low estimate.
8. Find “comparables” who have received financing (market approach). Another popular method to establish valuation for any company is to search for similar companies that have recently received funding. This is often called the market approach, and is similar to the common real estate appraisal concept that values your house for sale by comparing it to similar homes recently sold in your area.
9. Look at the size of the market, and the growth projections for your sector. The bigger the market, and the higher the growth projections are from analysts, the more your startup is worth. For this to be a premium factor for you, your target market should be at least $500 million in potential sales if the company is asset-light, and $1 billion if it requires plenty of property, plants and equipment.
10. Assess the number of direct competitors and barriers to entry. Competitive market forces also can have a large impact on what valuation this company will garner from investors. If you can show a big lead on competitors, you should claim the “first mover” advantage. In the investment community, this premium factor is called “goodwill” (also applied for a premium management team, few competitors, high barriers to entry, etc.). Goodwill can easily account for a couple of million in valuation.
So what is a reasonable valuation for a company like NewCo? My advice for early-stage companies like this one is to target their valuation somewhere between $1.5M and $5M. A lower number suggests that the founders are giving away the company, while a much higher number may suggest hubris or lack of reality on the part of the owners. Of course, we have all read about the “new” company with $100M valuation, but I haven’t met one yet.
About the Author:
Marty Zwilling is the Founder and CEO of Startup Professionals, a Phoenix based company which offers startups a range of offerings and consulting services. He is a member of the Arizona Angels group, where he serves on the Selection Committee. He is a mentor to startups through the Arizona State University Technopolis program, and has done guest lectures on entrepreneurship in their MBA program. He is also on the Board of a half-dozen startups, and has an extensive technology background with IBM and other large and small companies. He may be contacted directly through his web site http://www.startupprofessionals.com or via eamail at firstname.lastname@example.org. More articles can be found on his daily musings site http://blog.startupprofessionals.com