(http://blog.gust.com/10-rules-of-thumb-for-startup-investment-valuation/)
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, saying “make me an offer,” or
quoting an exorbitant number.
I’ve written about this before, but it’s a mysterious subject, and I’m always learning more. This time I’ll
use a hypothetical health-care web site company named NewCo as an example to illustrate the points.
Two founders 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 the rollout, 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 the components and “rules of thumb” that I recommend to every startup:
1.Place a fair market value on all physical assets (asset approach). This is the most concrete valuation
element, usually called the asset approach. New businesses normally have fewer assets, but it pays to
look hard and count everything you have. NewCo might be able to pick up an initial $50K valuation on
this item.
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. NewCo has filed a patent on one of their software tool
algorithms, which is very positive, and puts them several steps ahead of others who may be venturing
into the same area. A “rule of thumb” often used by investors is that each patent filed can justify $1M
increase in valuation, so they should claim that here.
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. NewCo doesn’t have any of these yet.
4.Early customers and contracts in progress add value. Every customer contract and relationship needs
to be monetized, even ones still in negotiation. Assign probabilities to active customer sales efforts, just
as sales managers do in quantifying a salesman’s forecast. Particularly valuable are recurring revenues,
like subscription amounts, that don’t have to be resold every period. This one doesn’t help NewCo just
yet.
5.Discounted Cash Flow (DCF) on projections (income approach). In finance, the 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. NewCo is projecting revenues of $25M in
five years, even with a 40% discount rate, the NPV or current valuation comes out to about $3M.
6.Discretionary earnings multiple (earnings multiple approach). If you are still losing money, skip ahead
to the cost approach. Otherwise, multiply 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. If you have no better info, use 5x as 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. Since 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? $500K might be a low estimate.
8.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. Let’s not
take any credit here for NewCo.
9.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. For NewCo,
the market is not new, but the management team is new, so I wouldn’t argue for much goodwill.
10.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.
Remember that all the components, except the last, are cumulative. Even if a given investor excludes
some of the components from consideration in your case, your credibility will be bolstered by the fact
that you understand his interests as well as yours. In any case, the analysis will prepare you for the
heavy negotiation to follow.
Precision is not the issue here – the task for the entrepreneur is to build a company that is worth at least
$50M before thinking about an exit — no investor wants to spend more than five minutes arguing the
fine points of the last valuation dollar.
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, justified from the elements
above. 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.
Posted By: Rohit Tom Abraham
Thursday, December 7th 2017 at 1:46PM
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