If this title got you excited, you could be a fan of television shows or funding events, where unlimited money seems to be on offer and deals closing like some everyday bargain. The real world could be different, though.
Once you have a prospective investor excited about your team, your merchandise, and your business, they will invariably ask about your company’s valuation? Many entrepreneurs stumble at this stage, losing the deal or the majority of their possession. They either give no answer or quote an excessive and indefensible number that convinces the investor that they don't understand fundamental economics. Kevin Harrington, from Shark Tank, says
"Nothing turns off an investor more than when an entrepreneur comes in with a ridiculous valuation"
The entrepreneurs who actually get to make a cut with the investors are excellent negotiators, who back their case with sound logic and solid numbers. The investors, on the other side, appear to be making quick negotiations and snap decisions. However, this is because the pointers for estimating a ballpark valuation are already available to them. Most of the serious investors have significant experience in this area. They can judge a business for what it is within a few minutes. So, before you begin ask yourself if you know your market size, cash flows, working capital, break even, and strengths/weaknesses.
Two creators of a brand new medical care internet site firm named XYZ have spent $200K of individual and family funds over a 12-month period to start the business, get a prototype site ready to go, and have already produced some Buzz in the Internet community. The creators now want a $1M Angel investment to do the advertising for a nationwide XYZ rollout, assemble a team to manage blogs along with other resources, and possibly even pay themselves a wage.
How much is XYZ worth to investors at this stage? What percent of XYZ does the investor own after the $1M infusion? Well, if the parties agree to a pre-money valuation of $1M, then the post cash investor possession is 50%. And on the other hand, if the pre-money valuation is $4M, the creators’ stake remains at a comfortable 80%.
Occasionally, creators forget to include all the computer equipment they purchased or upgraded to get the company started. The value of patents and trademarks isn't certifiable, particularly if you're only at the pre-operating stage. A general guideline frequently utilized by investors is that every patent filed can justify ~$1M increase in valuation. Assign value to all paid professionals, as their abilities, training, and knowledge of proprietary business technology is very valuable. Back in the heyday of the dot com startups, it wasn't uncommon to see a value increment by $1M or every paid full time professional developer, manufacture, or designer. That would be a far cry now. But, do not forget to include your sweat equity for unpaid efforts of creators and executives. Similarly, monetize the value of existing client relationships and contracts, even contracts which have not yet been signed.
The above is an asset based valuation and there are various other ways to value a startup. One of them being discounted cash flows or DCF method. The discount rate usually applied to startups might vary anywhere between 30-60%, depending on the readiness and degree of credibility you can collect for the financial estimates. In the above example, if XYZ is projecting revenues of $25M in five years, even with a 40% discount rate, your NPV or current valuation comes out to about $3M. But DCF works best where there is at least some traction already, which forms the base for the forecast.
Another popular method is using valuation multiples based on EBITDA, Net Income, Revenues and so on. Choosing the right multiple and arriving at your own financial numbers correctly is critical. Remember, overvaluation is as much of a problem as under valuation. Also, do not pick unrelated multiples, the investors have the market pulse. Unless you are well-versed in these areas, it is best to seek expert help, such that you do not end up estimating the value of your enterprise incorrectly. Eurion Constellation has been helping startups value their businesses in U.S., Europe and India over distance working arrangements, leaving a trail of happy customers.
Labels: Business, Corporate Finance, Research, small business, Startups, Strategy, World