Determining Future Valuation of a Startup

Future Valuation

My previous blog post (https://www.offtoa.com/wp/?p=237) described why an entrepreneur needs to determine today the likely valuation of the startup company at  some point in the future. That’s what I will discuss in this post.

How to value?

Let’s assume you predict the company will be acquired in 5 years. You stated all your assump­­tions about your business strategy and transformed them into pro forma income state­ments, balance sheets, and cash flow statements for the next 5 years. You now have enough data to make an educated guess about the value of the company based on other companies who have had liquidity events with similar financials. Of course, there are many problems with such a valuation:

  1. Your assumptions are just assumptions, not facts. In fact, some of them are just guesses. That is why you need to use as many sources as possible to validate your assump­tions. That is why you should show your assumptions (not just your financial statements) to potential investors; let them question the assumptions (and revise as necessary).
  2. Many factors influence the value of a company besides just its financials. Such intangibles relate to the market, the economy, intellectual property, state of competitors, the level of merger & acquisition activity in your industry, the “hotness” of your industry sector [1], and so on.
  3. We will be valuing your company based on multiplying various elements of your pro forma financial statements by multiples specific to your industry. However, the values of these multiples change over time. A big change in the public stock markets will cause a big change to the values that should be used for the multiples for your industry.

To value your company at the end of the fifth year, do the following

  • Take the annual revenue for year 5 (aka “trailing revenue”) and multiply it by the industry revenue multiple. The industry revenue multiple is computed in one of the following ways: (a) Look at the last n acquisitions of private companies in your company’s industry [2]. Compute the average of their acquisition prices divided by their last year’s annual revenues. (b) Look up the average P/S (Price/Sales) ratio for the industry on any finan­cial website; this will give you a high valuation because publicly traded stocks are more liquid (and thus more valuable) than private stocks.
  • Take the annual gross profits for the 5th year (aka “trailing gross profits”) and multiply it by the industry gross profits multiple. The industry gross profits multiple is computed in one of the following ways: (a) Look at the last n acqui­sitions of private companies in your company’s industry [2]. Compute the average of their acquisition prices divided by their last year’s annual gross profits. (b) Look up the average P/S ratio for the industry on any financial website; divide it by the average gross profit margin for the industry; this will give you a high valuation because publicly traded stocks are more liquid (and thus more valuable) than private stocks.
  • Take the annual EBITDA for the 5th year (aka “trailing EBITDA”) and multiply it by the industry EBITDA multiple. The industry EBITDA multiple is computed in one of the following ways: (a) Look at the last n acquisitions of private companies in your company’s industry [2]. Compute the average of their acquisition prices divided by their last year’s annual EBITDA. (b) Look up the average P/S ratio for the industry on any financial website; divide it by the average EBITDA/sales ratio for the industry; this will give you a high valuation because publicly traded stocks are more liquid (and thus more valuable) than private stocks.
  • Take the annual EBIT for the 5th year and multiply it by the industry EBIT multiple. The industry EBIT multiple is computed in one of the following ways: (a) Look at the last n acquisitions of private companies in your company’s industry [2]. Compute the average of their acquisition prices divided by their last year’s annual EBIT. (b) Look up the average P/S ratio for the industry on any financial website; divide it by the average EBIT/sales ratio for the industry; this will give you a high valuation because public stocks are more liquid than private stocks.
  • Take the annual earnings after tax for the 5th year (aka “trailing profits”) and multiply it by the industry profits multiple. The industry profits multiple is computed in one of the following ways: (a) Look at the last n acquisitions of private companies in your company’s industry [2]. Compute the average of their acquisition prices divided by their last year’s annual EAT. (b) Look up the average P/E (Price/Earnings) ratio for the industry on any financial website; this will give you a high valuation because public stocks are more liquid than private stocks.
  • Compute the average of the above five averages. This will give you as accurate an estimate as you can compute for the valuation of the company . . . given the three caveats above

What to do with that future valuation?

Let’s assume that you follow the procedure described above and you determine that the company will be worth, say, $20,000,000 in 5 years. What good is that knowledge? The answer is: You can use it to determine what percent ownership of the company today will be worth in 5 years. Continuing with this example, if you have determined that the company will have a value of $20,000,000 in 5 years, then a 25% stake will have a value in 5 years of $5,000,000. Therefore, if you offer an investor a 25% stake in the company today for, say, $1,000,000, you are

  • Explicitly stating that the company is worth (today) $4,000,000, which you will have to justify!
  • Implicitly (via your financial statements) stating that the $1,000,000 investment can create a $5,000,000 return if all the assumptions become reality, and the company has a liquidity event in five years at the valuation multiples that are currently being assumed. The IRR for that $1M investment becoming $5M in 5 years, by the way, is 38%.

The above is extracted from my latest book, Will Your New Start Up Make Money? Buy your copy in Kindle or paperback format at http://www.amazon.com/Will-Your-Start-Make-Money-ebook/dp/B00JOOZQNE. By the way, Offtoa.com does future valuation automatically for you based on your answers to a few simple questions.



[1] According to Mark Andreessen (http://techcrunch.com/2013/01/27/marc-andreessen-on-the-future-of-the-enterprise), valuations can vary by as much as fourfold based on the hotness of the sector.

[2] Inc. Magazine occasionally publishes this data on their website at www.inc.com. The latest data is available by subscription from Hoover’s at www.hoovers.com.