What is Valuation?
The term valuation means to determine what something is worth, i.e., to assign something a value. In the case of a startup company, the value of the company at its very beginning, at the moment that somebody thinks of an idea, is pretty easy to determine; it is very close to zero. As the company evolves, as it reaches each significant milestone, it becomes more and more valuable.
There are two good reasons why we want to value a company.
- The first is to determine a price at which a part of the company should be sold. Say, for example, you have determined that the company needs to raise $1,000,000 now in order to reach its next significant milestone. The big question is: should you sell 10% of the company for $1,000,000? Or 25%? Or 50%? Or 75%? The answer should not be made in arbitrarily. If you decide on 10%, you are declaring that the company is worth $10,000,000; after all, if 10% is worth $1,000,000, the entire company must be worth $10,000,000. If you want to make such an offer, you must be able to justify that the entire company is worth $10,000,000. By the same logic, if you decide on 25%, you are declaring that the company is worth $4,000,000. And 50% implies the company is worth $2,000,000. And 75% implies the company is worth $1,333,333. So, having a tool to value a company right now, enables you to determine what percentage of the company you should sell in order to raise the cash you need. For companies with a financial history, this is relatively easy to do, and many books have been written on the subject (e.g., see Koller). However, for startups, there is no financial history, so valuation of this type is extremely difficult.
- The second is to determine what the company’s value should be in the future. Unlike today’s situation described in the previous bullet in which there is no financial history, a valuation of the company at the time of a predicted future liquidity event can be based on predicted financial results. Now the steps to create a valuation become (a) define a predicted liquidity date, (b) define all your business strategy assumptions (and argue and resolve those arguments), (c) create the company’s pro forma financial statements based on those assumptions, and (d) value the company at the liquidity date based on trailing financials as of that date. My next blog entry will show how this is done.
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.