Tag Archives: valuation

How Investors Value Your Startup

Let’s start by discarding two myths:ダイヤモンド査定

  • Investors do not want control of your company! That is the last thing they want. What they do want are (a) handsome returns, and (b) for you to responsibly manage your own company so they don’t have headaches.
  • Investors do not care what past valuations were. On previous rounds, you may have received poor advice and valued your company at, say, $5M, and you found some unfortunate investors to purchase stock at that ridiculous valuation. Oh well, that’s too bad. It has zero effect on what the company is worth today.

What do investors want?

So, what do investors want? And how will they decide what your company is worth? Five main factors influence them:

  1. Is the opportunity exciting? If it isn’t exciting, they won’t bother valuing the company at all.
  2. Is the team qualified to execute on the plan? If not, you just aren’t worth the risk.
  3. Valuation based on current performance. Based on current trailing financials (i.e., what you have already done regarding revenues and profits), and multiples applicable to your specific industry, what is your company worth today?
  4. Valuation at desired time of liquidity. Based on expected performance (i.e., what you say about expected revenues and profits in your plan), and multiples applicable to your specific industry, what will your company be worth in the future? See below and blog on Determining Future Valuation.
  5. At what stage is the company? The biggest hurdles a startup has are:
    • building a product
    • getting the first revenue
    • demonstrating a repeatable sales model
    • demonstrating sustainable growth without continuing to invest external cash.

As you jump each of these hurdles successfully, the risk of total failure decreases significantly. Investors have their own rules of thumb about how that “risk of total failure” affects valuation. Here are my rules of thumb:

  • If you have not yet built your product, assume valuations will be no more than 25% of the valuations calculated using the techniques shown below.
  • If you have built your product but have not yet received revenue, assume valuations will be no more than 50% of the valuations calculated using the techniques shown below.
  • If you have built your product, started receiving revenue, but have not yet demonstrated a repeatable sales model, assume valuations will be no more than 75% of the valuations calculated using the techniques shown below.
  • If you have demonstrated a repeatable sales model and are looking for investments to “ramp up,” then the following techniques for valuation are applicable.

What To Do With Future Valuation?

Let’s talk a bit more about item 4 above. What will investors do with that future valuation once it is computed? They certainly won’t use it for today’s valuation. What they will do is use it to determine what value the company needs to have today so they can receive an acceptable return on their investment. Assuming that FV is the computed future valuation of the company at the time of liquidity, IRR is the investor’s desired rate of return and n is the number of years between now and the liquidity event, the calculation goes as follows:

Current Value of Company = FV / (1 + IRR)n

So, for example, let’s say the FV is determined to be $15M (using the techniques of the blog, Determining Future Valuation), and the investors desire a 50% IRR (not unreasonable considering the degree of risk) over 5 years. Plugging those numbers into the above formula, we get:

Current Value of Company = 15M / (1 + .5)5 = $1.98M

So, if you are looking for those investors to invest $500K now, expect them to ask for 25% of the company (because $500K is 25% of $1.98M); if you are looking for those investors to invest $250K now, expect them to ask for 12.5% of the company. And so on. But this applies only after you have demonstrated a repeatable sales model.

Now you need to factor in the risks described above. If your company is:

  • Pre-product, valuations decrease by around 75%. So continuing with the above example, the company now has a current valuation of around $500K. So, if you are looking for those investors to invest $500K now, expect them to ask for 100% of the company (obviously not a good idea); if you are looking for those investors to invest $250K now, expect them to ask for 50% of the company.
  • Pre-revenue, valuations decrease by around 50%. Continuing with the above example, the company now has a current valuation of around $1M. So, if you are looking for those investors to invest $500K now, expect them to ask for 50% of the company; if you are looking for those investors to invest $250K now, expect them to ask for 25% of the company. And so on.
  • Pre-repeatable sales, valuations decrease by around 25%. Continuing with the above example, the company now has a current valuation of around $1.5M. So, if you are looking for those investors to invest $500K now, expect them to ask for 33% of the company; if you are looking for those investors to invest $250K now, expect them to ask for 16.6% of the company. And so on.

None of the above is motivated by greed or a desire for control; it is pure economics. Investors want (and deserve) a fair return for their investment.

Of course many other factors come into play including experience, negotiation skills, degree of desperation to obtain cash, and availability of competition for deals (for the investor) and investors (for the entrepreneur).

Alan DavisDavis is a serial entrepreneur currently in his fifth startup. He is also an angel investor and the author of six books.

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.

 

Startup Valuation

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.

Why value?

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.