The first thing I want to say is, more than a “formula on paper” approach, valuations are about the meaningful assumptions you make about the past and future performance of a startup so there is an “art” involved. Secondly, you’re value is what the market says it is…and you’re really not worth much till you are profitable.
Valuation is the monetary value of your company. The difference between pre-money valuation and post-money valuation is also very simple. Pre-money refers to your company’s value before receiving funding. Let’s say a venture firm agrees to a pre-money valuation of $5 million for your company. If they decide to invest $3 million, that makes your company’s post-money valuation $8 million.
But if you are a pre-revenue startup trying to raise money, you would still need a valuation figure that is acceptable to all parties, before you see a single dollar materialize. Remember to see the valuation from the investors’ perspective and don’t gloss-over things like the likelihood of success, the time frame to exit and the quality of the management team- these are important to an angel.
Keep in mind that the same startup could come up with different valuation figures -depending on the market climate and investor sentiments – at different points in time or while working with different types of investors. So the assumptions you make about the future market scenario, future revenues, customer behavior and so on, along with your timing can play a large role in valuations and successful funding. It also means that every time you approach a VC/Angel, you might want to look at your calculations and tweak them a little based on relevant factors.
There are different methods to arrive at valuations, some of them are- The DCF (Discounted Cash Flow), The VC method, The score card method, The Berkus method etc…
Which method you use depends on the type of company you wish to valuate, and what sort of information (reliable & accurate) you have at hand – the more historical data you have, of financial performance, either of your own company or of a close competitor, the less assumptions you have to make and the more believable your valuation might appear.
Here is a simple example (borrowed from here)-
Two founders of a new health‐care web site company named NewCo 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 blogs and other resources, and maybe even pay themselves a salary. How much is NewCo worth to investors at this point (premoney valuation)? What percentage of NewCo does the invest or 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, how to justify this $4M valuation?
The most straightforward method could be, the discounted cash flow (DCF) or income approach describes a method of valuing a company using the concepts of the time value of money. All future cash flows are estimated and discounted to give them a present value. The discount rate used is the appropriate cost of capital, and incorporates judgments of the uncertainty (riskiness) of the future cash flows. 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.
What you are looking for is the net present value (NPV) of your ability to produce future revenues as projected, factored by the risk in your plan. There are several of these interactive calculators available via the Internet to explore the concept without hiring a CA. For example, if NewCo is projecting revenues of $25M in five years, even with a 40% discount rate, your NPV or current valuation comes out to about $3M.
If you are making a healthy profit already, you can estimate your company’s valuation by multiplying 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, and averaging the results. The industry tables, factors to assess, and the scoring process are available via several web sites and software is available to do this as well.
This is a good way to arrive at a valuation figure that seems fair and acceptable to both parties, figure out how much investment you are looking for and how much stake you wish to give up for that, and that will give you your “target” valuation figure which you then need to substantiate using the data available.
You might find that you are not able to, and that’s good, because at least it will give you a realistic sense of the number you can substantiate.
Also remember when you are raising funds, valuations are not cast in stone; they are usually starting points for several rounds of negotiations, bear than in mind when that number first pops out of your mouth and don’t forget one day you will have to deliver on those promises!
In my next post I will try to capture some information on “Covertible Notes” a sort of debt that turns to equity, this is also an acceptable way to raise funds when the startup is very young and a fair valuation is proving very difficult to arrive at.
Some useful resources (apologies if some of them seem repetitive), also see the infographic below.