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Valuing a Startup for Investment

How to make sure you're getting the right deal

Valuing companies can be a tricky business and valuing a start-up even more so. As a founder of a business looking for investment, how do you know what your business is worth? How do you know what potential investors will value your business for and conclude how much equity they want in return for their investment? How do you know if the valuation is fair or if you're giving away too much equity?

If a business has no or little revenue yet, or the business has negative working capital (is spending more than it makes), how can anyone put a value on it that makes it worth investing in?

A good starting point is to look at the 3 traditional methods of valuing a company. Each of these has many variations within it, but they can be broken down into the following:

1) Multiples: The principle is that you take a company's earnings, and apply a multiple to that number to get a valuation. The most common used multiple is 'PE (price to earnings') ratio. This involves taking the ratio of yearly earnings to value of comparable companies on the stock market (or private companies where possible), and applies that to a company's earnings. However, this at best gives a guide, as there is often disagreement about what is considered a 'comparable company' and only works if the company in question has earnings already. It is tempting to apply this method to forecasts, however the risks on this make this an unlikely method for an investor to be happy with, particularly as these multiples can be extremely misleading even with more established companies - and for example led to the huge overvaluing of companies in (and the crash of) the dotcom boom.

2) Discounted cash flow: The basic premise is to take future cash flow projections and discount them based on an agreed calculation. The risk with this method is that if the projections are wrong, usually because the assumptions on which the projections are based are flawed, the entire valuation can be wrong. Often disagreement will come from what those assumptions and projections are. Whilst in theory a company with no revenues can use projections to value themselves using this method, the amount of assumptions and lack of evidence to back this up, in a method that is already hard to apply with confidence, means this method is not often used by investors for startups.

3) Assets: Whereas the two previous methods are based on looking at the future, the asset method looks at the present, simply by assessing the balance sheet and what the value of the assets minus liabilities is. The debate in this instance would be around what assumptions each asset valuation is made on. However, most startups do not have assets, and if they do they certainly would not want to be valued based on what is likely to be a small amount of assets.

All these methods have flaws, even for established businesses, primarily that they are based on assumptions, and often those assumptions are a key negotiating point between business owners and investors. On top of that, which method should be used? Sometimes one method is more obvious that others for a certain business, however usually each party will want to use the method that values the business closest to what they want to sell or pay for it. Therefore as a business owner, even for a startup, it is worth running the numbers on at least some multiple and discounted cash flow scenarios, to see what sort of figures you get - this is likely something any investor would do. But don't get caught up with those numbers, and make sure your assumptions are clearly defined and as realistic (so you can justify them) as possible.

However, as startups are so difficult to value, with little or no data to work from, an alternative method has been established which is often now used, particularly by venture capitalists, called 'The Venture Capital Method'.

This method works on the basis that the value of a company is the value implied by the investment itself, rather than any assumed future value such as a multiple. It also assumes that both the business owner and investor will have a number in their head as to what they think the business is worth, and therefore what numbers they are willing to do a deal on. Therefore, investors using this method will start with what they think the business is worth, and then working out a deal around it. How do they work out what it is worth? This is the hard bit, but they will be basing it on other deals done either in the recent past, themselves, or by talking to other investors who they know.

This may sound vague and totally subjective (which it is), but without data it is probably a more sensible solution than trying to do complex calculations based on massive assumptions - and fundamental a business is worth what someone will pay for it. This route therefore means that all negotiations between investor and business owners become around what the current valuation of the business should be, with the business owners job being to try to justify as high a possible valuation, with the deal terms following after a number has been agreed.

Once you have settled on a valuation number, then the calculations are simple:

Valuation amount + amount to be invested = post-financing valuation (how much your business is going to be worth after the investment)

Amount to be invested / post-financing valuation = percentage of company the investor will want

So for example, you agree your business is worth 600,000 (also called your 'pre-financing valuation), and you want 200,000 investment.

600,000 + 200,000 = 800,000 (post-financing valuation)

200,000 / 800,000 = 0.25

Which means that 25% of the company will be required for 200,000 investment

All of the above is important to understand, but often what happens with offers is the investor gives you an equity percentage required without agreeing a valuation. This method is therefore useful as you can work out what their valuation is, and then have a basis on which to negotiate the equity percentage they have asked for:

200,000 / 0.25 = 800,000

800,000 - 200,000 = 600,000

As a business owner, you don't have to be able to do all the more complex calculations yourself, but if you really want to understand where investors are coming from with their investment offers, you need to understand the basics and at least understand the venture capital method. You may want to be able to run some of these numbers yourself, get someone to run them for you, or at least you should be able to look at and understand the numbers and assumptions the investors have used to get their investment offer - to give you a footing on which to negotiate.

Latest comments (1)

Claas Grimm CRO, Red Hot CG3 years ago
In my experience it always comes down to Discounted Cash Flow (the calculation is pretty simple) unless the investment goes into a product or service that is meant to create strategic buyout value instead of generation of cash flows.

Equally important is to understand the expected returns on the investment. Investors have a finite interest in the company. A high failure of venture capital investment means that only business cases that are able to provide a high multiple return on equity are eligible for venture capital.
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