How to Calculate the Value of Your Early-Stage Startup. (Insight on Million $ fund raising methods)
Without years of financial data to rely on, startups and their investors (angels and venture capitalists) have had to rely on more creative ways to substitute for these inputs. In a nutshell, the process goes back to quantifying a bit of basic finance: ‘risk versus reward’. In startup terminology, it’s: ‘traction versus market size’.
As a startup founder, you will invariably face a time when you need to think about the valuation of your company. Whether you’re pre-revenue, post-revenue, in fundraising mode, or simply granting your employees stock options, you’ll need to have a valuation to operate off of. Of course, in a fundraising setting your valuation will ultimately come down to a negotiation, but it’s worth utilizing some best practices to justify your number and gain as much leverage as possible in these situations.
This article focuses on the steps you should take to calculate a reasonable valuation for your early-stage startup, with some context added that explains why that number becomes so important should you hit the proverbial startup homerun.
Step 1: Perform a Self-Assessment
Make a List of Your Assets
The first thing to consider in formulating a valuation is your balance sheet. List out the assets in possession of the company (less any liabilities). Assets could include, but are not limited to, any of the following:
Although you won’t be able to reference the true market value of most of your assets (outside of your cash flow), your list of assets sets you up to be able to look at comparable valuations of other, similarly-equipped startups.
Define “Revenue” (KPI’s)
For many startups, revenue initially serves primarily as market validation. That is, the revenue you earn in the very early days typically isn’t enough to sustain the growth the company needs to see in order to capture the market you want to own in the short-run. So, in addition to (or in place of) revenue, look to identify your key progress indicators (KPI’s) that will help you justify your valuation. This is where you can get a bit creative. Here are some common KPI’s:
user growth rate (monthly or weekly)
customer success rate
daily usage statistics
At this point, it’s important to note that if you have little to nothing in the asset column and no KPI’s (i.e. you haven’t launched anything yet), it might be best to go the arbitrary valuation route, like this method from Guy Kawasaki.
Size Up Your Team
A good team can go a long way towards scoring a relatively high valuation. In other words, having solid talent in place is something that investors value highly. The goal of self-analyzing your team is not to necessarily put a number or value on specific personnel, but rather to simply take an honest look at your team on paper.
What experience do your team members have? What have you built together in the past? Have you ever launched or ran a startup company in the past? Do you have domain expertise? Have you had a successful exit? Did you work for a prestigious company or go to an elite school?
All of these things are examples of variables that move the proverbial needle in the minds of those you’ll be negotiating your valuation with: investors. Be prepared to highlight your team in the best light possible. Otherwise, the ‘team’ element could end up as a negative when it comes to your ultimate valuation.
Step 2: Choose a Model
There are many competing approaches to valuing a startup without revenue. I’m going to highlight a few of the most commonly used and well-respected methods by investors.
Dave Berkus is an active angel investor and lifelong entrepreneur. He came up with the following early-stage valuation model for startups:
Add to Company Value up to:
1. Sound Idea (basic value, product risk)
2. Prototype (reducing technology risk)
3. Quality Management Team (reducing execution risk)
4. Strategic relationships (reducing market risk and competitive risk)
5. Product Rollout or Sales (reducing financial or production risk)
Since you’re pre-revenue, the fifth element (financial traction) doesn’t apply. Therefore, the maximum value of your company using this method is $2 million. Based on the factors you’ve considered in Step 1, take your best shot at objectively filling in relative values for the first four elements in order to reach your valuation target.
Risk Factor Summation Method
This model takes a broader approach to valuing your company by breaking the risk down into 12 sub-categories. They are as follows:
stage of the business
sales and marketing risk
funding/capital raising risk
12.potential lucrative exit
Each sub-category of risk is assigned a grade of ++, +, 0 (neutral), -, or --. The scale for scoring each element is:
++ = add $500 thousand
+ = add $250 thousand
0 = do nothing
- = subtract $250 thousand
-- = subtract $500 thousand
Again, you’ll have to do your research (see Additional Resources at the end of this article) to get closer to an objective, relative measure for each component. Use comparable to help you get there, then tally up the results to get your valuation.
To get the best sense of whether your valuation is accurate (or, “sellable”), it’s best to use a few different models and compare results. Here are links to some other popular methods:
Cayanne Consulting Calculator
If you’ve got a steady cash flow and are generating sustainable revenues, the method you utilize for valuation will look a lot more like the models investors use to value mature companies.
Ideally, you will show investors that your revenue stream reduces the financial risk of the company while increasing the prospect of a ‘big-win’ at the same time. Most investors are looking for a 10 to 20 times return on investment (ROI) opportunity, at least. So, revenue — along with your business model (and things like customer acquisition cost) — should help you demonstrate this possibility.
Follow these steps to calculate a baseline valuation figure:
Calculate your revenue run rate (RRR), which is the most recent month’s sales times 12.
Look at your historical growth curve to calculate monthly, or better yet, your weekly revenue growth rate.* If your revenue correlates to user growth, then use this figure.
Calculate an adjusted RRR based on your growth rate by applying the growth rate to the most recent month’s sales and extrapolating out over the course of a year.
Multiply your adjusted RRR by a factor of ten to put yourself ‘in the ballpark’ of a rational valuation figure.
Further adjustments will undoubtedly be made to your sales multiple based on the factors you considered in Step 1, but this method will give you a reasonable valuation number to work off of.
Note that, in order to use the adjusted RRR, investors will want to see a repeatable, rational sales process. Customer acquisition cost (CAC) becomes extremely important here. The further you can demonstrate that your CAC reduces the risk of you not hitting your adjusted RRR figure, the higher the sales multiple you’ll be in a position to command.
Step 3: Adjust for Reverse Factoring
Pre-Money Valuation Versus Post-Money Valuation
Heading into negotiations with investors, first-time founders need to understand the difference between pre-money valuations and post-money valuations, as well as the implications they each carry with them.
The current pre-money valuation of your company is simply the valuation of your company at the present moment before accepting investment proceeds. It’s the number we’ve focused on in this article because it’s the starting point. When you discuss negotiating a valuation, you’re dealing with the pre-money valuation. As you’ll see, the post-money valuation is a calculation, not a negotiation.
The post-money valuation can be calculated as: pre-money valuation + investment proceeds = post-money valuation.
Why is the post-money valuation so important? There are two primary reasons:
The post-money valuation sets the bar as the current value of the company immediately after receiving funding. This impacts stock option issuance prices as well as the ‘paper-value’ of existing shares held.
Additionally, the post-money valuation dictates how future pre-money valuations will be calculated. If the company continues to grow and hit goals, the next funding round should see a nice cushion between the prior post-money and the new pre-money. If not, you may experience a flat or down round, which isn’t good for you or your investors.
Setting Ownership Targets
Many early-stage investors aim to own a particular percentage of a company with their investment. For example, an investor may want to own 20% of a company with their seed round investment and have an investment range of $250 to $500 thousand per deal.
Using these parameters, you can reverse factor the valuations they typically fund. In this example, the 20% would be based on the post-money valuation. Let’s figure out the range:
$250,000 / (pre-money valuation + $250,000) = 20%
pre-money valuation = $1,000,000
$500,000 / (pre-money valuation + $500,000) = 20%
pre-money valuation = $2,000,000
If you’re outside of an investors’ comfort zone, you may want to adjust your numbers or find another investor.
An Example: Facebook
Facebook made a lot of people a lot of money, including its early-stage investors. Let’s look at one of their first investments as an example of how significant the valuation can be for the companies who achieve soaring success.
In May of 2004, Facebook began serving ads on its site to generate revenue. That year, they generated $382,000 in revenue and raised $500k from Peter Thiel & co. at about a $4.5 million pre-money valuation.
Based on the actual numbers, Peter Thiel paid about 12 times on year-one revenue (partial year) to invest. At the time, it’s likely that the targeted multiple used in structuring the investment was higher than this given the extraordinarily steep nature of the actual growth curve.
That $500 thousand investment yielded about a 10% stake in Facebook at the time of conversion to equity (the financial instrument was a convertible note rather than straight equity). At the time of Facebook’s IPO in 2012, Thiel’s $500 thousand investment was worth about $1,700,000,000.
Doing some quick math, you can see that each percentage point of ownership granted to Thiel at the end of 2004 ended up being worth about $170 million at IPO. Had the pre-money valuation been slightly higher and Thiel’s ownership percentage (and share total) been slightly lower, his overall take would have decreased by some nine digit number. Granted, he would have done fine regardless in this situation — but you get the point.
By now, you should have a solid understanding of both how valuations are typically calculated for startups and why they ultimately matter. At the end of the day, a valuation is any number that your company and your investors agree it should be. That said, it’s best to do your homework before engaging in the negotiation process with a potential investor. Not only will it make you look prepared, it might even give you the extra bit of leverage you need to make the deal work in your favor.
Read in tutsplus.com