How To Value Your Company? Everything You Need To Know About Your Startup’s Equity.
The process of valuing a startup can be both challenging and complicated. The end result is essentially a ‘best guess’ valuation that’s based on such things as the previous experiences of the investors and past performance of similar companies.
By focussing on some key factors, you can give your startup a strong valuation, and from there you can approach your financing round. Unicorn or not, when capital raising is based on a strong valuation, your growth and development comes from as solid a foundation as possible.
This blog will cover how to value your startup and will then discuss factors affecting the valuation, such as how much you aim to raise and how much of the company you might want to sell.
How to value a company
Valuing a startup is not a simple process. There are as many methods and nuances to performing a valuation as there are venture capitalists looking to make an investment.
The most appropriate valuation method for you is likely to be different than another startup. Different levels of founder experience, operating in different industries, different ideas, all these things impact the valuation, making valuations very personalised.
In short, valuations are often more art than science.
Although not straightforward, it is possible to perform a valuation using recognised valuation methods suitable for your sector or industry.
The most common methods used are:
· discounted cash flow (DCF)
· market multiple
· valuation by stage
Each will be expanded on more below. Variations of these methods represent the majority of valuations involving startups.
All of these methods rely on a certain amount of information being available to perform a valuation calculation. This can be company financial accounts (or projections), competitor information and market history (competitor buyouts, public listings, fundraising rounds…).
Having little revenue (or none at all) makes valuing a startup notoriously difficult. Startups can be fundraising when they are still years away from making sales, let alone profits. Sometimes, a startup has no comparable competitors and might even be developing its own market, making comparisons impossible and valuations very tricky.
Some of these non-profitable startups hold truly astronomical valuations. Companies such as Snapchat, Airbnb, SpaceX and Uber all achieved unicorn status (valuation > $1bn) before they were profitable.
A startup valuation can go far beyond the value of its parts. Instead, additional startup value is derived from the synergies that exist between the resources, intellectual property, technology, brand and any financial assets at the startup’s disposal. Investors also see value in non-tangibles such as first-mover advantage.
Ever wish you could read an investor's mind?
Now let’s look at some common startup valuation methods.
1. Discounted cash flow (DCF)
Discounted cash flow analysis is a valuation method employed to provide an estimate of a company’s value based on its future cash flows. DCF calculates the present-day value using the projected amount of money it will generate in future. The projections include the company embarking on new projects, making investments and other strategies that might generate income.
DCF analysis uses a discount rate to determine the present value of expected cash flows. The discount rate refers to the interest rate used in the present value calculation.
For example, £100 invested by you today in a savings account offering a 10% interest rate will grow to £110 in the future.
So, £110 (in the future) when discounted by the rate of 10% is worth £100 today (present value).
Discussing discount rates is beyond the scope of this blog, but a basic rate to use in a valuation formula would be a risk-free rate. For example, the rate offered by a 10 year UK government bond. Risk-free in this context refers to the very low risk of default. This rate is chosen as an investor has a choice about what they invest their capital in, a UK government bond or a startup, by using DCF analysis these investments can be compared and the opportunity the startup offers can be weighed against a risk-free alternative.
To perform the DCF calculation there are three basic steps: forecast the expected cashflow, select a suitable discount rate and finally discount the cashflows back to a present value.
The formula for DCF analysis is:
CF1 is cashflow year 1, CF2 is cashflow year 2.
r is the discount rate.
An example calculation would be:
Investment wanted: £75
Future Cashflow: Year 1 £100, Year 2 £100, Year 3 £100,
Discount Rate: 10%
The present value of future cashflow is calculated as:
Year 1: £90.91, Year 2: £82.64, Year 3: £75.13
Subtracting the initial investment from the sum of the discounted cashflows gives us a net present value of £173.68. This indicates an investment of £75 in year 0 will provide positive future cashflow and a return for the investor.
2. Market multiple
Market multiple as a valuation method is popular with venture capitalists. It gives investors a reasonable indication of what the market is willing to pay for a company. In broad terms, the market multiple approach compares the startup to other recent valuations of similar companies operating in a similar market.
As an example, if we take the GreenBank company from above, by looking at the market we can see that banking startups are being valued at 8x their revenue. Knowing this, we can use it as a starting point and then adjust the multiple for other factors. By being environmentally friendly we believe we have a unique advantage in the market, giving our multiple a premium of 2. So, we can pitch to investors with a 10x multiple. Alternatively, we may want to recognise that our valuation is occurring at an earlier time than other recent transactions and we need to adjust the multiple down to 7x.
Valuing startups at an early stage requires the financial forecasting of sales and earnings for when the company has matured. Many startups are funded by investors years before they become profitable, mainly because the investors are convinced by the founders and the business model and believe it will be a success in the future.
One drawback of market multiple valuations is that there is often no market data available to be able to find comparable valuations. Even when there are competitor deals available, sometimes very early stage valuations are done behind closed doors and the terms of any deals are kept confidential. This can make performing a market multiple valuations very difficult.
This approach, as its name suggests, values a company based on how much it would cost to create a new company just like it from nothing. This is based on the idea that any sophisticated investor would never invest more capital in a company than it would cost to replicate that company.
The cost to duplicate a company can be based on various aspects. For a tech startup, it might involve the cost of research and development, patent applications or the time spent building a mobile app. The cost to duplicate approach to valuation can be viewed as a fair starting point for an early-stage startup. This is because it’s based on actual expenses and other tangibles that can be verified.
The downside of the cost-to-duplicate is that it doesn’t value the future potential of a startup. After all, for successful startups, the future financial upside can be enormous. The intangible assets held by the startup, such as brand recognition and first-mover advantage, are also neglected in this valuation approach.
For these reasons the company valuations returned by this method can be viewed as a starting point, or the lower end of a valuation range. This can then be adjusted to take into account factors that the founders believe add value, such as intellectual capital.
4. Valuation by stage
The valuation by stage approach can give investors a rough idea of company value. Investors using this method will be angel investors or venture capitalists. The valuation they come up with using this method will be based on their experiences of investing in similar startups and how far along its life cycle the startup is.
As a company progresses along its life cycle and becomes more developed the more the value of the startup grows (generally speaking). In part, this is because the risk to the investor is lower and the business model becomes more advanced.
An example of a valuation by stage model would be:
£50,000 - £250,000
Strong idea and business plan
£250,000 - £600,000
Strong management team in place
£600,000 - £1,000,000
Final product ready or ready for market
£1,000,000 - £2,500,000
Customer base established
Producing revenues and path to profitability
The value stratifications will be variable based on the industry the startup is based in and other factors such as the experience of the founders. In almost all cases, if your startup has nothing but a business plan, it will receive the lowest end of a valuation range. This recognises the extra risk placed on investors. As it can be seen, as a company progresses forward and hires a management team and develops a product, its value increases.
It’s not uncommon for investors to make some of these milestones conditional on releasing tranches of investment. For example, an initial investment might be provided to allow the company to progress to the next milestone, whereby once reached the investors will release more capital to move the company on again.
How much equity to give up?
Every startup is different, and the conditions surrounding them are individual to that business and those founders. Whether you’re pitching to angel investors or private equity, there is no standard formula to follow that will tell you how much equity an entrepreneur should be willing to give up.
That said, some general guidelines can help founders to avoid mistakes when making this first big step in the startup’s life cycle.
In any initial fundraising round, it can be prudent to not give away more than 10-20% of your equity. This is because any more than that can make further fundraising rounds difficult, with your share becoming more and more diluted each time. You will have to balance getting the money now and reaping the rewards further down the line.
If you can give up less than 10% that would be ideal, however, if you aim for this you may not end up with the capital you were looking for and some investors may not be interested in taking on risk for such a small equity share. A balance needs to be struck. For low equity stakes, investors may not be willing to give up their time and expertise to help you along the way, the equity you give away has to be enough to entice investors and get them excited.
Ultimately, valuing your startup accurately is important. Being able to defend your valuation and show why you have arrived at that value is also important. Investors are going to challenge your numbers and you have to be able to convince them that your startup is worth every pound you say it is. Being transparent, realistic and thorough in your valuation consideration is vital in this respect, especially if you have a fixed value of equity you expect to exchange for the capital you need. Get your valuation wrong, and you may have to give up more than you’d like to get the money you need to move your startup forward.
A final concern to have when approaching an equity sale is the individual investor you’re pitching to. If this individual is someone you want to partner with for their business expertise and experience, in the long run, it may be worth giving up slightly more equity than you’d planned on. Bringing the right investor on board, with all their market knowledge, can ultimately help your startup grow beyond your financial projections, and so in this way, they will help your business become more valuable in future. Making the decision a no-brainer for the right person.
A valuation calculation for any startup is going to be difficult, unpredictable and based on lots of factors, some outside of the startup. Investors often have their ideas about valuations based on their previous knowledge and experiences. To maximise the value for their startups, founders can focus on key elements of their business to ensure it is best placed to build revenue, leverage opportunity and mitigate risks, inherently adding value.
Valuations can be impacted by the management team; the potential size of the opportunity in any given market; the competitive environment; and the need for further financing later on. It is important to remember that no valuation is permanent, and the act of fundraising and attracting investors can increase the startups’ valuation, based on the expertise you’re bringing to your team. This blog has covered some key valuation methods and discussed giving up equity. By considering these it can help you decide the best way of moving forward and approaching a valuation of your startup. The process of valuation is worthwhile as it allows you to understand your market, your consumers and to develop a convincing growth strategy, which will help investors understand that your business is worth investing in.
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