TenTopTechniquesforStartupValuation

ByMartinC.Zwilling,StartupProfessionals,Inc.

Onceyouhaveapotentialinvestorexcitedaboutyourteam,yourproduct,andyourcompany,the
investorwillinevitablyaskWhatisyourcompanysvaluation?Manyentrepreneursstumbleatthis
point,losingthedealormostoftheirownership,byhavingnoanswer,orquotinganexorbitantand
indefensiblenumberthatconvincestheinvestorthatyoudontunderstandbasiceconomics.
Thisisaparticularlydifficultchallengeforearlystagecompanies,lookingfortheirfirstAngelfunding
round,sincetheyarelikelytohaveveryfewassets,veryfewcustomers,andonlyatrickleofrevenue.
Thefoundersneedmoney,butarentreadytogiveupmajorityownership,yettheinvestorneedstohave
ownershipquantifiedtorationalizeatraditionallyhighriskinvestment.
Letsconsiderahypotheticalexample.Twofoundersofanewhealthcarewebsitecompanynamed
NewCohavespent$200Kofpersonalandfamilyfundsoveraoneyearperiodtostartthecompany,geta
prototypesiteupandrunning,andhavealreadygeneratedsomebuzzintheInternetcommunity.The
foundersnowneeda$1MAngelinvestmenttodothemarketingforanationalNewCorollout,builda
teamtomanageblogsandotherresources,andmaybeevenpaythemselvesasalary.
HowmuchisNewCoworthtoinvestorsatthispoint(premoneyvaluation)?WhatpercentageofNewCo
doestheinvestorownafterthe$1Minfusion(postmoneyownershippercentage)?Well,iftheparties
agreetoapremoneyvaluationof$1M,thenthepostmoneyinvestorownershipis50%(foundersgiveup
halfinterest,andlosecontrol).Ontheotherhand,ifthepremoneyvaluationis$4M,thefounders
ownershipremainsatahealthy80%level.
Sowhatmagiccanthefoundersusetojustifya$4Mvaluation(oreventhe$1Mvaluation)atthisearly
stage?HerearealistoftipsandtechniquesthatIrecommendtoeverystartup:
1. Placeafairmarketvalueonallphysicalassets(assetapproach)

Thisisthemoststraightforwardvaluationelement,oftencalledtheassetapproach.New
businessesnormallyhavefewerassets,butitpaystolookhardandcounteverythingyouhave.
Sometimesfoundersforgettoincludeallthecomputerequipmenttheyboughtorupgradedto
getthebusinessstarted.Besuretoincludeofficespace,officeequipment,furniture,tools,and
thevalueofinventoryorprototypeproducts,includingdevelopmentcosts.Fromthispoint
forwardthevaluationgetsmoresubjective.

2. Assignrealvaluetointellectualproperty

Thevalueofpatentsandtrademarksisnotcertifiable,especiallyifyouareonlyattheprovisional
stage.Yetthefactthatyouhavefiledisverypositive,andputsyoumanystepsaheadofothers
whomaybesteppingintothesamearea.Aruleofthumboftenusedbyinvestorsisthateach
patentfiledcanjustify$1Mincreaseinvaluation.

Ifyouareincorporated,thenyourcompanynameisalsoprotected.Ifyouhaveacquireda
marketingorientedInternetdomainname,andsometrademarks,thesealsogiveyoua
competitiveheadstart.Youshouldmakethecasethatthesetogetherarealsoworthasmuchas
therealassetsinthevaluationprocess.

3. Allprincipalsandemployeesaddvalue

Assignvaluetoallpaidprofessionals,astheirskills,training,andknowledgeofyourbusiness
technologyisveryvaluable.Backintheheydayofthedot.comstartups,itwasnotuncommon
toseeavaluationincrementedby$1Moreverypaidfulltimeprofessionalprogrammer,
engineer,ordesigner.

Dontforgettoincludethesweatequityforunpaideffortsoffoundersandexecutives.If
NewCostwofoundershavebeenworkingforayeareachonthiscompany,thatfactcouldbe
factoredinasiftheyhadbeenpaidaconservativesalaryof$100Keachperyear.

Ifthemanagementteamhassuccessfullybuiltacompanylikethisbefore,andhasdeepdomain
knowledge,asizeablepremiumforstrengthofthemanagementteamshouldbeadded.

4. Earlycustomersandcontractsinprogressaddvalue

Monetizethevalueofexistingcustomerrelationshipsandcontracts,evencontractswhich
haventyetbeensigned.Assignprobabilitiestoactivecustomersalesefforts,justassales
managersdoinquantifyingasalesmansforecast.Highlightanyrecurringrevenues,like
subscriptionfees,thatdonthavetobesoldfromscratcheachtime.

5. Usediscountedcashflow(DCF)onrevenueprojections(incomeapproach)

Infinance,thediscountedcashflow(DCF)orincomeapproachdescribesamethodofvaluinga
companyusingtheconceptsofthetimevalueofmoney.Allfuturecashflowsareestimatedand
discountedtogivethemapresentvalue.Thediscountrateusedistheappropriatecostofcapital,
andincorporatesjudgmentsoftheuncertainty(riskiness)ofthefuturecashflows.Thediscount
ratetypicallyappliedtostartupsmayvaryanywherefrom30%to60%,dependingonmaturity
andthelevelofcredibilityyoucangarnerforthefinancialestimates.

Withoutgettingintoallthemathematics,whatyouarelookingforisthenetpresentvalue(NPV)
ofyourabilitytoproducefuturerevenuesasprojected,factoredbytheriskinyourplan.There
areseveraloftheseinteractivecalculatorsavailableviatheInternettoexploretheconcept
withouthiringaCPA.

Forexample,ifNewCoisprojectingrevenuesof$25Minfiveyears,evenwitha40%discount
rate,yourNPVorcurrentvaluationcomesouttoabout$3M.

6. Multipleofdiscretionaryearnings(earningsmultipleapproach)

Thisapproachisusuallyappliedtoamorematurestartuponethathasatleastacoupleofyears
offulloperation,andhasalreadypassedthebreakevenpoint.Ifyouarestilllosingmoney,skip
aheadtothecostapproach.

Ifyouaredoingwell,youcanestimateyourcompanysvaluationbymultiplyingearningsbefore
interest,taxes,depreciationandamortization(EBITDA)bysomemultiple.Atargetmultiplecanbe
takenfromindustryaveragetables,orderivedfromscoringkeyfactorsofthebusiness,and
averagingtheresults,withthefinalaveragecalledthe"multiple".Theindustrytables,factorsto

assess,andthescoringprocessareavailableviaseveralwebsites,andsoftwareproductsare
availabletodotheworkifyoulike.

Avariationonthisthemeistolookatfutureearnings,ratherthancurrentearnings,andapplya
backwardmultiplier.Investorswantsuccessfuldealstoreturnatleasttentimestheiroriginal
investment.Roughlyspeaking,ifadeallookspromising,theywilltrytoestimatewhatthe
companywillbeworthinfiveyearsandthendividethatfigurebytentoarriveatthecurrent
valuation.

7. Calculatereplacementcostforkeyassets(costapproach)

Thecostapproachisemployedtogreateffectondifficultorunprofitablebusinesses.Itattempts
tomeasurethenetvalueofthebusinesstodaybycalculatinghowmuchitcouldcostforanew
efforttoreplacekeyassets.Mostinvestorstracktheinvestmentfundsandmeasuretheprofit
makingpotentialofthatinvestment.Undertheumbrellaofthecostapproach,itmakessenseto
usethereplacementvaluetoestimatethecurrentmarketvalueoftheenterprise.

IfNewCohasdeveloped10onlinetoolsandafabulouswebsiteoverthepasttwoyears,how
muchwoulditcostanothercompanytocreatesimilarqualitytoolsandwebinterfaceswitha
conventionalsoftwareteam?$2Mmightbealowestimate.

8. Findcomparableswhohavereceivedfinancing(marketapproach)

Anotherpopularmethodtoestablishvaluationforanycompanyistosearchforsimilarcompanies
thathaverecentlyreceivedfunding.Thisisoftencalledthemarketapproach,andissimilartothe
commonrealestateappraisalconceptthatvaluesyourhouseforsalebycomparingittosimilar
homesrecentlysoldinyourarea.

Usuallyyoucanfindonlineinvestorsiteswiththerelevantinformationonrecentfundingactivity.
Ifyoucantfindtherelevantinformationinthepublicdomain,youmayneedtoaskyourbusiness
advisorstoquerytheirinvestorfriends.Therearealsoprofessionalvaluationconsultantswhocan
certainlyhelpyouinthisregard,foraprice.

Dontforgettheoldrealestateadageoflocation,location,location.Ifyouandyourbusiness
arephysicallylocatedinjusttherightplaceattherighttime(nothinglikebeingnextdoortoa
majorsupplierorcustomer),thenbesuretoincludethisfactorintoyourvaluationestimate.

9. Lookatthesizeofthemarket,andthegrowthprojectionsforyoursector

Thebiggerthemarket,andthehigherthegrowthprojectionsarefromanalysts,themoreyour
startupisworth.Forthistobeapremiumfactorforyou,yourtargetmarketshouldbeatleast
$500millioninpotentialsalesifthecompanyisassetlight,and$1billionifitrequiresplentyof
property,plantsandequipment.

Intheinvestmentcommunity,thispremiumfactoriscalledgoodwill(alsoappliedfora
premiummanagementteam,fewcompetitors,highbarrierstoentry,etc.),andgoodwillcan
easilyaccountforacoupleofmillioninvaluation.

10. Assessthenumberofdirectcompetitorsandbarrierstoentry


Competitivemarketforcesalsocanhavealargeimpactonwhatvaluationthiscompanywill
garnerfrominvestors.Ifyoucanshowabigleadoncompetitors,youshouldclaimthefirst
moveradvantage.Investorslookforabigenoughwindowofopportunityforacompanyto
generateprofitsbeforecompetitorsswoopinandcrimpmargins.Ontheotherhand,ifthereare
morethanthreesimilarcompetitors,that'sabadsign,andwillhurtyourvaluation.

Ifyoucanshowthatyourcompetitorshavelargebarrierstoentry,thisalsomayqualifyyoufor
apremiumvaluation.Barrierstoentryrepresentuniquecircumstancesthatthwartcompetitors
attemptsfromenteringthetargetmarketandcapturingamajormarketshare.Suchbarriers
includeuniquepeopleskills,governmentregulations,marketshare,partnerships,recognized
brandname,economicandmarketconditions,existingcustomerrelationships,andmanyothers.

Insummary,youcanseethatstartupvaluationsalwaysstartwithrealfinancialdatawhichyoushouldbe
readytoprovide.Theanalysisthenextendsintomanysubjectiveareas,sobepreparedwithownyour
assessmentalreadysummarizedinyourFinancialModel.Beawarethatmostinvestorsfollowasetof
pragmaticsolutions,moreartthanscience,andonlytheexperiencedinvestorwillevenunderstandor
appreciatesomeoftheapproachesdiscussedabove.

Evenifagiveninvestorexcludessomeoftheabovecomponentsofvaluefromconsiderationinyourcase,
yourcredibilitywillbebolsteredbythefactthatyouunderstandhisbusinessaswellasyours.Inanycase,
theanalysiswillprepareyoufortheheavynegotiationtofollow.Rememberthatprecisionisnotthe
issueherethetaskfortheentrepreneuristobuildacompanythatisworthatleast$50Mbefore
thinkingaboutanexitsonoinvestorwantstospendmorethanfiveminutesarguingthefinepointsof
thelastvaluationdollar.
Inanycase,flexibilityisthekeymessageyouwanttoconveyalongwiththefactthatyourprimary
interestislaunchingthestartupaboutwhichyouarepassionate,andwhilechangingtheworldthrough
thisstartupyoualsointendtomakeagreatdealofmoneyforyourselfandfortheinvestor.Theideal
scenarioisthatbothpartiesexitthenegotiationbelievingthatthedealisfair,althoughtheywouldhave
bothlikedtohavereceivedmorevalueontheirsideofthedeal.Attheoutsetitisimportanttoremember
thatitwillbemuchbettertoownasmallerpercentageofalargesuccessthanalargepercentofastartup
thatdoesn'tgetofftheground.
SowhatisareasonablevaluationforacompanylikeNewCo?Myadviceforearlystagecompanieslike
thisoneistotargettheirvaluationsomewherebetween$1.5Mand$5M.Alowernumbersuggeststhat
thefoundersaregivingawaythecompany,whileamuchhighernumbermaysuggesthubrisorlackof
realityonthepartoftheowners.Ofcourse,wehaveallreadaboutthenewcompanywith$100M
valuation,butIhaventmetoneyet.

Abouttheauthor
MartinC.ZwillingistheFounderandCEOofStartupProfessionals,Inc.,aPhoenixbasedcompanywhichoffers
startupsarangeofpackagedofferingsandconsultingservices.HeisamemberoftheArizonaAngelsgroup,where
heservesontheSelectionCommittee.HeisamentortostartupsthroughtheArizonaStateUniversityTechnopolis
program,andhasdoneguestlecturesonentrepreneurshipintheirMBAprogram.HeisalsoontheBoardofahalf
dozenstartups,andhasanextensivetechnologybackgroundwithIBMandotherlargeandsmallcompanies.Hemay
becontacteddirectlyatmarty@startupprofessionals.com.