Valuing a Start Up
Conjuring Wealth out of Thin Air
In order to raise money for a venture, you must first come up with a valuation for the nascent enterprise.
Valuing a start up can seem like an act of legerdemain, a magic trick. How do you put a concrete value on something that only exists as an idea, vision, or, at best, a partially formulated enterprise?
There are two interconnected valuations:
- The Valuation of the enterprise based on financial projections
- The pre-money Valuation for the current round of funding
The link between the two is what shows potential investors that if they put money in at the current proposed funding valuation, that they stand to make a significant return, if and when the company reaches a valuation based on the financial projections.
Estimating the present value of future cash flows is the game. The first valuation is based on creating scenarios around your financial projections and estimating a realistic discount rate to pull those numbers back to present value.
This valuation technique has lots of numbers populating a spreadsheet and math is involved, which gives it an air of authority, validity and accuracy. But all those numbers in the spreadsheet are forecasts based on assumptions and predictions that, at the end of the day, were pulled out of thin air.
Those numbers are usually overly optimistic both in their size and the timing of when they will come in as revenues. Any experienced investor will look for these numbers to be credible as an indication of whether or not the founders are reliable business people.
The source of this overstatement error, and a red flag for investors, is reflected in in the fact that, being so close to the project and emotionally invested in its success, the revenue projections created by the founders are too high and the expenses too low.
Don’t fall prey to your enthusiasm and hype and keep a little emotional distance when working on financial projections and the related budgets.
“Hockey Stick” projections
It used to be that radical prediction of growth in revenues was a dead giveaway of an inexperienced and overly optimistic founder. But now with Growth Hacking marketing techniques, a revenue graph that looks like a “hockey stick” can generate excitement among investors; with the caveat that the strategy is reasonable in support of this kind of growth.
The discount rate is the other important factor. Calculate, refine and adjust your discount rate based on comparable public companies and their rate of return, or other risk-adjusted returns investors require in the market for a similar enterprise.
We look at public companies because they are the ones that we have access to their financials. Go to the EDGAR section of the Securities and Exchange Commission website www.sec.gov and look at the 10K filings. You need to identify comparable companies as part of your industry and competitive analysis as well as for valuation, so the SEC site is a great resource.
The nature of your forecasts is to get an idea of the future. Unless you have a powerful crystal ball, this is best expressed as a range of values. Your financial projections are essentially Income Statements projected into the future. They should show an EBITDA and free cash flow that support a significant present value range of the future cash flows.
Optimism and Pessimism
Determine the range of cash flows by creating scenarios on either side of your expected projections: an optimistic scenario and a pessimistic scenario. These scenarios will show you what kind of room and resources you will have to weather events when things don’t go exactly as planned.
You want to make sure that even if things don’t go as predicted that there is enough of a cushion to survive. Compare the present value range to the valuation you are asking for the current round of funding (the second valuation mentioned above).
The pre-money Valuation
This valuation is market driven and negotiated based on the interest of potential investors and their appetite for your particular set of risks. This funding valuation needs to be supported by a feasible scenario (the first valuation) where the investors stand to make a significant multiple of their investment.
For example if you ask for a round at a $10M valuation (that is $2 per share for 5 million shares say), and the present value of the projections is in the $1B range then you can show that this venture has the potential to be a 100X investment, or two orders of magnitude. That is the kind of potential investors like to see. If the investment has that kind of credible potential then even if it falls significantly short, there is still the potential for a sizable return. That type of scenario mitigates perceived risk in an investor’s mind.
That could be appealing and attractive to some investors with an appetite for the particular technical and market risks of your enterprise and their belief that your growth projections are credible. This is the psychological crux of the deal and where greed needs to override fear to complete a transaction.
How much for how much
This is the valuation that is used to calculate how much of the company you are willing to part with in exchange for the funding. For example if you are proposing a funding round at a $5 million valuation and you intend to raise one million dollars then you are proposing that the investor will get 20% ownership of the company.
If any of this is confusing, let me summarize and restate this approach to try and clarify the points. There are two valuation numbers associated with raising capital:
- The valuation based on discounting the cash flows from your financial projections over a range of scenarios. This is a clear-cut present value calculation based on the time value of money. The numbers being discounted to present value, however, are numbers that you invented and their credibility is crucial.
- The value of the enterprise based on how much a potential investor is willing to pay for a share of the company as it stands today. This valuation is a market driven negotiation with potential investors and takes into account the perceived uncertainties surrounding achieving the cash flows you are projecting.
The pre-money valuation of the company (the value before investors put in their capital) should be some fraction of the valuation based on the present value of the future cash flows so the investors see they stand to make some multiple of their initial investment.
There is art and nuance involved in coming up with a suitable valuation. Think about how much money you need in order to get to revenues and a sustainable business model, and how much of the company you are willing to part with in order to get those funds. This is the fundamental trade-off.
A sensible strategy is to first get a range of valuations for the present value of the projections and then divide the average by 10 or 50 or 100 and make that the asking valuation for investment. This denominator will depend on what round of funding you are in and what milestones you have already achieved. The closer to sales, the lower the multiple; it is all about risk and reward. Whether there are investors that will have an appetite and what the demand will be is another question.
Use this approach to calculate and converge on the funding “ask” supported by the PV of future cash flow valuation. This process is transparent and can create a great deal for your company and your investors. This is the magic of creating something out of thin air, an idea, and putting a dollar figure on it.
Let me know what you think and if this is in any way helpful. Thanks!