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Startup Valuation: 3 Tips For Putting A Price On Your Company

Guest post by: Nathan Beckord

Article Overview: When raising angel or venture capital, startup founders are often concerned with questions about the valuation of their company. Putting a value on an early stage company-- especially one with very little or no revenue and negative cash flow-- is difficult to do, since most traditional valuation methods do not work well for startups. In this article, we discuss how startup companies are valued by investors and how you should set a valuation range when dealing with seed, angel, or VC investors.

Startup Valuation: 3 Tips For Putting A Price On Your Company

Part of my job description involves prepping startups to raise capital. One of the most common issues that concern entrepreneurs is how to address the "valuation question." I understand this concern; raising money puts a very un-ambiguous stamp of "worth" on what you've worked so hard to create. As such, it is logical that entrepreneurs want to approach the negotiating table with a bullet-proof spreadsheet detailing and supporting their (proposed) valuation down to the last dollar.

Which is exactly why they hate my answers to the question, "what is our valuation?"

• Your company is worth is what the market will pay for it, and,
• Valuation is an art not a science.

They hate these retorts for several reasons; for one, it essentially means that valuation hinges on their negotiating skills (which is daunting because they're going up against professional investors / negotiators). Second, these are fuzzy answers-which are not what they expect from a CFA with a graduate degree in finance.

Unfortunately, I cannot make it much less fuzzy. It's not because I don't understand valuation; on the contrary, I spent the first few years of my career doing nothing but valuations of technology companies.

But the challenge is that none of the traditionally-accepted valuation methods really apply to early stage startups. Let's briefly review why:

• Discounted Cash Flow Model: A DCF model "feels" the most robust because it is very quantitative and analytical, and it results in a single valuation number. In a DCF, we forecast several years of revenue and expenses, and then discount the resulting cash flow back to the present using a "venture capital expected rate of return." The models are beautiful, sophisticated, and complex. They dazzle.

But here's the problem: a skilled Excel wizard can make a DCF spit out any valuation they want. Because there is no (or very little) historical data with most startups, forecasts are pure conjecture and fantasy. In addition, the model is extremely sensitive; adjust the discount rate down slightly and our growth rate up, and suddenly your valuation doubles. No serious investor would ever pay much heed to this.

• Cost-To-Recreate Model: This is just as it sounds-we back into an estimate of what it would cost to duplicate or recreate the company with one of like utility. It is analogous to a make-vs.-buy decision, and the premise is that a prudent investor would pay no more for an asset than its replacement or reproduction cost. As one simple example, we might estimate the cost in terms of the number of man-hours of programming required to write a comparably-functional software program. While this method also spits out a tangible, "hard" number, it doesn't fully capture the future potential of a business, and it doesn't reflect the value of things like the brand (which can be quite valuable).

• Market Multiple Model: This is the most robust method and it is actually used in the venture world. With the market approach, we value a company by looking at recent sales or offerings of comparable companies, then we adjust the multiple to reflect specific characteristics of our company. This gets us closest to the answer above that "valuation is what the market will pay."

However, here's the catch: it is very hard to find accurate data on truly comparable startup comps. Not only is it hard to find apples-to-apples comps, but funding valuation data is often kept close to the vest. While some companies report this-usually when they get a huge valuation round-most startups do not, and as private companies they are not required to do so. (To clarify, many companies report how much they raised, but not at what valuation they raised it at). Even some of the very powerful databases we use such as Capital IQ do not always contain this data.

So, having crossed off traditional valuation models, what do seed and series A startups do?

How do we best approach the question of valuation? Here are three methods:

1. Use Stage of Development As A Proxy: A startup's path from idea to IPO can be charted as a series of major milestones (as well as hundreds of smaller stepping stones). At each milestone, a startup's valuation rises as more and more risk has been removed from the business. Thus, one way to assess valuation is to look at where your company is at, and match it to typical valuation ranges for each stage. For example a typical funding-path for a web business may as follows:

Stage -- Type Of Investor -- Typical Valuation Range

Concept/Business Plan -- Self Funded or FFF -- $250k to $1m

Technology Developed -- Angels -- $1m to $5m

Launch/Early Customer Traction -Seed VC, Series A VC -- $5m to $15

Scaling and Adoption CF- - Series A/B VC - huge variability ($15 to $25, with outliers up to $100m)

Rapid Expansion, CF+ -- IPO or Exit (Funds/Public or Strategic Acquirers) - huge variability ($100m to $1b)

Different types of investors play at each round, and if things are tracking well for the company, there is typically a sizable jump in valuation at each stage. For example, the increase in valuation between the first and second stages-- where we've eliminated most of the technology risk-- is usually relatively slight. Between the second and third, we've proven that a market exists-someone will buy the product. Many more investors are interested at this stage. Between the third and fourth, customers are piling on, which leads investors to pile on-thus creating astounding valuations like we see with Facebook or Twitter.

2. Put On Your Best Poker Face And Just Ask: Let's assume that you have a SaaS company that has built a decent first version of the technology, launched it, and generated a base of initial customers (and corresponding metrics). You've eliminated most of the technology risk and some of the market acceptance risk, and you only have one or two gaps to fill on the management team.

Looking at the table above, you determine that Series A deals for companies with similar characteristics often fall into the $5 to $15M range. Your customer prospect pipeline is filling up, and VCs have been receptive to your meeting requests; overall, you're feeling good about your funding prospects. Thus, at the end of a pitch meeting, when asked what we think your valuation is, you should either avoid the question (saying you'll let the market decide), or you should state simply (and without blinking), "we're looking for a $12 to $14M pre."

From my experience, if the ask is within the range of reason, there is usually not much further discussion. The VC takes note of it, and files the information away as a point for future negotiations. After all, it's not like we're demanding a certain valuation and trying to justify it. We're simply stating what we're looking for. It's analogous to selling a car...the buyer probably knows the general price range for cars like yours, and if you're within the relative range, then it comes down to how much he really wants the car. Whether he accepts the price you're asking also comes down to how many other buyers are interested, which brings us to the next point...

3. Get Other Buyers In The Game: This is the biggie. The level of interest in a deal is the single most important factor influencing valuation (and for that matter, for negotiating everything else on the term sheet). In short, if you have just one investor interested, he or she sets the price, and you are free to accept it or walk-you are a price taker. If you have multiple investors interested, then your leverage increases tenfold, and you become a price maker. In such situations, we have effectively created a "market" for your stock-and in some cases, this can escalate to become a heated auction environment (which is the reason why some valuations catch fire and go through the roof).

In sum, a little knowledge (of comps and ranges), a little confidence (the "art of the ask") and the ability to generate demand from multiple parties are your best tools to manage the valuation discussion and term sheet negotiations.

Remember: your company is worth is what the market will pay for it. Create a market for your startup, and you will have the leverage to get what you feel it is worth.

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Article Tags: angel, founders, setting valuation, startup companies, startup valuation, startups, valuation methods, valuing a business, valuing a startup, vc investors, VC valuation, venture capital



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