It’s frequently said that business valuation is in the gray area. This is also true and applicable as well as in the practice of valuing a startup business. Entrepreneurs require to put a value on their startups in order to raise money, and investors need to put a value on their investments to generate liquidity.
Herewith are some tips that can assist you to make sense of startup business valuation.
- You are what the market says you are. If investors are telling you that your startup is worth $1 million, then that’s what it’s worth. In this case, you might consider it’s worth more. You might even know it’s worth more because your company may have more than $1 million in liquid assets, or more than $1 million in receivables, or more than $1 million in sweat equity. But if you’re unable to raise money for your startup with a valuation above $1 million, then you’ll have to accept the market valuation.
However, this isn’t always true. It’s possible that your company has been overvalued or undervalued (more likely, overvalued), if you raise money from relatives and friends rather than professional investors. For instance, if you convince your father and your rich aunt to purchase shares in your business at $20 per share, it doesn’t mean that future investors will recompense more than $20 per share-even if your business grows and prospers.
- But you can also tell the market what you’re worth. It is possible to tell the market how to value your company, although this might seem to contradict the point made above. After all, if investors think your startup is worth $1 million, it’s usually because of something you’ve told them. By definition, startups don’t have a history of financial performance on which to base a valuation. Therefore, it’s up to the entrepreneur to develop a process for valuing the company based on comparables and financial projections.
In term of comparables, research how much similar companies in the similar industry and geography are worth. For this, you can utilize sites such as BizBuySell and BizQuest to determine how much businesses are selling for in the industry. Another way to get good comparables are by taking advice from a high-tech or high-growth startup, accountants and lawyers are among the best advisors to help you determine the market rate for comparable companies at your stage. Beware that based on the experience, attorneys incline to overvalue startups, and accountants tend to undervalue startups, so in this sense, it is better to talk to both before making a decision.
In term of financial forecasts, although it’s notoriously difficult to estimate revenue at a startup, you’ll need to do this to determine value-and eventually to defend your valuation. For instance, if you’re starting a accessories store, your valuation and financial projections will likely be lesser than if you’re starting a speculative biotechnology firm.
- You’re not really worth anything until you’re profitable. If you’re not profitable, your business probably isn’t worth very much. That is, it doesn’t have as much liquidity as it would have if it were profitable. Many businesses cannot be sold since there aren’t sufficient business buyers for every seller. Almost all unprofitable businesses cannot be sold for the same reason.
This makes valuation predominantly challenging for a startup. Since young businesses take time to become profitable, the trick of valuing startups is to focus on the future. First, determine how many years it will take to be profitable. A business with a long road to profitability will usually be worth less than one with a quick path to profitability. Next, determine how much comparable companies have been valued at when they reached profitability. A company that could be worth $5 million at profitability will be worth some fraction of that number at the startup stage, based on factors such as the likelihood of success, the time frame to exit and the quality of the management team.
There are some of the methods that can help you to value the startup these are Berkus methods, Risk factor summation method, Scorecard valuation method, Comparable transaction method, Book value method, Liquidation value method, discounted cash flow method, First Chicago method, and Venture capital method. So, what is the best valuation method?
Firstly, remember that the only methods really used by VCs are comparables and a rough estimate of how much dilution is acceptable by the founders, for example giving out 15% to 25% for a seed round comprised between $300k and $500k, or making sure that the founders remain majority shareholders after a Series A.
Secondly, let us remember that valuations are nothing but formalized guesstimates. Valuations never show the true value of your company. They just show two things: (1) how bad the market is willing to invest in your little red box, and (2) how bad you are willing to accept it.
Valuations are a worthy starting point when considering fundraising. They help to build up the rationale behind the figures and actualize the discussion. But in the end, these are just the theoretical introduction to a more major game of supply and demand.