19 January 2010

Startup Valuation: How Much Is Your Company Worth?

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. Thus, it is logical that entrepreneurs want to approach the negotiating table with a bullet-proof spreadsheet detailing and supporting their valuation down to the last dollar.

Which is exactly why they hate my answers to the question, “what is our valuation?”:
  • Startup valuation is an art not a science; and,
  • Your company is worth is what the market will pay for it.
They hate these retorts for several reasons; for one, it essentially means that valuation hinges on their negotiating skills (which is daunting since they’re going up against professional investors / negotiators). Second, these are fuzzy answers— 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 financial 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 intangibles like the brand (which can obviously 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 difficult to find accurate data on truly comparable startup financings. 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 funding-path for a web or software business may be as follows:


Different types of investors play at each round, and if the company is executing to plan, there is generally a sizable jump in valuation at each stage. For example, the increase in valuation between stages 1 and 2 – where we’ve eliminated most of the technology risk—is usually relatively slight. Between 2 and 3, we’ve proven that a market exists—someone will buy the product. A much larger segment of investors are interested at this stage. Between 3 and 4, customers are piling on, which leads investors to pile on—thus creating astounding valuations like we see with Facebook or Twitter.

2. Tell A Really Good Story: Because there are few really solid quantitative ways to value a startup, estimates of a company’s worth often come down to perception. This, in turn, comes down to how well you present your company in the form of your investor pitch and pitch deck. My rule of thumb here is simple: present the company in as favorable a light as possible, without misrepresenting it in any way. This includes how you position your company vis-à-vis the competition, what you choose to emphasize or call out with respect to opportunities and strengths, and so forth. As in sales, it pays to focus on the attractive and compelling parts of your business and the value your company brings. Pitch it with passion, while addressing any issues or ‘warts’ candidly and honestly (they will come out in due diligence anyway).

A corollary note is that
presentation matters. How you present the company to investors in the form of your pitch deck and business plan is a signal of how you will present the company to the outside world, and to future investors in later rounds. To elucidate this, I use the example of selling a car. A few simple things like a thorough cleaning, detailing and a good polish can spark an emotional response in the buyer and raise the valuation far more than the cost of such services.

The converse is true as well: a messy, unattractive, or problematic car will turn off most buyers; or, if buyers are still interested, they will use such flaws to beat down the price. This analogy carries through to due diligence: fixing a $20 rattling door handle preemptively removes that obstacle to a sale, just as cleaning up your startup’s capitalization table and IP assignment rights in advance will ensure the funding process goes that much smoother. In short, make it attractive and make it easy for the buyer to buy.

3. 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 pipeline is filling up, and VCs have been receptive to your meeting requests; your pitch and slide deck are polished, and overall, you’re feeling good about your funding prospects. Thus, at the end of a pitch meeting, when asked what you think your valuation is, the best approach is to either avoid the question (saying you’ll let the market decide), or to state simply and without blinking, “we’re looking for a $12 to $14 million pre” (with "pre" signifying pre-money).

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. Continuing with the analogy of 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.

37 comments:

  1. Suzanne Roberta DennemeyerJanuary 20, 2010 at 2:44 PM

    Excellent article Nathan.

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  2. POSTSCRIPT: An important addendum to this article is that valuation is just one factor in a deal (and not always the most important one). It's common and all too easy to get overly focused on valuation and not spend enough time/effort on the rest of the terms-- many of which will impact a startup in later rounds.

    For an excellent bit of further reading view Jeff Bussgang's article here: http://bostonvcblog.typepad.com/vc/2009/07/in-vc-deals-price-doesnt-matter-but-the-promote-does.html

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  3. One more additional link: Dharmesh Shah's tips and lessons learned from raising $33M for his startup:
    http://onstartups.com/tabid/3339/bid/11791/9-Quick-Tips-Learned-While-Raising-33-Million-In-Venture-Capital.aspx

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  4. Good information, thanks. Hope you are getting out and sailing this summer.

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  5. Thanks David! As matter of fact, I was out sailing the very moment you posted that comment! (but in the SF "summer" which is really pretty cold) Nathan

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  6. Thanks for sharing your knowledge. I was able to re-enforce some of the general ideas I had about start-up valuations. I have a an innovative dating service with a patented system ready to be launched, but i do not find easy to get to investors. Too many filters to get to them,you have to be connected, belong to the right group and be very rich. For instant, to pass their judgement the team company have to have a backgound that 99,9% of the time is meet by the rich and well conected in society. Have a pleasant life.

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  7. Ok, I would love hear what you guys think about this. I'm at a loss for how to think about something. How do you put a value on someone signing a commercial lease. Situation: Cosigner on commercial lease allows NEWCO to obtain space with $100/sqft tenant allowance. THis puts cosigner on hook (on a decreasing amount over time) for about $1.1mil, again decreasing over time as rent is paid. How do you build the value of that TA into valuation? First cash investor put in $100K for 15% of company. Second cash investor says that that values company at around $700K so his $400K investment should be worth about 60% of the total value of the company. Totally discounting the guy who singed a lease that got about $850K of TA (but had not hard capital outlay) Has anyone seen this before? how do you value this?

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  8. Jennifer-- regarding the first investor/second investor question, if they invested at exactly the same time, then the valuation would generally be the same. But, if second cash investor came in later, the valuation would (normally) be higher, so his $400k would buy proportionately less of the company. In other words, valuations and percents are not static. As for the lease question, I don't follow. In theory, a below market long term lease could be considered an "asset" but this wouldn't materially impact a startup's valuation, which is mostly driven off future potential of the company.

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  9. I'm sorry I wasn't clear enough. Think of it this way or let me ask it this way. It's not a below market lease question really but more of a matter of how do you value someone personally guaranteeing a lease to the tune of about $1mil?
    What is the value of that guarantee? Lets say if $100K in CASH buys 10% of the company, how much would a corresponding letter of credit or guarantee of $100K be worth? I can see where it would be worth less than 10% but what kind of rationale could you use to value? Sign this guarntee putting you on hook for $100K and get X% of company. Thanks! Love the feedback.

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  10. BTW, i've been poking around your blog..Awesome. Thanks
    Jen

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  11. Honestly, I have no idea. I can't think of any real-world analogy to what you describe...perhaps insurance premiums? It would likely be some fraction of a "cash" investment. Perhaps another reader will have a better idea; good luck!

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  12. Hi Nathan. I have a start up business. There interest of people around me to invest in the company. My problem is I dont know what percentage to give to them and what percentage will be left to me, since i want to remain majority share holder. Sould I just put a valuation the business and divide it into shares? or I dont really know. Please advise me.
    Thanks

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    Replies
    1. IvoireSms-- what stage is your business at? Have you developed the product or technology already? Have you proven the business model via customer development? Match your stage with the table above to get an approximate value. Then, divide the amount you are raising by the valuation + the amount. In other word, let's say you are raising $1m, and you determine your pre-money valuation is $4m. Thus, $1m/($4m + $1m) = 20% of the company.

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  13. It is really great to find an article that is exactly what I'm looking for. Based on your table I feel like I've set my valuation just about right. I've had one VC meeting and a couple of angel meetings and things are looking good for a Series A round.

    My question is do all investors in a round have to use the same valuation? I started with a $2.4M valuation. My dillemma is that I have an investor that has already committed to invest $100 @ a $2M valuation, and other investors that are willing to invest more at a $2.4M valuation. I really want to include the first investor because of what he will bring to the company, but he has a set valuation. Any ideas?

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    1. Typically, all investors in the *same* round will have the same valuation. But it's not uncommon to have a rolling close or a series of closes that get more *expensive* as time goes by...the justification here is that the earlier someone comes in, the riskier the company, and thus the lower valuation. If your $2M investor committed early and/or you can close him before the others, the different / lower valuation should be ok to all parties.

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    2. Thanks for the reply. It sounds like a rolling close will rack up the legal fees if you have to adjust the operating agreements multiple times. Has this been your experience?

      I might just do a convertible preferred note with a cap of $2M. That will give the early investor his equity at a target valuation and it should be a quicker close.

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  14. Hi Nathan,
    Most of the stuff I read about valuations seems to work for most businesses but I am working on a new startup that is a bit unusual.
    Bypassing all the mundane stuff...the first guess is that it will take $20 mil over the first year to be ready for "sales". The four year plan shows from between 50-100 mil in sales by end of year four. I do not see that it will get much bigger but it could.
    All that said...here is the kicker!! My pre-tax profits are in the 80-90 percent range after all the bills are paid. I am still running the financials but it looks crazy!!
    The biz will not be able to be copied and the revenue stream is consistent as long as we do not have WWIII.

    Do you have any thoughts what tools could/should be used to develop a valuation?

    Thank you in advance Nathan.

    My kindest,
    David

    Ps...I caught the Green Flash while sailing in the Indian Ocean back in 1992.

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    Replies
    1. Hi David, what you're describing would probably be best suited for a DCF valuation model, as it would probably be hard to find a good set of similar comps, given the unique attributes of the business you described. However, I would somewhat question the sustainability of 80-90% profit margin estimate...reality has a way of "creeping in" and bringing margins back down to earth over time (aka "reversion to the mean").

      Envious of the green flash-- the only green flash I've ever had is the Imperial IPA beer made by Green Flash Brewery in San Diego :) Nathan

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  15. Wondering if you can value a concept/biz model stage start up so that equity can be used as partial compensation for employees or if this just won't/doesn't fly.

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    Replies
    1. Peter-- certainly. Many / most startups use equity as part of the total comp package. And, many / most startups pay below market salaries WRT the cash portion, with the assumption that the upside potential of the equity (stock, options, or warrants) makes up for it. But it's not quite as straightforward as using the current value of the stock when it's granted, as that would be very low.

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  16. Thank you, Nathan. But how do I value a company at the biz plan stage when the only investment is my own an I want to comp others on the team in part with equity. Scratching my head.

    Peter

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    Replies
    1. Peter you're not going to get the easy, straightforward, formulaic answer you're seeking. You *could* set a valuation at this stage and use that to "pay"-- see the table in the post above-- for example, if your valuation is $1m, and someone did $10k of work for you, you could give them 1%. But you'd be overpaying, and this is not how it's typically done. More likely, you'd offer them a lower-end salary (e.g. maybe $85k if a comparable non-startup job is paying $100) and XX,000 stock options at a certain strike price (one usually quite a bit higher than what it's set at today).

      Balancing these two comp levers is both art and science, and is also a function of your skill at negotiation and your ability to *sell* the vision (such that the candidate believes those options will be worth something in the future). Hope this helps! Good luck.

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  17. Fantastic article and thanks for sharing the typical valuation ranges. Appreciate it.

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  18. Hi Nathan,

    Hope your blog is still active though the discussion isn't.

    Enjoyed the article, thank you for sharing. I am having a tremendous amount of difficulty finding comps (ideally multipliers of revenue or NI) or any general guidelines for service businesses.

    I have a 3 yr old business which is sort of a market early entrant in environmental testing and cleanup in China and became profitable after about 18 months. Book of business is healthy with about 600 completed projects and projections (based on historical performance and conservative expectations) are to grow 50-100% annually for next 3 years.

    So I have financials. What I'm looking for is a way to value this in a way that captures the market size and growth potential, brand value and early adopter position, and existing financial performance. I don't want to compare this to sale of ServicePro franchises in the US, but even that would at least be a start.

    Any ideas? Would using revenue be more suitable (to account for growth and market capture) or the standard EBITDA?

    Thanks in advance --

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    Replies
    1. Hi Mac,

      yes, I would be inclined to value this using a market comparables approach (i.e. revenue multiple), and then make adjustments for some of the things you mentioned (e.g. extra growth potential of the Chinese market, brand value (if yours is superior to comps, you'd adjust upward; the inverse is true as well); and so forth.

      As far as where to pull relevant comps, I don't know. You should probably contact a professional valuation firm (a large firm like PWC, or a boutique like Sycamore Park); they would have more sources of information and probably access to relevant databases.

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  19. Thanks -- will do both a DCF and multiples approach and see what the differences are.

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  20. Hi Nathan:

    I'm starting an apparel business and have developed my business plan, investor deck and a series of first round samples of the product. I've trademarked my name and am working with a good group of industry advisors that have a lot of experience (and success) in the business. I myself don't have experience in the business but I do have a successful career in advertising sales and marketing under my belt.

    I'm going to begin looking for angel money now after investing close to $50K of my own so far.

    The valuation seems like an exercise in throwing darts at a wall but what I've come up with is $3M after looking at your table.

    Any advice on how I should value my pre-launch company?

    Thanks!

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    Replies
    1. Hi Vaughan,

      Sounds like you have some good assets but the lack of direct industry experience and absence of distribution deals / customer traction will be a factor. I would avoid putting a price on your company (i.e., doing an equity round with a specific valuation) and instead aim for raising a convertible note, perhaps with a $3m cap.

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  21. G'day Nathan,

    We're a start up providing engineering services and just entered in to the 4th year. The company made break-even and a little profit by the end of 3rd year. Our headcount is under 20. In order to find the valuation, can we take the projected sales for the next 5 years, get the average projected profit over the next 5 years and multiply it by 5, 6, 8 or 10 times (I heard somewhat similar but big & established listed companies with multiple other verticals in services business' valuation is 8 to 12 times of their profit)? Or please suggest an appropriate alternate method. The purpose of valuation is for a "big" company interested in our profile.

    Thank you in advance.

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    Replies
    1. Hi, you could take a multiple of either revenue or profit by using comparable metrics from a public company; for example, if firms in your space trade at 4x EBITDA and your EBITDA is $2m, your valuation would be $8m (though realistically, we'd probably make adjustments to reflect that fact your stock is not liquid (-) or your growth potential is higher than the public comps (+); BUT you would not just add up *future* profit and take an average and apply a multiple to get *today's* valuation-- that doesn't make sense. Instead, to reflect the value of future profit, build a DCF model. Hope that helps.

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  22. Hello Nathan,

    Thanks very much for your response. When I mentioned the value of 'big' companies in our space..what I meant was from the available info [total value of shares / profit equals to 8-12 times]. In our case, the just finished 3rd year EBITDA was insignificant as it was just a little monty after break-even. Going by these, can I apply multiplier 4 or 5 on the next "5 years projected average profit" or is it not a right method at all?

    As you suggested, I also developed a DCF model for the next 5 years projections [YoY growth rate at 50% from this year's target and interest rate at 12%]. The valuation from DCF is lesser as opposed to 4x or 5x EBITDA valuation model.

    Which one is more appropriate to go with so as to keep the discussion going with the party interested in.

    Thank you again.

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    Replies
    1. HI-- the short answer is that if companies in your space trade at 8x ebitda, then that's (approx) what you'd trade at too. If your ebitda is negligible now but expected to be $5m in 2 years, then 2 years from now you might be valued at $40m (there wouldn't be a justification for simply halving the multiple, or taking an average).

      However, If you can find the comp companies' ebitda estimates for 2014 and 2015, then you could calculate a forward multiple. To use simple #'s, perhaps comps in your space currently trade at 8x TTM ebitda, but 6x 2014 ebitda and 4x 2015 ebitda. Thus you could use a forward-looking multiple to reflect potential growth. The caveats are that finding those comp #'s might be hard, and you'd have to convince folks of the certainty of hitting your forward #'s (bird in hand vs. 2 in bush). Hope that helps! Good luck.

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  23. G'day Nathan,

    Thanks very much for your inputs, it certainly helps.

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  24. I own a saas company that did $1.6m in 2013 and $1.9m this year (expected). No investors -- all on my own and it generates cash. What advice would you give for an exit in the next 6-12 months?

    Spend every dollar I can on marketing? Best way to do a valuation?

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    Replies
    1. If you want an exit in the next 6-12 months you need to create a *catalyst*-- a reason why someone will be compelled to buy you; otherwise the default is to watch and wait.

      This can take dozens of forms-- e.g. perception of competitive threat, or buying a growth story, entry into a new market, etc.; Not all catalysts are under your direct control, but you can def influence / build them.

      As for valuation, look at public SaaS comps, pick the 2-3 most relevant / similar, and deduce a TTM revenue multiple. Apply it to your figures. We often adjust the multiple to reflect things like rapid growth, but that does not sound applicable here.

      Good luck!

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  25. Thanks for a very interesting article and subsequent comments.

    I'm planning on representing a start-up for expansion in a different geography and would make investments to establish their market presence and revenues. The start up falls towards the lower end of the $5-15M and I could be a contributing factor towards them getting into phase 4 'Scaling and Adoption' and valuation $15-30M.

    On what basis do I negotiate an equity stake..? I'm also planning to take a margin on sales which would not really amount to much but would help with cash flows at a later stage.

    Thanks in advance

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    Replies
    1. Hard to say given the limited information. But most likely it would be structuring equity tranches to be earned based on MEASURABLE, value-increasing milestones...e.g. 0.25% for boosting sales by 25%, etc., up to 1% of the company. The fact that the company is already "valuable" and you're double dipping (equity and commission or royalty) would dampen amount of equity.

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