As we all know, your business is only worth whatever the highest bidder in the market is willing to pay. On eBay, it’s easy to discover prices as there is a formal bidding system. In the stock market, prices fluctuate in real-time, and every day a company has an updated valuation based on input from hundreds or thousands of stockholders. However, in the startup world, prices are more difficult to discover. Your company might only exchange stock for investment once a year. So how do you know what valuation is fair for your startup business?
Review Comparable Valuations. In the real estate market, the first thing your realtor will do is pull up the comparables of similar houses selling locally. This will establish a current market range for your property. Likewise, if you know what similar companies are selling at based on revenue, product, distribution and other factors, you can use this as a baseline to establish your valuation range. If you are unable to access comparable valuations, you can also look to market valuation metrics that measure valuation relative to revenue, earnings, and employees. You might be able to learn standard revenue and earnings multiples in your industry for startups. For example, if you are in a rapidly growing, hot sector, you might be able to attract a revenue multiple of 5x, or even higher. If you have $5 million in revenue, that could implay a valuation of $25 million. However, if you are in a slow growth, lower margin, less attractive business, you might garner a revenue multiple of less than 1x, implying a valuation of $5 million or less. Consider as many metrics as possible, and start to triangulate around a valuation range.
Discounted Cash Flow Analysis (DCF). The DCF is a common valuation tool that considers future projected cash flows and discounts them back to the present by factoring in a cost-of-capital (or risk). When you create your financial projections, it’s worth overlaying a DCF to give you a rough valuation estimate. However, the issue with DCF valuation for startups, especially those that are pre-revenue, is that most of the value will be locked up in years 5 and beyond, so this will prove to be a very speculative methodology, and one that won’t be sufficient on its own.
Think Like a Venture Capitalist. The VC investor is focused on return on investment. The VC is considering how to profit from a step-up in valuation over the next 3 to 5 years as the company prepares for an exit event in the form of an IPO, or more likely a sale. In the simplest case, you would estimate the exit event (i.e. $50 million sale in 5 years), considered the required ROI (i.e. 50% annually), consider future dilution (i.e. 20% to employees or future investors) and then calculate the present value. Simple math will get you into the post-money valuation range of just over $5 million. From that, you would subtract the proposed round of investment (i.e. $1 million) to get to your pre-money valuation of just over $4 million. This post...