A reader asks:

“How do you set a valuation for a start-up company?”

I’ll answer the question with a few other questions (and answers) of my own:

How much money do you need?

First, figure out how much money you need to run the business for “two rounds” and then add 3 additional months of expenses.  “Two Rounds” refers to periods of time in the business to sufficiently provide a test of your product/service/store.  The test is to determine if you have a viable product/service that people will pay money for and see value enough to either refer someone else or buy from you again.

For the sake of this example let’s assume you need $50,000 to run the business for two rounds plus the extra 3 months.

If you need to raise the $50,000 you now need to determine a valuation.  The question next is: How much of the company will you sell for $50,000?

The percentage you decide to sell will determine the valuation you are placing on the business at the time you sell.  For example, if you decided to sell 50% of the business, you placed a valuation of $100,000.  If you decided to sell 10% of the business, you placed a valuation of $500,000.  ($50,000 divided by 10%.)

What percentage is appropriate?  The answer to that question is really up to you and what investors are willing to pay.  You can place a $500,000 valuation, but if investors aren’t willing to pay you need to sell more than 10% of the business.  This would lower the valuation.  You also need to decide what you are comfortable with selling.  For me, I would rather have 10% of a $10 million business than 51% of a $100,000 business.

Do I look for all the money I need up front?  It is much easier to find capital once you have proven your concept and have the first investor under your belt.  Money follows money.  Investors follow other investors.  If you are looking to raise $1 million, you may want to stage it in three rounds of financing.

The first round might be to raise $200,000.  At this stage the valuation of the business will be low - let’s say you sold 20% for $200,000, the valuation would be $1,000,000.  Once you take this and use it to grow the business and start the proof of concept, you can go back out and look for the second round of financing.  Perhaps in the second round you look for $300,000.  Since you already have an initial investor and some proof of concept you can raise the valuation. Perhaps you are now willing to sell 15% for $300,000.  This places the valuation at $2,000,000.  In the third round you then look for the other $500,000 and are willing to sell 20% of the business.  The valuation is now $2,500,000.

Having sold 55% of the business, you now retain 45% ownership in a $2,500,000 business.

These numbers are all examples. You should work with a professional such as an investor who has invested in a minimum of ten deals.  They can help you come up with a good valuation method for your company.

David Gass
Founder, Business Credit Services, Inc.
Earn.com Expert Advisor