Startup Valuation

Asset-Based Valuations: This valuation method derives a valuation by adding the total asset value of items including land, property, and equipment, and then subtracting the liabilities of the company. Clearly, this is not a good model for new or growing businesses with very few if any hard assets. It does not take into account the future earnings potential of the business, or other difficult to value items such as patents, code, or brand or market recognition.

Earnings Multiplier Models: Earnings multiple valuation methods compare well established earnings metrics of similar companies in a particular industry and assume similar multipliers apply to your company. This method depends on historical stock prices and earnings data from a relatively large number of peer companies, typically publicly traded companies operating in very similar business segments. These methods can reveal connections such as, "Companies like yours are valued at 12 times your earnings per share." Early-stage startups rarely have revenue and associated earnings needed to for this quantitative method to be a valid measure of the valuation goal.

Quantitative Methods of Accounting Valuations: A quick review shows why these methods do not work for early-stage startups: Discounted Cash Flow (DCF). Using this method, the current value of the company is estimated using future cash flow projections and discounting (adjusting down) the value of those cash flows. As you may recall, having money now is worth more than money in the future. For the accountant or valuation professional to build accurate future cash flows guesses, they look to the past cash flow performance of the company the more years available, the better. The DCF method also depends on accurate cash flow projections-something difficult for early stage startups to predict.

Accounting-based methods are called quantitative because they depend on evaluating the financial reports of the business over a multi-year timeframe. Startups Need Not Apply: As you might be guessing, quantitative valuation methods are not useful for early-stage startups. Why? Quantitative valuation models depend on several years of financial reports as well as forward-looking forecasts. It is not uncommon for a valuation specialist to review three to five years of historical financial reports using the past financial performance to derive revenue and cash flow projections to arrive at a business valuation. Clearly, early-stage startups do not have such financial history to support an accounting based valuation.

Understanding Accounting Valuation Methods: Talk with a CPA or company accountant about business valuation and you'll hear terms such as discounted cash flow, earnings multiples, and discretionary cash flow, Accountants use these and other procedures to evaluate the financial condition, performance, and ultimately place a valuation on a business key point, well established businesses.

Investors that require that your current and recent past revenues to completely support the valuation you propose are not willing to take as much risk as other early stage investors. So, no, your actual revenues do not need to tie directly to your valuation estimate. Of course you can build a set of financial projections that show how you'll grow your revenues rapidly, and therefore support a Discounted Cash Flow valuation model. But as many investors say, "Anybody can make money in Excel". If you encounter such investors, keep pitching to other investors until you find someone who values other intangible valuation factors, such as customer or user acceptance of your product / service.

An investor focused on revenue or profit projections as the primary basis for valuation is likely experienced with the Discounted Cash Flow (DCF) idea of valuing an investment. While DCF is an accepted method for later stage, more mature companies, it is not well suited for early stage startups.

Here's how to respond: 1. "Our valuation estimate is based on many factors, with current revenue run rates being only one of them.” 2. "While our current revenues are relatively low, they are a clear validation of the market opportunity for our company." 3. "We believe our ability to execute, our large target market size, and our proven and passionate customer base all support our valuation target."

Your Revenues Don't Support Your Valuation: Early-stage, Low Revenues Scenario: You use the risk mitigation valuation method to arrive at a valuation of $1.5 million dollars based on all of the accomplishments you've achieved so far. You pitch a local angel investment group and in the final slide of your pitch, you review your next steps and relate that are working on raising a total of $250,000 to support your next stage of growth. After your pitch, one of the investors asks what your monthly revenues have been for the last 3 months. You respond between $8000 and $12,000. If you multiply these revenue averages by 12, your current annual revenues would be around $120,000. The angel investors says, "well, how can you place a value of $1.5 million when you are only making $10 grand a month? At best, you are only worth $250,000!"

More Control: Too high, meaning, "this is a negotiation and you need to give on some elements of the deal." If founders are flexible on other deal terms such as preferred share rights like voting and board seats, investors might be willing to accept a higher valuation.