7
Understanding Your Valuation
How much is your company worth? How will buyers be coming up with a valuation for your business?
If you pay attention to the stories promoted by media organizations, multibillion dollar exits may sound like the new normal. That is certainly a milestone to shoot for. Yet, in reality, as of this writing, the average exit price is still about $200 million. It is definitely nothing to be ashamed of if you are selling your company for millions.
You certainly don't want to undersell yourself, your company, or your investors and team. You don't want to sell yourself short of (potentially) billions of dollars. But you don't want to ask for far too much and have serious buyers dismiss you because they think you are being unrealistic.
You also probably have a legal responsibility to other shareholders. You need to be able to show them how valuations work, what is fair, and when they may be foolish—or even crazy—to turn down an offer.
So what is a startup worth?
The simple answer is this: whatever someone is willing to pay for it at any given time.
There is also an art to valuing startups. There are common mathematical equations others will apply to your business as well.
Variables Affecting Your Startup's Value
These are just some of the variables that can be used to calculate what your company may be worth and the offers you can expect and demand.
- Current market and economic conditions
- The company buying you
- The competition over acquiring your company
- Method of payment (cash or stock)
- The terms, including earnouts, vesting and resting, and so on
- Recent valuations of your company at fundraising rounds
- The moat you have built around your business or lack of it
- How organized and prepared you and your documents are
- The strengths or weaknesses of relationships with potential acquirers
- What a new buyer can do with your company and its parts
How well you position your startup and how well you do at selling it, including the strength of your pitchbook and story, can make a big difference in maximizing an exit, too.
Common Methods of Business Valuation
Startups that already have established revenues and profits are relatively straightforward to value. There are several traditional ways to do that, especially when it comes to acquisitions by financial buyers. The following sections explore some of the ways you may choose a figure for your startup.
Your Number
If you have other shareholders, then you have legal responsibilities to them. You cannot just fire sell your company without their input or turn down good offers without their approval.
However, it is worth having your own number in mind. Even though it always makes sense to get outside advice, if you don't have to get the approval of other stakeholders, then you should have a number that makes sense to take.
For first-time entrepreneurs, this isn't about winning the M&A lottery and acquiring an obscene amount of wealth on your first exit. It may be about walking away with a life-changing sum that will take finances off of your mind. An amount that will ensure you don't have to worry about being broke or homeless or not being able to retire (if you ever want to). You may be looking for enough to do everything you want for your children and family and to give them opportunities. You may want an amount that will enable you to go on to other projects and focus on what you want to solve and change because you can, not because you need the money.
Just make sure you are genuinely getting enough to give you a good return on all of the time, energy, and money you've put in—unless you really need to fire sell your company and just get out what you can.
Earnings Multiples
Publicly traded and mature businesses are typically traded on multiples of their earnings. This is a comfortable method that Wall Street uses and a default way of comparing companies on the fly.
The big problem with this approach for many startup companies is that they have no meaningful earnings or net profit. Even if you do, it may not really reveal your true potential, especially to a strategic buyer who can dramatically multiply those earnings overnight.
The Comparables Approach
On the surface, this can be one of the simplest methods to understand and calculate on the spot. It can be even simpler for smaller, more traditional businesses—especially those that may turn to business brokers to advertise and sell their companies.
Like valuing a house, it is about looking at what other similar companies in your space with similar size are selling for.
For example, if another Amazon seller in your niche with similar financials just sold their business for $X, then yours is also worth $X, plus or minus any variances. Other adjustments may be made by user count, recent IPOs of similar companies, and so on.
Cost to Replicate
How much would it cost someone else to simply duplicate what you've built? If a bigger company wanted what you have, how much would it cost the company in time, money, hiring, and risk to replicate it and get it to the same stage?
Ideally, buying you is the cheaper, faster, and least risky option.
Discounted Cash Flow Method
This approach creates a forecast of potential cash flow for a specific time period or life of the company, factors in a desired return on investment (ROI), and applies a discount to factor in risk. The earlier stage the startup is, the higher the risk for the buyer, and the deeper the discount will be.
Additional Valuation Methods
Other business valuation approaches include the following:
- Berkus method (assumes a specific revenue by year five, assigns values to specific line items, and determines an overall value and return for investors)
- Venture capital method (projects future revenues, assigns a trading multiple to estimated net profits, and provides a desired return)
- Book value (evaluates the tangible value of existing assets)
- The scorecard valuation method (ranks a startup based on multiple factors, including team strength, opportunity size, sales channels, and so on)
How to Value Pre-revenue Startups
There are plenty of pre-revenue startups, and even those losing sizable amounts of money every year get bought or go public. So, what are the methods that can specifically apply to early-stage, pre-revenue startups? What can you do to increase your valuation?
Traditionally, the most desired method of valuation has been based on EBITDA. It is about the income, just like a dividend-paying public stock or rental property.
Of course, it can be quite a while before your startup has revenues if you haven't prioritized that out of the gate. That doesn't mean you can't enjoy a big exit.
If you are still pre-revenue, the common methods of valuing startups at your stage include the Berkus method, the venture capital method, the scorecard method, risk factor summation, and the First Chicago method. The following sections take a quick look at each of these approaches.
The Berkus Method
The Berkus method assumes a startup will have $20 million in revenue by year five. It assigns a value of up to $500,000 for five line items. This gives a new pre-revenue startup up to $2.5 million in value and almost a 10× return for investors.
Values are assigned to these factors and summed up:
- Business idea
- Having a prototype
- Strength of the management team
- Strategic relationships
- Having rolled out a product or starting sales
Venture Capital Method
This method begins by projecting future revenues (for example, five years from now), assigning a trading multiple to estimated net profits based on industry benchmarks, and then providing the desired return for an investor.
The Scorecard Method
This valuation method uses comparable companies at the same stage in the same industry and region as a base point.
Simply put, theoretically, if your startup is identical to another that was just valued at $10 million, then yours should be worth $10 million, too. The scorecard method then adjusts the value of the subject startup based on the following factors:
- Strength of management
- Size of opportunity
- Product/tech
- Competitive environment
- Marketing and sales
- Need for additional capital
- Miscellaneous factors
Risk Factor Summation
This method of valuation looks at 12 risk factors and adds or subtracts monetary value on a five-point scale from very high risk to very low risk for each one:
- Potential exit
- Reputation
- International
- Litigation
- Technology
- Competition
- Funding
- Sales and marketing
- Manufacturing
- Legislation
- Stage of business
- Management
First Chicago Method
This valuation method bases the future value of a startup on its projected cash flow. It is effectively a discounted cash flow model (as already described in this chapter). It also moderates these projections, balancing worst-case, base-case, and best-case financial projections.
How to Increase Your Valuation Faster
If you aren't excited about your potential value after using these methods and calculations, what can you do to take control of it and accelerate your value ahead of an exit?
Improve Your Pitch
The art of a great exit often comes down to being able to cast a great vision, present it well, and sell the idea of what could be. Once you put your mind to it, you may be surprised at how much your company could be worth in the right hands.
Get Those Revenues In
If you feel that a lack of revenues, or limited revenues, is a roadblock to the exit you want and need, then start selling.
Your startup is at a whole new level when you have proof of commercial viability and product-market fit.
Another great avenue to take is to begin selling to your potential acquirers' customers. When they see the fit with their customers, you've taken a lot of risk and uncertainty off the table, and that adds a lot of value.
Get Your Prototype or Minimum Viable Product Done Today
You might have a great team, technology, and vision, but without a tangible product, you haven't proven you can take it over the finish line and unlock its real value. Stop over-engineering it and get it out in the world.
Build Out Your Team
The quality of your team alone could be the reason you are acquired and where buyers see most of the value. Hire better executives, key team leaders, and the best talent in your space. This can add a lot of benefits to your business in the meantime, too.
Typically, the acquisitions that are focused on a team are, for the most part, called acquihires, when the actual business itself takes a step back from an interest perspective. Acquihires typically happen when the acquiring company sees the opportunity to speed up the hiring process by bringing onboard an already assembled team that it can repurpose to something else. Acquihires are a great way to accelerate the onboarding of talent by recruiting groups of individuals at the same time as opposed to recruiting employees one by one.
Position Your Startup in the Right Way
Remember that M&A is about the buyer's perception. When fundraising, you often have to reposition your startup to match what different investors are about.
For example, you may have a biotech startup doing something revolutionary for women. For one investor, you may highlight the tech side. For another, the science. Another may be more passionate about funding female founders or the impact investment aspect.
The same is true when it comes to acquirers. This enables you to benchmark your startup valuation against a very different set of companies.
Valuation versus Terms
Valuation has its place, though experienced founders will tell you that they would prefer to let the buyer pick the price, if they can choose the terms.
The details, terms, and fine print can make far more of a difference in the net and the ultimate outcome. This is especially true for founders.
The terms lay out important factors such as types of shares, clauses that come along with vesting, earnouts, and other rules of the deal. In fact, sometimes a lower valuation can be preferred and prove more profitable over a higher one.
Know what a fair and attractive valuation is, but don't get hung up on it. Don't allow it to hide the real underlying math and conditions.
Why You Never Want to Disclose Your Valuation
You will be performing your own audit, calculations, valuation, and financial modeling in advance. You want to know how others will value your company according to these different methods ahead of time.
To start, you want to make sure you can really expect a number in the ballpark of what makes sense for you and your shareholders and is acceptable to your investors. You also want to be sure you aren't being taken advantage of and can speak knowledgeably about these valuation methods.
However, you don't want to disclose this valuation or range of valuations to your potential acquirers or to the public.
If the transaction remains private, your acquirer may not want the price made public in the news. Don't sabotage your own deal before it gets done.
You also don't want to show your hand in advance of negotiations. Let buyers pitch their offers first. They may be thinking of a number hundreds of millions or billions more than you are thinking.
They can have a whole different perspective on why they need you and what this deal could be worth. Your acquirer can also add an incredible amount of value to your company overnight.
Avoiding High Valuations with No Rationale
If you've read The Art of Startup Fundraising or raised a few rounds of financing with great advisors around you, then you already know that higher valuations aren't always better.
If you start floating your own extreme valuation demands, serious buyers may dismiss you and go right to the competition they think is reasonably priced or at least is still in touch with reality.
If you end up switching from M&A mode back to trying to fund-raise, then higher-than-needed valuations can make things more difficult in the future. They can even create more issues internally.
If there is really no solid math behind an extraordinary valuation, then the deal may not stick. Sooner or later someone in the process is going to call it out. They have legal responsibilities to their investors, too.
Don't drive your valuation too low, either. Whether this deal happens or not, these valuations can influence your ability and the terms of being able to acquire other businesses. That can be crucial to your overall growth and profitability.
Although it may seem superficial, valuation also has a very real impact on your appeal and credibility as a company. This can make a big difference when it comes to hiring, recruiting advisors, getting press, drawing other investors, and even in who wants to become a customer and how much they are willing to pay for your product or services.