How to Value Your Startup Business for Equity Financing
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There are a lot of ways to fund your startup business, and all of them require savvy planning and detailed execution. Here’s easy-to-understand, helpful advice on the daunting task of choosing the value of your business before coming from potential investors.
Valuing a start-up company is like valuing a piece of art.
Beauty is in the eye of the beholder. The “artist” (startup founder) thinks the company “must be” worth at least $10 million. The “appraiser” (potential investor’s accountant) finds the company’s “book value” to be $500, but thinks it’s probably worth only $399, so a 50% stake should cost $200.
The investor usually values the business somewhere between the two.
As you can see, the valuation of a startup is the art of effective investors of the possible value of a million-dollar idea with hard numbers and real research.
Three Maxims to Live By
Three maxims all startups should live by when valuing their business and calculating how much to give away:
- Don’t be scared to sell the equity if you plan to raise money. If you doubt it, read From Alchemy to IPO. Ten percent of a $100 million is a heck of a lot more than ninety percent of a $100,000.
- Your company is worth whatever somebody will pay. No matter what your internal feelings are about how wonderful your company and idea may be, if the market tells the business is worth $250,000 right now, then that’s what it’s worth. So if you want to grow $25,000, you must sell 10% of the company.
- Your business will become more valuable over time. Selling equity should be done in stages. If your enterprise plan is well thought out, you can plan these “tranches” of capital. Perhaps in round one, you ask $1 per unit for your provisional patent, pending trademark, or a great idea. In round three, after you have issued patents, registered trademarks, and have some cash flow, perhaps you ask $5 per unit.
The truth is that if you do your homework and can show where your digits came from, show you comprehend competing products, and supply a rational basis for a market penetration analysis, you can tell an investor what your company is worth and probably get them to pay you that value.
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Market Comps and Financial Projections
So where do you get these numbers? You can’t base them on past performance, because you have none. You can’t use price-to-earnings ratios. You can’t use a multiplier of trailing gross revenue. You don’t have a track record yet. Now enters the speculative game of using market comparables (comps) and financial projections.
Anyone who has ever bought a home is familiar with the concept of corresponding one home to another and determining a rough price range based on recent and previous sales of similar situated homes and properties. Companies can be valued the same way.
For products you can:
- Analogize your pricing to that of competing products (you have to meet or beat their pricing—or make a significantly superior product),
- Calculate your cost to make your product, and
- Subtract this from the sales price to get a net revenue on a product basis, then
- Calculate the total market size, which usually requires online research
- Calculate your estimated market penetration rate based on your industry—this is perhaps the most difficult part. You may have to purchase some reports to get these numbers right.
- Multiply the result of the penetration by the earnings per product
Now you have some data to work with.
Next, you need to predict annual penetration boosts and put these digits into a pro forma financial statement, which includes other costs. A good pro forma template can help.
With pro-forms in hand, you can now graduate to the more traditional business valuation methods.
Earnings are the most important and controlling factor for the valuation of closely-held performing companies. This means you should focus on the projected earnings in your pro forma and consider using one of the following three income approaches to determining the fair market value (“FMV”) of the company:
- Discounted forthcoming cash flows method
- Capitalization of earnings approach
- Excess earnings approach
Valuation is Hypothetical
While the details of each approach are beyond the scope of this article, remember two things:
- The valuation of any startup company is almost entirely hypothetical. This is something that you must disclose in detail to anyone from whom you might make money.
- There are very special and complex state and federal regulations for taking money from other people to invest in a startup. Consult your attorney for details.
A final word of warning: Be cautious when using online business valuation calculators. They are very generic, very optimistic, and hardly scratch the surface of the elements involved in calculating value. For the best effects, consult with a professional business lawyer.
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