This is because many start-ups are in the ideation stage, and it is nearly impossible to value a company that has few assets besides an idea and the promise of commitment by a few eager cofounders. One way to avoid this question early on is to consider convertible debt, a form of mezzanine funding mentioned above. At some point, however, it will be necessary to determine your start-up’s value.
Valuation and why it matters is important for every start-up up to understand. This is because it affects not only the company’s short term prospects, but can also have important ramifications down the line. There are many online resources available to entrepreneurs that will help them to better understand how valuation works.
Of course, one of the key questions is how does the investor obtain a certain valuation and, hence, the shareholding he or she accepts in the business. Many factors come into play to determine this, key among them being the cash flows a company expects to make, current performance, and even the number of investors interested in the deal.
There are various methodologies used to come up with a company valuation. The key ones include: discounted cash flow (DCF), multiples based, and assets-based methodologies.
(Discounted Cash Flow) Model The DCF methodology computes the cash flows the start-up expects to make in future and discounts this to the present. This means taking all the cash in the future and making adjustments for inflation and risk to find out the value of these cash flows as at present. The discount rate is a highly debated variable, and it will be set by the funder when evaluating the investment. It is a good idea to create several scenarios with different discount rates and therefore different net present values; make sure you can explain the reasoning behind the different scenarios.
The multiples approach compares similar start-ups to obtain the valuation. This would mean if one start-up – similar to yours in terms of sector, size, business model, etc. – with sales of 2m ($20k) is valued at 10m ($100k) it implies a value to sales multiple of 5 (10m/2m, or in dollar terms $100k/$20k). If the start-up is truly similar to yours, you can use this multiple to value your start-up. Assuming your start-up had sales of 4m ($40k) its valuation would therefore be 4m x 5 = 20m (or $40k x 5 = $200k in dollar terms).
Net Assets Model
The net assets valuation approach calculates the total value of the tangible assets it has. For start-ups, this would usually result in the lowest valuation, since most start-ups do not own a lot of assets – it is the intangible assets like the idea, the potential, and team talent that excites investors.
It is important for each entrepreneur to note that the final price in a deal is a combination of the valuation and negotiation between the investor and entrepreneur.
Do not raise more than you can handle! Many investors we interviewed warned against raising too much money too quickly. If your valuation is high early on in your company’s lifecycle, investors will expect you to show similar (if not faster) growth when you raise money again in the future. If you cannot justify a rise in value, you may need to settle for a down-round – an investment that results in a lower company valuation than previous rounds. That not only leads to unhappy investors, but can also seriously hurt employee morale.