How Do You Value A Startup?
Valuing early-stage companies is more of an art-form than it is a science, especially when it is a business that has just started its journey. A valuation of a business is determining what someone is willing to pay for it. So really, valuation is more of a sales process, which is backed-up with evidence. In this how-to guide, our CEO, Sacha Bright gives his musings on how to best value a startup.
The valuation of a company determines the value of ownership that an investor holds in the business.
The common answer to ‘how do you value a startup?’ is usually that an investor has compared their valuations to similar businesses at this stage, and so bases the valuation on this. However, there are many other ways to value a business, including net present values and cash-flow discounting, which involves future estimates of the value of the business with a discount to represent the risk of investing at an early stage.
In the early-stage context, however, predicting future cash flows is a stab in the dark, more so when the company is still in the pre-revenue phase of its development.
But we believe, by asking this question, an investor is really just testing you as an entrepreneur. They may already have an idea of what they feel your business is worth. This is your opportunity to sell the investment opportunity and provide evidence of how and why you valued your business at a certain amount. What you need to show them based on the returns you have predicted, is the value you have placed on you, your team, your product, your service, your intellectual property, your current assets and future assets, and evidence of a business that is similar to yours which exited and made a return for its investors.
This provides trust in your valuation, you must also show the investor that you have discounted the valuation to represent the risk of investing in an early-stage business. Your estimate of the future valuation of the business is vital in valuing the business today.
With that in mind, we believe that you valuation should be centered around these three questions:
- By investing a certain amount, how much will an investor get back in a certain time frame?
- What is the market currently worth and how much of it will your acquire through this investment
- What is the business team worth, and will they have the experience and skill to deliver and execute the business plan?
- How much is my intellectual property and assets worth now, and how much will it be worth in the future?
Remember, a valuation is only based on what someone is willing to pay for it. So bear in mind risk and reward. Ask yourself: Would I buy this company at this valuation right now? Remember, the valuation is at the pre money stage, so would you buy the company at the proposed valuation if it had the money in the bank ready to invest in the business plan.
Another important question to ask is whether a business qualifies for SEIS and/or EIS? This could have some sway on the investment decision and valuation as it increases the attractiveness of the proposition and can result in investors perceiving the opportunity as having less risk attached.
So, if you are a business owner, and asking for £1 million on a valuation of £3 million, for example, be prepared to answer the following questions:
- What’s the investment for and will that level of investment secure the success of the business?
- What is the risk to the investor and how are you going to protect them?
- How is the investor going to get their money out? And, what is the return?
A venture capitalist, for example, on success would want at least ten times the return. So your business plan will need to show an exit of £30 million in 2-5 years on a £3 million valuation. Don’t just pluck a random figure out of thin air, stress test your formulas.
“As my mentor Bob Chase regularly told me: the one thing you can guarantee about forecasts is that they will be wrong as soon as you have written them. No one has a crystal ball, but if you are to prevail, you need to have a great plan and the ability to implement it,” Sacha Bright says.
“Remember, the idea itself is only part of what an investor is looking for, the skills and expertise to carry out that idea successfully form a major part of any savvy investor's decision. So you and your team are an important part of the valuation process. If you an your team, for example, used to earn jointly £800,000 per annum, that’s a large investment into the business, if you’re not taking a salary.
Your exit valuation will be based on a similar business that has exited before. We would suggest you do this with at least 3 businesses so you can provide evidence if asked. Find out what they sold for and what their profits were for that year. Divide the sale price by the profits and you then have a multiplier. Then take into account your assets and future profits to devise your exit valuation.
Think of it like surveying a house. When determining a price, a surveyor will get at least three sale prices from similar properties in your area and then take into account the improvements you have made and the location of your home.
The end result for any valuation is; Can you sell this to an investor? Don't get hung up on keeping all the shares, after all 100% of nothing is nothing, but 10% of 100 million is a lot! Be open with your investors, don't get set in stone, negotiate and close the deal.
Authors: Oliver Murphy & Sacha Bright
Disclaimer
To the best of our knowledge, the information we have provided is correct at the time of publishing. Sacha Bright is not a solicitor or accountant and we recommend that you seek professional advice on any topic discussed.
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