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Thursday, June 18, 2009

What Is Your Start Up Worth?

Establishing a valuation for an early stage company is challenging. There is little financial history to predict future earnings and the real character of the company is still forming making it difficult to find comparable references with similar financial history.

Entrepreneurs are frequently unfamiliar with traditional ways to value companies and may approach valuation as an ownership issue rather than the market's assessment of their company's worth. Conversely, savvy investors attempting to acquire an ownership stake in a company may attempt to take advantage of an entrepreneur's desperate need for working capital by artificially deflating the valuation using the current company valuation and not the future growth and earning potential of the business.

Despite these challenges investors and entrepreneurs do need to agree on valuation based on a reasonable scientific method of establishing valuation.

This will keep fund raising negotiations on track, less emotional and instill confidence in current and future owners that the valuation is real and a legitimate reference point for future rounds of funding.

To this end I have elicited the expert advice of Lucia Wallace, Senior VP at Houlihan Lokey, to help craft this blog. Lucia is familiar with negotiating valuations for companies of all sizes in various stages of maturity. She has taken an interest in early stage companies and has provided good advice on what valuation approaches are best for early stage companies.

We will start out with an overview of traditional methods used to value companies and how they do or do not fit early stage companies.

Discounted Cash Flow (DCF) - This valuation method uses an estimate of future cash flows generated by a company. A discount co-efficient (discount rate) is applied to the estimate. This discount rate is based on the level of risk associated with the estimates.

In many cases a start up has no historical reference for cash flow making the DCF method of valuation suspect. A business owner may inflate the cash flow to demonstrate the great potential of the business to please investor expectations. An investor may deflate the predicted revenue to obtain a greater percentage of the company (or would assess the business owner's expected cash flows as having a high degree of risk). With no real history of cash flow the debate over cash flow valuation can result in an uncomfortable negotiation scenario were each party is arguing for a valuation without any real basis for the argument. At the end of the day, the discount rate is supposed to reflect the appropriate level of risk - which is extremely difficult to pin-point (if you do not want an excessively wide range of values).

Book/Asset Value - There are a number of valuations based on the value of the assets of a company. For technology based start ups this may be the value of the product/technology developed to date, patents, cash on hand, etc. However, the primary asset of a start up or early stage company is the collection of intangible assets (patents, technology, workforce, management team, advisors, access to cash, etc.), which is very difficult to value. Hard assets (furniture, plant, real estate, equipment value, etc.) have an easier determinable value, however, generally make up a small portion of total value of a company. Future value is the important piece of the puzzle because early stage companies are usually growth companies with the real investment value of the company in the future not the present.

Visits/Traffic/Eyeballs - A web oriented company can predict its future value based on expected web traffic. There are good comps for this. However, not all visit/traffic business models are the same. For instance, if there is a product platform developed to support content delivery or a unique business process has been crafted to differentiate the company the visit/traffic approach does not give you the full valuation picture. In the end the traffic has to be tied to some demonstrable and supportable revenue number. Just indicating that the company is going to generate traffic is going to be challenged.

So how do you get a substantiated value for a company that makes sense to investors and to start up business owners?

The best approach is to compare your company to another similar company. Back in the day an investor made an investment in an entity with no financial history. From that point on a "comp" has existed for all future investors and entrepreneurs.

The world has become more complex, in a good way, providing all kinds companies to choose from to establish a valuation for your early stage company. A start up can establish a valuation based on Market Multiples for comparable companies.

Market Multiples - Market multiples can be derived from either publicly traded companies, financing of private companies, and/or M&A transactions. Using this approach, you calculate the multiple on a financial metric (e.g., enterprise value /current value, enterprise value / future value (one or two years out) or enterprise value / current or future EBITDA) for the comparable company, and apply that multiple to your financial metric.

  • The easiest way is to find publicly traded companies, as both valuation and financial information is easily available. Let's call these Public Comps. Note that the valuation in the public domain is generally for a "minority" ownership (i.e., a few shares), and not for a significant or even "controlling" ownership position. If you are selling some aspects of control, you need to account for that.
  • You could also use a private company that has recently received funding, and pre-money valuation has been publicly disclosed, and you are familiar with some financial metrics (e.g. approximate revenue). You can calculate revenue multiples (or multiples on unique visitors, or EBITDA multiples) based on these Private Financing Comps. More likely than not, however, you won't have detailed financial information, so its difficult to draw detailed conclusions from this approach. If you are creative, though, you might be able to gather some information from the investor About the private companies in their portfolio - many are proud of these investments and publicly display them on their web sites, talk about them and market them to other investors and consumers.
  • You can also use an M&A transaction (M&A Comps), for which both the transaction value and the target's financial information are available. Similarly, you can calculate revenue, cash flow or earnings multiples implied by the M&A transaction. Please note that an M&A transaction also reflects a premium for gaining control.
Trade of Shares For Investment - Valuation, investment and equity distribution are all tied together. I discussed equity distribution in a previous valuation Blog.

Keep in mind that the investor is investing in a very early stage company. This = risk for the investor. To mitigate the risk of the business plan not playing out exactly as planned the investor may ask for a greater percentage of the company then may be might expect. This should not be confused with conceding "control" of the company to the investor. In most cases, the last thing the investor wants is to control/manage your company. This is why they are so interested in the team running your company. You should be focused on getting the investor interested in your company, establishing measurable valuation and obtaining an amount of working capital that will conservatively allow you to focus on running the business and not remaining in perpetual fund raising mode.

In conclusion, start up valuations are hard to evaluate with traditional valuation approaches. The best way to obtain a satisfactory valuation for the business owner and the investor is to compare your company to similar companies that have public valuations. Yes, the valuation of the company may impact percentage ownership. Valuation and equity discussions will be intertwined in negotiations so make sure the basis the valuation and equity distribution are clear.

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