Shark Math Part 2: Determining Valuation
In the last post, we introduced the terms “Pre-Money Valuation” & “Post-Money Valuation” and discussed how they are used to determine equity splits based on the size of an investment. We also mentioned that changes in valuation will directly lead to changes in equity. In this post, we will continue that discussion by describing methods for determining the Pre-Money Valuation of a company.
Revenue and Income Multiples
Perhaps the most common method of determining valuation is to calculate it as a multiple of revenue or income. For clarity, revenue means the total of all sales minus returns. Income is the amount of profit you have after all expenses are deducted. The multiples will vary based on the industry. Professor Aswath Damodaran teaches a class at the Stern School of Business at New York University devoted to determining corporate valuation. He has published tables that show average multiples for a variety of industries.
Revenue Multiples http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/psdata.html
Income Ratios http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/pedata.html
Based on these tables, an Internet Software company with annual sales of $1,000,000 will have a pre-money valuation of $6,970,000 based on its revenue multiple of 6.97x. If that same company has an annual profit of $100,000 then its pre-money valuation will be $13,607,000 based on its earnings multiple of 136.07x.
Early stage startups frequently operate at a loss. As they mature, they may operate at break even for a period during which they invest potential profits back into the company to support growth initiatives. Thus, these companies may have to rely on the revenue multiple only.
Discounted Cash Flow
Besides multiples, Discounted Cash Flow can be used to determine valuation. To use DCF, you need to make assumptions about the cash a company will generate each year, and the prevailing interest rates.
For example, assume a company will earn $1000 next year and that interest rates are 2%. If you put $980.39 into a 2% simple interest savings account, then you will have $1000 in one year. So a company that will generate $1000 next year is worth $980.39 today. If you repeat this calculation for a number of years and add up the values, you can determine the current value of the company based on the projected cash flows. Spreadsheets even have built in functions to perform these calculations for you. In Excel, the function is called NPV, which is short for Net Present Value.
Keep in mind that there is always risk that the revenue projections will not be accurate, so investors will often ask you to discount the value as a way to mitigate the risk of missing your projections.
There are many other methods available to determine valuation. Some are described in these books:
Founder’s Pocket Guide: Startup Valuation by Steve Poland, published by 1x1media
Term Sheets & Valuations by Alex Wilmerding, published by Aspatore books
Regardless of the method you use to determine your pre-money valuation, you should understand that it will only be the first step in a negotiation process. Your investors will likely use their own valuation method that will probably result in a lower value. Then you each get to defend your proposed valuations while chipping away at the valuation proposed by the other party.
If you need to go through a negotiation, you might wonder why you should bother with a formal valuation process. Here are a few justifications:
– It will help you establish a “reasonable” starting point for the negotiation
– It will help you understand the valuation being proposed by your investors
– It will demonstrate to your investors that you understand the importance of the valuation and investment process
With this information in hand, you’ll be better prepared to swim with the sharks in your local investment tank.
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