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Use these 10 metrics to estimate your start-up’s funding value
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Martin Zwilling writes on Startup Professionals Musings that once you have a potential investor excited about your start-up team, your product, and your company, the investor will inevitably ask, “What is your company’s valuation?” Many entrepreneurs stumble at this point, losing the deal or most of their ownership, by having no answer, saying “make me an offer,” or quoting an exorbitant number.
Consider a company whose two founders have spent $200,000 of personal and family funds over a one-year period to start a company, get a prototype site up and running, and generate buzz in the internet community. The founders need a $1 million angel investment to market the national rollout, build a management team, and maybe even pay themselves a salary.
How much is the company worth to investors at this point? What percentage of the company does the investor own after the $1 million infusion? “If the parties agree to a pre-money valuation of $1 million, then the post-money investor ownership is 50% (founders give up half interest, and lose control),” Zwilling writes. “On the other hand, if the pre-money valuation is $4 million, the founders’ ownership remains at a healthy 80% level.”
Here are the components and “rules of thumb” that Zwilling advises to arrive at that “magic” formula:
1. Place a fair market value on all physical assets. New businesses normally have fewer assets, but it pays to look hard and count everything, perhaps picking up an initial $50,000 valuation.
2. Assign real value to IP. “The value of patents and trademarks is not certifiable, especially if you are only at the provisional stage,” Zwilling observes. This company has filed a patent on one of its software tool algorithms, which puts it several steps ahead of others who may be venturing into the same area. A “rule of thumb” often used by investors is that each patent filed can justify $1 million increase in valuation.
3. Assign value to all paid professionals, according to their skills, training, and knowledge of your business technology.
4. Early customers and contracts in progress add value. Monetize every customer contract and relationship — even those in negotiation. Assign probabilities to active customer sales efforts, just as sales managers do in quantifying a sales forecast.
5. Use discounted cash flow (DCF) on projections. The discount rate typically applied to start-ups may vary from 30% to 60%, depending on maturity and credibility level. If the company projects revenues of $25 million in five years, even with a 40% discount rate, the net present value is about $3M.
6. Consider the discretionary earnings multiple approach. If you are still losing money, skip ahead to the cost approach, Zwilling suggests. Otherwise, multiply earnings before interest, taxes, depreciation, and amortization (EBITDA) by a target multiple taken from industry average tables or derived from scoring key factors of the business, or default to 5x as the multiple.
7. Calculate replacement cost for key assets to measure the net value of the business today by calculating how much it could cost for a new effort to replace key assets.
8. Look at the market size and growth projections for your sector. The bigger the market and the higher the growth projections from analysts, the more your start-up is worth.
9. Assess the number of direct competitors and barriers to entry. If you can show a big lead on competitors, you should claim the “first mover” advantage.
10. Find comparables that have received financing. This “market approach” is similar to the real estate appraisal concept that values your house for sale by comparing it to similar homes recently sold in your area.
Remember that the components, except the last, are cumulative. Even if a given investor excludes some of the components from consideration in your case, your credibility will be bolstered by the fact that you understand his interests as well as yours. In any case, the analysis will prepare you for the heavy negotiation to follow.
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