Tuesday, May 10, 2011

Lesson #32: How to Value Your Startup Business

Posted By: George Deeb - 5/10/2011


& Comment

One of the questions I get, more often than not, is what is the appropriate valuation of my business.  Typically related to an upcoming financing or pending takeover offer.  And, the answer is quite simple: like for anything, your business is worth what somebody is willing to pay for it.  And, the methodologies applied by one buyer in one industry, may be different from the methodologies applied by another buyer in another industry.  In today's post, I will give you some key drivers on how to value your business, in a way that will make sense to you, and will be in line with investor expectations.

To start, let's not forget about the obvious: the natural economic principles of supply and demand apply to valuing your business, as well.  The more scarce a supply (e.g., your equity in a hot new patented technology business), the higher the demand (e.g., multiple interested investors competing for the deal, and taking up valuation in the process).  And, if you cannot create "real demand" from multiple investors, "perceived demand" can often work the same when dealing with one investor.  So, never have an investor think they are the only investor pursuing your business, as that will hurt your valuation.  And, before you start soliciting investment, make sure your business will be perceived as new and unique to maximize your valuation.  A competitive commodity business or "me too" story, will be less demanded, and hence require a lower valuation to close your financing.

Related to the above, is the industry in which you operate.  Each industry typically has its unique valuation methodologies.  A next generation biotech or clean energy business, would get priced at a higher valuation than yet another family diner or widget manufacturer.  As an example, a new restaurant may get valued at 3-4x EBITDA and a hot dot com business with meteoric traffic growth could get valued at 5-10x revenues.  So, before you approach investors with valuation expectations, make sure you have studied the valuations acheived in recent financing or M&A transactions in your industry.  If you feel you do not have access to relevant valuation statistics for your industry, engage a financial advisor that can assist you. 

In terms of techniques investors use to value your business, they will study things like: (i) revenue, cash flow or net income multiples from recent financings in your industry; (ii) revenue, cash flow or net income multiples from recent M&A transactions in your industry; and (iii) a discounted cash flow analysis of forecasted cash flows from your business.  As mentioned earlier, these multiple ranges can be very wide, and vary substantially, within and between industries.  As a rough ball park, assume EBITDA multiples can range from 3x to 10x, depending on your "story".  And, forecasted earnings growth is typically the #1 driver of your valuation (e.g., a 25% annual net income grower may see a 25x net income multiple, and a 10% annual net income grower may see a 10x multiple).

If there are no earnings yet, with your business plowing profits into long term growth, then revenue multiples or some other metric would be used.  Revenue multiples for established businesses are typically in the 0.5x-1x range, but in extreme scenarios, can get as high as 10x for high flying dot commers with explosive growth (e.g., Groupon).  But, that is, by far, the exception to the rule.  And, if there are no revenues for your business, unless you are a bio tech business waiting for FDA approval or some new mobile app grabbing immediate market share before others, as examples, raising funds for your business, at any valuation, will be very difficult.  Investors need some initial proof of concept to get their attention.

Worth mentioning, private company valuations typically get a 25%-35% discount to public company valuations.  While at the same time, M&A transacations can come at a 25%-35% premium to financing valuations, as the founders are taking all their upside off the table.

And, remember, at the end of the day, the investor will have a very good sense to what a business is worth, and what they are willing to pay for it.  As they see deals all the time and typically have their finger on the market pulse.  So, collect a few term sheets from multiple investors, and compare and contrast valuations and other terms, and play them off each other to get the best deal.  As a rule of thumb, expect to give up 25-50% of your equity, in your first financing round, depending on the size of the investment and the type of investor (e.g., angel vs. venture capitalist).

Most importantly, you need to put on the hat of your investor in setting valuation.  To get them excited about your startup vs. the hundreds of other startups they see each year, they are looking for that next 10x return opportunity.  So, make sure your 3-5 year forecasted earnings, will grow large enough in that time frame, to afford them a 10x return.  So, as an example, if you are worth $5MM today, post financing, and the new investor owns 25% of the company ($1.25MM stake), they are going to need a financial plan that will get their stake up to $12.5MM (and the company up to $50MM) within 3-5 years.  Which, as an example, could mean driving EBITDA up to $5-$10MM within that period.  So, do not show them a forecast that grows less than that, and make sure you have built a credible financial plan to acheive these levels before approaching investors.

There are too many nuances to valuing a startup business than I could do justice in this short post, but hopefully this post gives you a good sense to the high level issues in play.  If you have any questions for your specific situation, just ask.

For future posts, please follow me at:  www.twitter.com/georgedeeb

Red Rocket is a featured contributor on entrepreneurship for many trusted business sites:

Copyright 2011- Red Rocket Partners, LLC