How you value your startup influences the remaining share that the founder has in the company once the investment round is over. Moreover, it also determines how much money would the firm owners have after an acquisition.
The question here is how to calculate the value of any startup. Let us understand valuation in detail.
What is valuation?
The addition of equity and debt values gives valuation. Investors are more interested in evaluating equity. The common problem with startups is that they are new in market because of which there is no track record. Startup valuation is more of logic rather than some science and several ways are available for the same.
Methods used for valuation
Asset Based method is the best way for the valuation of a firm’s equity. It is quite similar to accounting method in which the total debt is subtracted from the total asset value obtained from the balance sheet to get the equity. However, startups lack in such assets so it gives a low valuation.
Talking about startups, it is best that they take into consideration a future reward that they expect according to their intellectual property, recognition in the market and other such business aspects. Talking in the language of accounting, when the difference between actual assets that is net of debt and the underlying promise is counted, the result obtained in known as goodwill. This factor justifies the introduction of a certain multiplier to the result of the book value difference between assets and debt.
The multiplier is a qualitative figure that implies future promise in the market, the trends, decision power of the investor and negotiation. Inflation and time factors would also be considered in case competing companies want to invest the same amounts in order to get equivalent money. Asset Based method used with a multiplier is known as Cost to Reproduce Valuation Method at times.
Making a list of the company’s past expenses and revenues to get the status of the company 3 to 5 years down the line is known as Discounted Cash Flow method.
It is generally appropriate for companies that have a track record for costs and revenues but startups can also use it as an effective method. The reason for this is the thinking it needs for the future projections to strategic plans along with a deep analysis of the market so that expected revenues can be estimated.
The method also includes an interest rate so that the future cash flows can be discounted, known as the Weighted Average Cost of Capital. (WACC)
WACC is basically a calculation obtained according to corporate finance theory that takes into consideration the market conditions and risks that come with the startup to get the approximate investment money cost for the startup.
Startups can also get an insight into the equities and debt values of companies that have a similar operation. Pre-revenue startups can get a list of some similar companies that work in the same market and obtaining the equities and later comparing them to the startup according to the average or median, for example.
Startups that are in the phase of revenue generation can equate the ratio of the equity value to the sales figures of the comparable companies to the valuation and sales figures of the concerned startup.
In the Berkus Method, a particular dollar value is associated according to criteria like the idea, management team and market traction taking into consideration the establishment of strategic partnerships and sales figures.
Granular calculation is the main advantage of this method. However, it is capped at 2.5 million dollars as the maximum. This amount is not enough for startups that hold a great promise and have fundraising programs before commercialization and generation of revenues.
Combination of all the four aforementioned methods is known as Weighted or First Chicago Method. It assigns a particular percentage to three valuation figures like one from the lower end of the spectrum according to the result of Asset Based method, another from the middle end and third one from the higher end.
When middle and high end estimates are used, quite good results can be obtained with the help of methods like Discounted Cash Flow or Market Comparables.
No definite guidelines
Regardless of the method used, it is imperative that the final figure agreed upon with investors and stakeholders is usually negotiation rather than “mathematics”. At times, investors have their own rules to assess a startup’s value according to the demographics, founders and the target audience.
The combination of investment figure and target post-investment share percentage gives rise to a de facto valuation. This method is known as Venture Capital valuation method.
How to value shares?
Startup owners are often concerned about the relationship between valuation and equity ownership. Other concerns that may arise are the points that investors take into consideration to determine the percentage of stake and the key ideas for founders to negotiate valuation figures.
The relationship between valuation and equity ownership can be understood by the simple fact that ownership percentage is a ratio of the shares owned to the total shares.
Valuation number gives a calculated value for the pre-money value of the stock price. This means that is the share pool is 500 shared before the investment, and the pre-money valuation is 5.6 million dollars, then each share is priced at 11,200 dollars. If an investor pays 1 million dollars, he is buying approximately 89 shares. Now, the share pool has become of 589 shares. It is clear that the investor holds 15% of the total shares.
The ownership of founders is influenced by this and it is known as dilution. After the investment, the founders have 85% of the equity share.
Understanding IRR (Internal Rate of Return)
When an investor decides for post-money share, it is associated with an IRR that investors expect. If the company is sold few years down the line, the percentage of stake will help in acquiring a particular amount.
When that amount is related to the present investment, IRR value is obtained. Projected yearly revenues multiplied by an industry and sector-specific multiplier gives the value at which the company can be sold in the years to come.
What is important to note here is the fact that company owners should have enough ownership despite the investments so that dilutions do not affect their ownership rights. Voting rights related to the shares that are issued should be considered seriously because owners of a company ought to have enough decision-making power besides future dividends and capital generation.
Entrepreneurship is about understanding the vision and making it a reality through steady steps rather than taking an aimless leap. Aim after you understand business tactics so that your startup makes it to a profitable and reputable brand. Make sure it does not die a painful death because of your incompetence.
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