How much is your company worth? If you’re an entrepreneur trying to raise equity investment, this is something you’ll need to figure out. It can be tricky to do, especially if you’re a start-up with little or no historical data to be benchmarked against. But while there is no single formula to calculate valuation, it’s still possible to determine a value that both makes sense to you and is reasonable to investors. To help you do this, we outline some of the most important things to keep in mind when valuing your business, and the valuation methods commonly used for pre-revenue and post-revenue companies.
Getting the right valuation
As we’ve mentioned, no method provides a definitive, correct answer, and it’s often said that estimating the value of a business is more of an art than an exact science. It’s usual to use a combination of methods to arrive at a value range that can then be negotiated.
Another thing worth noting is that market forces like supply and demand can play a huge part in determining the value of your company. But as fundraising takes time and can be a business distraction, holding out for a higher valuation may not always be feasible and you might risk running out of cash. Moreover, when you’re fundraising, getting the highest valuation possible shouldn’t be the main focus of your efforts. As Paul Graham, co-founder of Y Combinator, writes in his essay How to Raise Money:
“Fundraising is not the test that matters. The real test is revenue. Not only is fundraising not the test that matters, valuation is not even the thing to optimize about fundraising. The number one thing you want from phase 2 fundraising is to get the money you need, so you can get back to focusing on the real test, the success of your company. Number two is good investors. Valuation is at best third.”
As well as not being the most important thing to prioritise, obtaining a valuation that’s overly high can potentially have significant disadvantages. It may make it harder to raise further funding rounds, because unless you raise a down round (which you or your investors may be reticent to do, plus investors will often have anti-dilution rights that will be triggered in this scenario), the bar will be set higher each time. Institutional investors can be more sensitive to valuation than individual investors, who may have incentives like tax breaks that make a higher valuation easier to justify. Be mindful that an artificially high valuation can be a barrier to raising the funds you need to succeed later on.
There’s also a possibility that it could make it more difficult to sell your business when you want an exit. If you don’t grow as much as expected, you may not be able to generate a good return for the investors to want to sell.
Below we have outlined some common valuation methods for pre-revenue and post-revenue businesses.
- Berkus method. In the absence of all financial information, you can assign a financial value to five fundamental aspects of the company, and then sum them. For example, you may take the capabilities of the team, the size of the opportunity, and the TRL level of your technology (e.g. MVP or idea stage), and then sum the assigned pound values. For pre-revenue companies, the maximum value per aspect should be no more than £250k.
- Scorecard valuation. This method is similar to the Berkus method, but relies on a points system. Each fundamental aspect of the company is given a score out of 10, and then the answers are averaged. That score then relates to a predetermined valuation based on the points, e.g. 7/10 might equal £700k, assuming the 10/10 value is £1m.
- Risk factor summation method. A lesser-known valuation method, but well worth mentioning. From a portfolio perspective, investors say 1 in 10 investments will be a huge success, 3 or 4 in ten will return a multiple of c. 1-2x investment, and the rest will return nothing. Knowing this, investors can use statistical concepts to calculate the valuation, based on portfolio risk.
- Discounted cash flow. A discounted cash flow is the sum of all future cash flows for 5 or 10 years, with each of those cash flows being discounted by a certain percentage. The higher the discount rate used, the riskier the investment. For established companies, this can be as low as 10%, but for start-ups, this can be up to 50%.
- Venture capital method. This method starts with the end in mind. The aim here is to determine the exit price and then reverse engineer the calculations until you reach a pre-money valuation.
- Comparable / multiples. A common approach is to compare a fundamental metric of a start-up to others. In this example we will use revenue. If an analyst’s research reveals that recent transactions in the market show that a company in your sector sells for 6-8x their revenue, then a similar multiple may be used for your own company. Before this can be implemented however, there are several considerations, such as:
- Quality of earnings. Are their earnings sustainable and comparable to your own?
- Size of company. Start-ups carry significantly more risk than established companies. Therefore, just as in the discounted cash flow method, a discount factor is used.
- Similarity of offering. Are you comparing apples and oranges?
- Growth rates. Fast growing companies can command higher multiples. There are many reasons for this, such as higher expectations of future cash flows, higher demand from investors and, if first to market, the opportunity to increase market share quickly.
- Market ownership. Companies who own significant market share in newly created markets usually experience very high multiples, such as Facebook, Spotify, or Uber. Even though these companies may operate in the same sector, using these companies as comparable multiples is not advised due to their ability to operate at scale and compete aggressively.
4. Net book value. Quite simply, take your assets and minus your liabilities. It is unlikely a start-up would use this method, but if they do, it is usually for liquidation purposes.
As you can see, there are several ways to calculate your start-up’s value. Whichever method you choose, don’t forget the main purpose of the whole exercise: to get cash into your business and ensure a fair exchange of value in the process. Good investors will always want to make certain that founders / management teams are adequately incentivised. They’ll seek to protect management and re-up their equity stake if they don’t feel that they’re incentivised enough. Capitalisation tables can often be completely restructured in later rounds. The main goal now is to get the cash you need and grow the business with the help of your investors.
Alexander Leigh, Senior Investment Executive
Michael Rees, Assistant Investment Executive