255
Chapter 13
Valuation Techniques
13.1 Introduction
Every founder believes in his heart of hearts that his venture is truly worth a
fortune, and it will be funded. From the founder’s perspective, it should be
obvious to every investor what an outstanding opportunity is being offered.
So why don’t investors beat a path to their door?
This chapter will explain how investors approach a business valuation. A
business valuation is the process used by investors to determine the nan-
cial worth of a closely held (private) company. For our purposes, a closely
held business is an organization owned and operated by a relatively small
number of owners.
The valuation process begins with an understanding of your company,
following a series of generally accepted valuation techniques, such as:
◾ Determining which business valuations are most applicable to your
company
◾ Analyzing the company’s nancial statements and pro-forma statements
◾ Assessing comparative and market statistical information
◾ Determining appropriate discounts and premiums
◾ Calculating current company valuation
256 ◾ The Guide to Entrepreneurship: How to Create Wealth for Your Company
13.2 Value vs. Price
“Some men know the price of everything and the value of noth-
ing.” —Oscar Wilde
The “value” of your startup is an economic theoretical concept. It is an
estimate of the likely price at a given point in time. “Price” is the precise
amount of money asked in exchange for something. In your case, you are
asking Angels to invest X amount of money into your startup company in
exchange for Y percentage of ownership (based on shares).
Since traditional company values are based on objective measures, such
as gross revenues, net prots, cash ows, net assets, increased sales, etc.,
valuing a pre-revenue company is highly subjective. Complicating matters
is the known “founder’s syndrome,” which is overvaluing your baby. It all
comes down to deciding if you will be satised with a slice of a rapidly
expanding pie (Figure13.1).
13.3 Pre-Seed Financing
“Price is what you pay. Value is what you get.”
—Donald Trump
The majority of founders contribute personal funds, along with “sweat
equity,” to their ventures at the pre-seed round. Founders “nance” their
Value vs Price
Dynamic gure
Nothing precise
Subjective
Based on fundamentals
Based on economic
benets
Predictability, stability
Static gure
Precise number
Objective
Based on negotiations
Based on intrinsic
benets
If can’t get
champagne, get wine
Value Price
Figure 13.1 Value vs. price—Do not become infected by the “founder’s syndrome”
by overvaluing your creation.
Valuation Techniques ◾ 257
companies in one of three ways: (1) sweat equity, (2) bootstrapping, or (3)
personal funds, as seen in Figure13.2.
Sweat equity is a term of art, and is meant to represent the combined value
of the knowledge, time, and effort that a founder puts into a new venture. In
addition, founders also frequently engage in “bootstrapping.” Bootstrapping
is nding ways to postpone external nancing or funding through creativity,
ingenuity, thriftiness, cost cutting, or by other resourceful means.
13.4 What Is Your Company Worth at
StartUp (Seed Round)?
“The secret of getting ahead is getting started.” —Mark Twain
At the time of the seed round investment, the “initial pre-revenue valuation”
represents different things to each party. To the founders, it represents the
culmination of all their efforts to start the company. To the investors it pro-
vides the best early measure of their possible return on investment (ROI).
ROI is the concept of an investment of some resource yielding a benet to
the investor. A high ROI means the investment gains compare favorably to
investment cost. In purely economic terms, it is one way of considering prof-
its in relation to capital invested.
1
13.4.1 Initial Valuation at Seed Round
“If you want to know the value of money, try borrowing some.”
At this stage, the founders are trying to maximize the initial valuation
because it will severely impact their stock dilution. Stock dilution is a
Income Approach
Easiest to justify
Widely applicable
Can include both controlling
and minority interest
appraisals
Future-oriented
Based on projections
Discount rate, capitalization
rate, or hurdle rate difficult
to justify
Advantages Disadvantages
Figure 13.2 Income approach—Value determined by forecasting future earnings.
258 ◾ The Guide to Entrepreneurship: How to Create Wealth for Your Company
general term that results from the issue of additional common shares by a
company. This increase in the number of shares outstanding can result from
a primary market offering (including an initial public offering), employees
exercising stock options, or by conversion of convertible bonds, preferred
shares, or warrants into stock. This dilution can shift fundamental posi-
tions of the stock such as ownership percentage, voting control, earnings
per share, or the value of individual shares. A broader denition species
dilution as any event that reduces an investor’s stock price below the initial
purchase price.
2
Conversely, the investors are trying to minimize the initial
valuation because it represents their percentage of ownership in exchange
for their invested capital. These are conicting requirements.
13.4.2 Valuation at Series “A” Round
“It takes two to see one.” —M. Szycher
Series A rounds are typically undertaken by Angels. (For more on this, see
Chapter 15.) Investing in seed and startup companies is high risk. Consider
that less than 10% of startups provide a reasonable return to their investors.
For this reason, Angels seek only investments in companies with a high
potential for quick market entry, with innovative products.
There are no good mathematical ways to calculate valuation in the
absence of revenues. Therefore, Angels must rely on “qualitative” measures
to assess pre-revenue valuations. Table13.1 provides a list of the important
factors Angels use in valuing their investments.
Table13.1 Qualitative Factors Determining Valuation of Pre-Revenue
Organizations
Factors Weighted Score (%)
Management team (“Bet on jockey, not horse”) 40
Opportunity (“Market pain”) 20
Innovation (“Disruptive, breakthrough,
groundbreaking”)
20
Competition, intellectual property protection 10
Business model (marketing, sales, distribution
channels)
5
Current state of company development 5
Valuation Techniques ◾ 259
Angels target 5x to 10x ROI cash-on-cash return on their investment in 4
to 8 years, which yields an internal rate of return range (IRR) of between 25
and 75%. The internal rate of return (IRR) or economic rate of return
(ERR) is a rate of return used in capital budgeting to measure and compare
the protability of investments. It is also called the discounted cash ow rate
of return (DCFROR) or the rate of return (ROR).
The term internal refers to the fact that its calculation does not incorporate
external factors (e.g., the interest rate or ination rate).
3
Internal factors include:
1. Company history and its current operating performance
2. Company’s projected operations and future earning capacity
3. Company’s nancial position and capital structure
4. Current or anticipated rate of growth in sales and prots
In the nal analysis, in Series A, the actual value/price you get for your pre-
revenue company depends entirely on YOU. It depends on what YOU negoti-
ate. As Chester L. Karrass, the guru of negotiations famously advertises: “You
don’t get what you deserve, you get what you negotiate.” Figure13.3 summa-
rizes some of the important differences between value and price.
13.5 Valuation Approaches—Companies with Revenues
“It’s better to be roughly right than to be precisely wrong.”
—J.M. Keynes
Before considering the various methods or procedures employed to deter-
mine value of a small company with revenues, we need to explore the
DFR method
[aka discounted cash ow (DCF)]
– Discounted Future Returns:
n
PV = Σ [CF
n
/ (1 + r)
n
] + Terminal Value
t
/
(1 + r)
t
t=0
Terminal value is the present value for all cash ows (CF) in perpetuity
Present value (PV) is determined as the sum of the present value plus the
present value for all years beyond the forecast period.
Figure 13.3 DFR method—Value determined by future returns, including a terminal
value.
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