What a startup is worth comes up a lot when looking for money. The worth or evaluation of a startup is a inexact science that combines rules of thumb, some simple math, years of experience and eventually what someone will actually pay (or invest in you). In order to come up with these evaluations, you should have a systematic approach that can be vetted, modified and compared to other similar companies.
Some Terms and Definitions
Throughout this post, I will use the following terms and definitions:
Pre-money Evaluation: This is what the startup is worth before the money goes in.
Post-money Evaluation: What the startup is worth after the money goes in. It’s also conditional on including or excluding the employee option pool.
Option Pool: The pool of stock options that are available for employees
Fully Diluted: The total number of shares issued including options that could convert (which includes the employee pool)
Round: A funding event. Common rounds are: Seed, A, B, C or D
Internal Rate of Return (IRR): The yearly return that a series of cash flows achieves over the life of an investment.
Net Present Value (NPV): The value of future money today, given a certain, safe return.
Cost of Money: The return you could get if you took whatever money you want to invest and put it in a safe investment.
Return on Investment (ROI): How many times over your money comes back to you from an investment (minus your initial investment)
Compound Annual Growth Rate (CAGR): The year-over-year growth rate of an investment over a specified period of time.
Different Kinds Of Companies
Evaluating the worth of a startup depends a lot on the company. A traditional brick and mortar company will have a far different evaluation than a high flying Software as a Service (SaaS) company. What evaluations boil down to is the risk involved in the investment as well as the return. Risk can be hard to evaluate since there are so many risk factors that come into play. For example, a traditional brick and mortar corner store is less risky then inventing a new automobile company but the return if the new automobile company takes off far exceeds the return for the corner store. Even within an industry, the returns for specific companies can vary a lot. That’s why it’s important to consider many different factors when evaluating what your startup may be worth. This is only really a guess since the real worth is what someone will actually pay you.
Different Kinds of Evaluations
There are several different methods you can use to evaluate what your startup is worth. These methods do have some basis but in general, most are rules of thumb that seem to have worked. There are more formal ways to evaluate the worth of your startup but those are costly and for most of us, not worth it until we either exit or get large sums of money. In the case of getting a substantial investment (say from a VC), the evaluations are typically done by the VC and not that flexible. Now, lets take a look at some of the more common ways a startup company evaluation is calculated. Check out this company_evaluation_model for a way to calculate the various methods.
Method: Investment In
At a minimum, your startup should be worth the amount of money that has been invested in it. Now, sometimes reality sneaks in and this turns out to be wrong but it’s always a good place to start your analysis. The reasoning goes that the market (e.g. your investors) have decided that your company is worth at least the amount they want to put in. For most companies, this should be your minimum evaluation and in reality, it should be above that. Of course, things get complicated when your company is distressed or in a market that is decaying. In that case, your evaluation could be pennies on the dollar.
Method: 1x Yearly Revenue
This method is the simplest and usually reserved for companies that are in an established market with stable growth. The theory on this goes that the goodwill of the owner, the stability of the market and the low profit margins (these businesses are typically on the low end for profit) only amount to the company really being worth it’s yearly revenue. There are other multipliers for this, depending on the industry and the competitiveness of the marketplace.
Method: 10x Investment In
This one is the classical VC model. The thinking goes that an investment needs to return 10x in 3-5 years so that the fund can make its numbers. Now, I know this seems like cooking the books but this criteria is an important one to consider since your company will be evaluated against it.
Method: Internal Rate Of Return
Similar to the 10x method, the IIR is a way to determine the return, over time, of a series of cash flows (investments and profits) and is used as a means to compare different investments (even though it’s not necessarily a good way to do so). The typical investor wants a 5 year IIR of > 20%.
Method: 7x Profit or 3x Revenue
Another popular multiplier method is the 7x Profit or 3x Revenue model. This is usually used for fast growth companies and markets where the company has a leading position or the market growth is skyrocketing. The reasons for 7x profit or 3x revenue stems from the companies ability to scale their operations to meet the huge market demand. This ability garners a higher evaluation but is short lived once the companies growth starts to slow (mostly due to growing pains of scaling).
Method: Industry Comparables
By far the most defendable method is to compare what others have paid for similar companies. These comps are the basis for which you can compare your startup to one that has established an exit (either being bought or going public). Comps can sometimes be hard to figure out but the data is out there. The best place to start is the Money Tree Site or the websites of the companies that were bought. Most will have a press release or announcement as to what the company was sold for.
Method: Black-Scholes Employee Option Pricing
Black-Scholes is really not a method used to evaluate your company but should be used to figure out your employee option price once you have an evaluation completed. The reason being that this is the preferred method for the value of a restricted stock option (which means they cannot be sold).
Mix and Match
The method you use depends a lot on your business. In general, you should run all of them and compare the results to see how close each one comes to the other (be sure to check out the company_evaluation_model, which has the above models in it). Mixing and matching the different models will give you the ability to check your assumptions as well as cross check your math. When doing an evaluation, it’s important to come at it from various directions so that the overall evaluation is more creditable. Of course, these methods are only quick and dirty models that get you in the ball park of your true evaluation but for most of us, it’s a good starting point.
What The Market Will Bear
In reality, your startup is worth what someone will actually pay for it. Until someone puts money down, most of your evaluation calculations will be based on guesses and gut feels. There are certified individuals that are trained to evaluate a business and set a price. These professionals are costly but do provide a certified value that is backed up by a complex analysis, based on industry best practices. If you ever get to that point, consider yourself lucky since that usually means someone is serious about buying or investing in your startup.
[…] a link today; to an excellent brief on valuations and basic investing glossary for the uninitiated: https://www.thedailymba.com/2010/04/03/how-to-evaluate-a-startup-company/ Categories: Entrepreneurial business Tags: business, Investing, venture capital, venture […]
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