Unplugging the Mystery of Startup Valuations

By Guest Author on 2, March, 2010 5 | Topic: Entrepreneurship

The mystery of startup valuations has existed since the day 1st startup was born! This topic is fundamental, emotional, scientific and artistic at the same time. I have been asked this question often, and in different forms like “What is my idea worth?”, “How can I get 10 crores funding, but retain control of my company?”. The answer depends on the person who answers the question. Entrepreneurs like to increase the number as much as possible while not annoying the investor, and investors like to peg it to as low as possible, while keeping the entrepreneur interested and motivated. I will try to demystify the mystery below.

For starters, valuation is the number which shows how much the company can be sold off completely for. Typically, if 10% of shares are issued for 1 crore, then company valuation is 10 crore – pre-money is 9 crore and post-money is 10 crore. One of the ways to arrive at a valuation number is try 4 – 5 methods and take an average.

Some of the methods I have used in the past are:

* 2x revenue + 10x profits divided by 2

* Discounted cash flow – sum of present value of next 5 years cash generated by the business

* Relative valuation – compare to the valuations of other companies in the category or stage

* Value of cash (founders money, friends contribution), assets (office, machinery, laptops) and intangibles (time given by team, salary sacrificed) put in the business

Each of the four methods above has a degree of ambiguity associated to it based on assumptions you may take. But make sure the assumptions are reasonable and truly representative of the risks and opportunities involved in the business. However, the averaging out gives a fair idea of what range the valuations can be. Once the minimum and maximum are set, agreeing at a valuation number becomes a rational negotiation exercise.

Example:

Company XYZ

* 2x revenue + 10x profits divided by 2 – 12 crore

* Discounted cash flow – sum of present value of next 5 years cash generated by the business – 16 crore

* Relative valuation – compare to the valuations of other companies in the category or stage – 10 crore

* Value of cash, assets and intangibles – 2 crore

The seller will always chose method 2, which gives the highest value, while the buyer will chose method 4 for obvious reasons. Averaging out the 4 gives a fair valuation of 10 crore. This may not be the final value agreed upon but it gives a fair idea of what are the possibilities. The entrepreneur can then decide how much funding he needs, how much is it worth, and how much of the company he needs to share with investors.

After solving this mystery, the next steps for an entrepreneur shall be to do a good homework of what will be his selling points to investors. And also justify valuations based on rational and mathematical technique. At this stage, I will advise entrepreneurs not to be greedy and pump up the numbers – there is a risk that you may be the only person who believes in that number. In a negotiation, it is always best to gain trust and credibility. As they say, “In God, I trust – others have to show numbers”!