Meet Larry Lee, Director of the Center for Innovation and Entrepreneurship and the Small Business Development Center at Northwest Missouri State University. Lee and the SBTDC provides small businesses and technology venture firms in the region with the analysis, consultation and training support they need to confidently grow and develop.
So you’re ready to raise money for your tech startup. To do that, to solicit any kind of substantial investment, you’ll first need to put a value on your startup.
That valuation gives you a starting point to begin negotiations. Entrepreneurs need it to know what kind of capital they need from angels, venture capitalists, and other investors and what amount of equity they’re willing to trade. Investors need it so that can put a value on their investment to generate liquidity.
But there are a couple of challenges to putting a price tag on a startup.
First, a startup company doesn’t have a history of financial performance on which to base its value—which makes valuation more of an art than a science. The value of the startup is really at the whim of the market: it’s only worth what the market is willing to pay for it.
Second, while entrepreneurs may want to value their startups as high as they can without looking silly, angels and VCs are looking for a smaller valuation, so they can reap a bigger share of ownership.
So the valuation of a startup ends up hinging on negotiation skills. What can you convince an investor that your company is worth?
You could pick a nice fat number out of the clouds. Or you could use one—or all—of three methods below to project your financials and argue your startup’s worth.
Before you jump into the valuation game, ask yourself these questions:
- Am I willing to give up some amount of ownership and control of my company?
- Can I demonstrate that my startup is likely to realize significant revenues and earnings in the next 3-7 years?
- Can I demonstrate that my company will produce a significant return for investors?
- Am I willing to take advice from investors and accept board of directors decisions I may not always agree with?
- Do I have an exit plan for the company that may mean I am not involved in 3-7 year?
1. Venture Capitalist Valuation Method
This quantitative method takes you through six equations to determine your startups value. To start the math, you’ll need to a projection of your company’s revenue in five years, the company’s after-tax profit margin in year five and the industry average price/earnings ratio.
Here’s the formula based on a fictitious company:
2. High Tech Startup Valuation Estimator
The High-Tech Startup Valuation Estimate from Cayenne Consulting lends a more qualitative approach to determining a startup’s pre-money valuation. The multiple-choice questions—25 in all—ask about:
- the stage, scope and purpose of the startup’s product or service
- its industry and market growth
- actual and projected revenues
- potential customers
- the range of management, research, and auxiliary expertise and experience
- the status and interest in protecting intellectual property
- the existence and development of a business plan
- previous investment
- pre-money valuations of comparable startups
This valuation model uses the answers the entrepreneur supplies to calculate an approximate valuation range for the startup. It’s a good place to start the research into a startup’s value. If you need help valuing your company, your neighborhood Small Business & Technology Development Center (SBTDC) can provide valuation consulting services.
5 Things You Should Have Before Approaching an Angel Investor
- Business plan
- Deal sheet (special exec summary)
- Power Point Presentation
- A mentor that will listen to and critique your oral presentation
Numbers vs. Wishes
Your CPA is yet another resource you can tap to help determine the value of your startup. Whether quantitative, qualitative, CPA or a combination of all three—the point here is attach a value to your startup that relies less on gut instincts or wishful thinking and more on financial projections that are grounded in your industry, your market and reality.
This post was originally published in January 2012.