Many entrepreneurs struggle with having the “valuation” discussion with investors. Given that many startups have no revenue, much less profits, well established quantitative methods like Discounted Cash Flow analysis simply do not work well.
All too often, it feels to the entrepreneur that valuations are just being pulled out of thin air. While it is true that valuing a startup is more art than science, here are three methods that entrepreneurs can use to guide their valuation negotiations:
1. The Venture Capital Method
This method was proposed by William Sahlman of Harvard in 1987. Let’s say an entrepreneur is raising $1 million for a software startup, and has a financial model that forecasts $5 million of profits in year five of operations. A little research by the entrepreneur reveals that the current price/earnings ratio of software companies that were recently acquired is 15x. Investors have told the entrepreneur that they expect a 20x return on their investment in five years.
Using the Venture Capital method, the entrepreneur will start by calculating the valuation of the company in Year 5, which is $75 million ($5 million multiplied by 15x). To arrive at the valuation today, she would divide that by the investors’ expected return to get to $3.75 million ($75 million divided by 20x). However, this valuation includes the investors’ $1 million investment, so she will still need to subtract that amount to get to the pre-money valuation of $2.75 million ($3.75 million minus $1 million).
2. The Scorecard Method
This method was developed by Bill Payne, a veteran angel investor. The entrepreneur starts by researching the average pre-money valuation for similar companies in her given industry and region, which can be obtained from third party sources such as the Halo Report, AngelList or PitchBook. The valuation is then adjusted based on a series of weights, the specifics of which are open to discussion with investors. Below is an example:
Average pre-money valuation = $3.0 million (Halo Report). Weighted percent of Normal = 1.08 (multiply across and sum the “Weight” and “% of Normal” columns)
Company pre-money valuation = $3.0 million multiplied by 1.08 = $3.2 million.
3. The Berkus Method
This method was developed by Dave Berkus, a veteran angel investor. It is very simple to use and was created specifically for the earliest stage startups as a “back of the envelope” way to find a starting point without relying upon any financial forecasts.
At the end of the day, valuation is the result of a negotiated agreement between investors and the entrepreneur. Even if these three methods are used as justification for the value of a company, there exist many other methods that may set the valuation differently. The entrepreneur will then have to decide whether or not to take an investor’s money at that value.
What’s your preferred method for valuing a company?
Editor’s note: Valuation photo via Shutterstock.