Most entrepreneurs want to know what their business is worth, especially if they are fundraising.
An entrepreneur asked me exactly that question today. He has a software business, and he had found a university professor’s paper online with a methodology for valuing different pieces of software. He wanted to see what I thought of it.
The simple answer is you can use all the methodologies in the world: your business is worth what someone will pay for it.
A more complex answer considers that valuing new businesses is very different than valuing established businesses.
How to value established businesses
In general, in a fairly priced market, the value of a business should be equal to the present value of all cash you expect to get out of the business in the future (either through selling your shares or dividends).
If you had perfect knowledge of the future, you could just do this through a discounted cash flow calculation. Take each future cash payment, apply your discount rate (cash in the hand is worth more than a promise of future cash), add them up and you’re done.
Of course, the future is not fully predictable. Your industry may be growing or shrinking, for instance.
A simple workaround that many people use is to find ‘comparable’ companies (e.g., in the same industry) with a known price (e.g., public). Even if the size of the companies is very different, the ratio of valuation to sales, or valuation to profits, is often similar across an industry.
So people will figure out the comparable for your firm, and set your value based on a multiple of your sales (e.g., 2x) or profits (e.g., 10x). This is the standard approach used by investment bankers.
If there is a concern that your company may go bankrupt, people won’t bother with comparables – since that assumes your business will keep operating – but instead will value your company based on your assets. This may include property, equipment – and for high tech companies – patents, and even employees. Many ‘acqui-hires’ in Silicon Valley involve selling the company for a fixed price per programmer, for instance.
Often people will use all four results, and will end up with four different numbers, which they will use to figure out a valuation range for your company.
The problem with valuing young businesses
The problem with young businesses is that they are very uncertain, and things are changing very quickly.
If your sales are $50,000 this year, and you’re in a high growth company, your sales could be $5,000 or $200,000 or even a million dollars next year (compare that to an established or low growth company, where sales next year are likely within 20-30% of this year’s).
In fact, let’s consider each of the methods used for established companies:
- discounted cash flow: nobody really knows what your business will do. Even a reasonable guess could easily be off by a factor of 20. (If you want to guess at this – since strictly speaking, this approach is still accurate – figure out the average expected sales price for the company, the percent chance you will sell at that price, and the number of years it will take.)
- comparables: because things are changing fast, you can’t compare with established companies. And how do you pick a comparable high growth company: do you choose only a successful company, and ignore all the firms that failed?
- break-up value: most early stage companies have very few assets, and can’t be sold for much if they fail. And are you valuing the company assuming failure, and ignoring the chance of success?
How angel groups value companies
To get around this, at early stages, many people use rules of thumb to value a company. Angel groups have attempted to bring science to this process by coming up with some formulas:
- the Berkus method (tends to value companies at ‘inflated’ Silicon Valley metrics)
- the scorecard method, which compares your company to other angel group deals (a good starting point)
- the risk factors method, which again compares your company to other angel deals
On average, an angel group deal has an average valuation of $1.5 million.
(Yes, these formulas result in an established small restaurant built up over decades with $500,000 in annual sales being valued at $1,000,000 … while two kids fresh out of university who have spent three months writing software can also have a $1,000,000 business. That’s because people expect the software to maybe become Instagram, and the restaurant to only ever be the restaurant.)
If an angel group attempts to use this formula with you, they can, and it’s just a negotiation ploy. Your business is worth what people will pay for it.
If you’re within a factor of two of their valuation, people will often compromise. By corollary, if you have a crazy overvaluation of your business, people won’t invest.
The money being raised valuation method
Strangely, often the amount of money being raised will give a very good rule of thumb range for the valuation.
- passive investors will expect any financing round to sell between 10-20% of your shares: if you’re only selling 2% of your shares why are you bothering? Similarly if you’re selling more than 20% they are an important part of your company and should play a more active role. If you’re raising $200,000, that values your company at $0.8-1.8M
- an active investor (e.g., a VC) will want all active investors to typically hold 20-40% of your shares. If you’re raising $1M from active investors that values your company at $1.5-4.0M dollars
- majority investors (active investors who want to control your business) will want to hold over 50% of your company. If you’re raising $500K, they will value your business at $400-499K.
Yes, you can game this system by raising more money. And if you are trying to raise $1M for a business that only really needs $200K, you will often find that hard to do.
This should still be used as a sanity check for your valuation and fundraising plans … and to tell the truth, I have used this rule of thumb reasonably well in raising money to date.
The bottom line: high and low end of the valuation
The bottom line as mentioned at the start, is that your business is worth what people will pay for it.
If you are in an early stage company, you will often find that the top end of your valuation is set by the angel group rules: no business can be valued above $3M.
The exception to this is when you have a company that is attracting a lot of interest from very well-funded, wealthy investors, i.e., when you are in a bidding war or a very frothy market. Until you have that first interested investor, it’s hard to get above $3M. (Yes, Google was valued at $100M in their first VC financing round – so there is a lot of upside on that negotiation if you can do it.)
Similarly, at the bottom end, the business has to be attractive to people to stay in. So if you assume that below-market salaries are being paid, take the number of employees and multiply by 2 year’s worth of market salaries. So if there are two full-time founders, and they could earn $50K per year working elsewhere, then the valuation needs to be at least $200K … or they might as well quit the business and get a job.
Where will you settle between $200K and $3M? That’s up to you.