There is an everlasting struggle between creativity and innovation vs cold business and hard finance.
Putting a price tag to your product is a fundamental starting point in raising the necessary capital to set off your business venture.
However, we recognize it is a very difficult thing to put a value your startup. How do you make a safe estimate? Is there any easy straight forward way to do that? What do you need to consider to give a realistic IRR and NPV calculation to your potential investors? How do you estimate the discount rate that you need to apply?
There is no step-by-step process or any kind of a magic formula to value your business. Depending on which side you are on the valuation and the estimation is highly subjective. If you operate as a VC and you are a potential investor you will possibly recognize the potential business value and the possible profits by investing on it, but you will underestimate the price of the start up because simply you are aware of the risk and the fact that the start up might not make it to its first year without your money. Also because you want to buy something potentially valuable to a bargain price.
On the other side of the coin, if you are the entrepreneur than you are going to estimate the price of your start up much higher due to the fact that you are putting a sentimental value towards it. Most probably you have made many wishful assumption on your business plan. Your assumptions and estimations are higher than they should and of course you take into consideration the psychological pressure and sentimental value of the business to you that you are risking more than just time and money.
Below are so key points on how to calculate the value of your startup.
Before you start you need to be aware that a new startup doesn’t have the financial records and the performance history in order to make safe assumptions and projections. The true value of the startup is essential to what the market is willing to pay for it.
You need to project on a 5 to 10 year basis the estimated revenue and cash flow of your company. You can do that by examining records of other companies in the same market i.e. considering the market average price/earnings ratio. Once this is done you will need to apply a discount rate based on the risk attached. In simple words, that is the risk of your startup not reaching the projected revenue targets.
From experience, I can tell you that discount rates vary between 20%-70% based on the market condition and the investor risk appetite. Usually Angel Investors will go for more than 50% of a startup. VCs will invest on lower discount rates but on more mature companies.
If you are a startup with a bit of financial and trading history you might consider to use the EBITDA (earnings before Interest, Taxes, Depreciation and Amortization) and multiply it by a conservative and justifiable factor.
Finally, you need to value the assets in your company. Most startups don’t have many real assets, but it is good to valuate whatever you have. What can be an assets for a startup except from obvious things? Well, your brand, trademark, patents, the people, the so called “sweat equity”, partners, contracts, qualified leads and prospects are assets that can help you quantify and justify the value of a startup.
Market Based Approach
Another approach to estimate the value of your company is to see the competition. What did your competitors managed to achieve? How much money did they raise? Which assumptions have they used? In plain terms this is like pricing your car. When you want to sell it you look at the range of the market prices and then based of the characteristics of your car you can safely estimate the average price.
Remember that the overall size of the market can have an impact of your growth rate projections. However there is always the case of a market bubble, (see the .COM at the start of the century and 15 years on we have the Green bubble). If you get lucky you will sell high, if not you might not be able to sell at all.
The competition analysis and the Strengths, Weaknesses, Opportunities and Threats “SWOT” analysis can play also a major role on your business value. Obviously more competitors mean less growth potential and smaller market share. However if you can demonstrate that your business is “watertight” through a robust SWAT analysis, that might actually help.
Last but not least, there is “Good Will”. Depending on intangible things like the experience and the people within the team, the deliverables track record, the market conditions, the social impact, etc an investor might be willing to pay a bit more
There isn’t a simple recipe for success. I have seen internet companies raising money with a simple draft business plan and other with assets, teams and trading history struggle. You can use any mix of approaches and methods to reach your goal for raising the capital you need. You need to re-adapt your pitching strategies and your business plan over and over again until you say what the investors want to hear on a realistic, and if I might add, conservative way.
At the end of the day it is all about connecting with your target audience (in this case the investors) and creating memorable perceptions.