Valuing a business is not a simple science, but it is as necessary as it is frustrating for entrepreneurs as they develop their businesses and especially important when they are looking for investment.
For new ventures which are pre-revenue or just in their early stages, the process of assigning a valuation can be exceptionally tricky.
Once a company is more mature and has revenues and profits, establishing a value can be as simple as multiplying their EBITDA (earnings before interest, taxes, depreciation, and amortisation) by an average sector-based multiple.
That clearly doesn’t help anyone value a business that has prospects but may be some distance away from sales or profits.
You will be pleased to hear that all is not lost and, despite the difficulties associated with finding that elusive valuation number, there are a few ways in which you can start to estimate the value of your venture.
The best way to predict the future is to create it
For many early-stage ventures their valuation will be based loosely on an estimation of their potential, and so one way to try and estimate the value of this potential is to forecast future cashflows – how much will be spent and how much will be earned over, say, the next 3-5 years.
A process called DCF (Discounted Cash Flow), much loved by MBAs, can be used to calculate the current or present value of future earnings – essentially working out what projected future earnings might be worth today if you could invest in them right now.
This sounds rightly abstract and accordingly is based on two rather shaky concepts; the accuracy of the forecasts and the level of risk (expressed as a discount rate) that anyone thinking to invest might apply to them. A large driver of the usefulness of this type of valuation is dependent on how accurate the forecasts are, and in a post-pandemic, post-Brexit world who can really forecast anything with real confidence? It also depends on how anyone evaluates the risk of what is being undertaken and that can be highly subjective.
Regardless of how inaccurate it might be, however, it is still worth going through this exercise, not least to see if you believe your own forecasts and can show others how you might go about achieving them.
Let’s start from the very beginning
If you can imagine starting again, right from the very beginning, it might be possible to work out exactly how much everything that has gone into a venture would cost if it had all been paid for at market rates?
The ‘Cost of Duplication’ is another way to come up with a sense of your own valuation as it involves calculating how much it would cost to build, from scratch, another company exactly like the one you have built. The logic here, is that no sensible investor would pay more for your company than it would cost them to create it themselves.
The process involves trying to recall exactly what has gone into building the business from Day. Generally, this will include the hours spent designing, writing, coding, researching, developing models, writing papers, patents, applications and so on, as well as any actual purchases made, or services supplied, which have enabled the venture to get to the stage it is at.
This approach is a common place to start for valuation as it is structured, relatively logical and mostly objective, when compared to DCF modelling, as it is based on actual business expenses.
It is of course, like all methods, imperfect, as it is, by definition, limited to what has happened to date and does not really measure the venture’s potential future value. It also encounters problems when founders try to evaluate the cost of creating intangibles like relationships, intellectual capital, brand and experience.
As it does not project value forwards, this approach is often used to set the lowest valuation benchmark baseline from which any other valuations can be compared.
I am a rare species, not a stereotype
Perhaps, not surprisingly, the Comparative method is loved and preferred by analysts and, by connection, venture investors, because it uses the evidence in the marketplace to drive a sense of the valuation of the business. It provides an indication of what the market is willing to pay for any venture and works by looking at how much similar ventures in the marketplace have raised in funding or have been sold for.
There is an obvious flaw in this approach as it is really unlikely that there is another company out there that looks just like yours, offers a similar product or service or has a similar strategy to create value but once again it can provide a sense of whether your valuation is sort of in the right place for companies that even a little bit like yours.
Go forth and multiply
In some ways similar to the Comparative approach, the Market Multiple (MM) model, which I mentioned right at the start, uses a sector/industry/stage related multiplier to value your venture against others in your sector or market.
The multiple will be used to multiply your sales (primarily) and profit (if relevant) to reach a valuation and the number will usually be based on an average of all companies in your sector. The multiplier may need to be adjusted up or down dependent on whether you are earlier or later stage than the other companies being reviewed – earlier ones attracting a lower multiple.
Once again, if you are pre-revenue, then you will have to use forecasts to estimate where you might get to in terms of sales or profit, and consequently this leaves this process open to the accuracy of the forecast.
Interestingly, however, it is often this approach often produces valuations that most closely approximate what someone is prepared to pay.
Good luck with finding the sales details you will need from other companies like yours!
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The Rule of Thumb model uses a fairly illogical approach to valuation by looking at what generic funders, including incubators/accelerators, use as their generalised approach to venture valuation as they may invest in many and find it easier to generalise.
In the US for instance, it is said that Mass Challenge assumes all ventures are, on average, worth $5m while Y Combinator often invests at around $125k for 7% equity ($1.8m valuation).
In the UK Entrepreneur First will often invest £80,000 for 10% equity (£800k valuation) irrespective of the type of venture as they are all basically at a very similar stage.
These just provide yet another coordinate in your valuation landscape but are, of course, highly dependent on each funder’s context and development model.
The investor’s attitude
Sadly, there is no published table look up that you can use to know what your business is worth, but either way it is always useful to put yourself in the investor’s chair to try and see the deal from the other side of the table.
An investor in a very early-stage venture, in addition to coming up with a valuation, also has to make a choice as to how much of your venture they want to acquire. In general, they will normally want to acquire as much as they can to maximise their potential return and effectively reduce their risk. Conversely, however, they also know that they need to ensure you, as the founders, are left with sufficient equity incentive to work hard and create value.
This balance is hard to find and for many founders, the euphoria of getting someone interested as an investor can often cloud their view when it comes to equity ownership and this can result in selling too much equity too cheaply.
Remember that the early-stage investor is likely to be significantly diluted if they think that there are further funding rounds in your future, so they will be unlikely to want to have too small a stake at the start. Spend a good amount of time in their shoes to make sure you get perspective.
And the winner is…
With luck this has helped you to understand that it is not easy to come to a completely accurate valuation of your company when it is young and full of promise.
It is a really good idea to use more than one model to give you a sense of confidence in your view of your own value and it allows you to build a richer valuation landscape as well as considered reasoning to back up your own numbers.
It is a cold hard fact that you must have an opinion of your own valuation before you enter into any funding activity as you can be guaranteed that the potential investor will have one. Be prepared!
Andrew Hatcher is a leading Mentor in Residence at Cambridge Judge Entrepreneurship Centre. He mentors weekly on Accelerate Cambridge and on Ignite.
Andrew Hatcher
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- “Your valuation seems a little aggressive…” - 5 May 2021
Wajahat Liaqat
Excellent analysis
Akcela - Startup Advisors
Ah the discounted cashflow, absolutely a favourite of MBA students because we are taught that’s the solution. Generally, it is – but I have to say, it is a practiced art and using it requires skill. In tech, certainly at the moment, everyone is simply talking 10 X (the market multiple). People are buying it too in our experience, as you rightly say in the article.