Thursday, March 21, 2013

How to value your start-up

"What is the appropriate valuation of my business?" It's one of the questions I get the most often from aspiring entrepreneurs. And what usually sparks it is an upcoming financing or pending takeover offer.
The answer is quite simple: Just as with anything, your business is worth what somebody is willing to pay for it. And the methodologies applied by one buyer in one industry may be different from the methodologies applied by another buyer in another industry. Here are some ways to value your business in a way that will make sense to you and line up with investor expectations.

To start, let's not forget about the obvious: The natural economic principles of supply and demand apply to valuing your business as well. The more scarce a supply (e.g., your equity in a hot new patented technology business), the higher the demand (e.g., multiple interested investors competing for the deal, and taking up valuation in the process). And, if you cannot create "real demand" from multiple investors, "perceived demand" can often work the same when dealing with one investor.
So, never have an investor think they are the only investor pursuing your business. That will hurt your valuation. And, before you start soliciting investment, make sure your business will be perceived as new and unique to maximize your valuation. A competitive commodity business or "me too" story, will be less demanded, and hence require a lower valuation to close your financing.

Another important factor: the industry in which you operate. Each industry typically has its unique valuation methodologies. A next-generation biotech or clean energy business would get priced at a higher valuation than yet another family diner or widget manufacturer. As an example, a new restaurant may get valued at three to four times earnings before interest, taxes and other items, and a hot dot-com business with meteoric traffic growth could get valued at five to ten times revenues. So, before you approach investors with valuation expectations, make sure you have studied the valuations achieved in recent financing or M&A transactions in your industry. If you feel you do not have access to relevant valuation statistics for your industry, engage a financial adviser who can assist you.

Investors will study things like: (i) revenue, cash flow or net income multiples from recent financings in your industry; (ii) revenue, cash flow or net income multiples from recent M&A transactions in your industry; and (iii) a discounted cash flow analysis of forecasted cash flows from your business. These multiple ranges can be very wide, and vary substantially, within and between industries. As a rough ballpark, assume earnings multiples can range from three times to ten times, depending on your "story." And forecasted earnings growth is typically the No. 1 driver of your valuation (e.g., a 25 percent annual net income grower may see a 25 times net income multiple, and a 10 percent annual net income grower may see a 10 times multiple).
If there are no earnings yet, with your business plowing profits into long-term growth, then revenue multiples or some other metric would be used. Revenue multiples for established businesses are typically in the 0.5 to 1 times range, but in extreme scenarios, can get as high as 10 times for high-flying dot-commers with explosive growth. But that is by far the exception to the rule. And, if there are no revenues for your business -- unless you are a bio tech business waiting for FDA approval or some new mobile app grabbing immediate market share before others, as examples -- raising funds for your business at any valuation will be very difficult. Investors need some initial proof of concept to get their attention.
Also note: Private company valuations typically get a 25 percent to 35 percent discount to public company valuations. While at the same time, M&A transactions can come at a 25 percent to 35 percent premium to financing valuations, as the founders are taking all their upside off the table.

And, remember, at the end of the day, the investor will have a very good sense to what a business is worth and what they are willing to pay for it. As they see deals all the time and typically have their finger on the market pulse. So, collect a few term sheets from multiple investors, and compare and contrast valuations and other terms, and play them off each other to get the best deal. As a rule of thumb, expect to give up 25 percent to 50 percent of your equity, in your first financing round, depending on the size of the investment and the type of investor (e.g., angel vs. venture capitalist).

Most important, you need to put on the hat of your investor in setting valuation. To get them excited about your startup vs. the hundreds of other startups they see each year, they are looking for that next 10-times return opportunity. So, make sure your three- to five-year forecasted earnings will grow large enough in that time frame to afford them a 10-times return. So, as an example, if you are worth $5 million today, post financing, and the new investor owns 25 percent of the company (a $1.25 million stake), they are going to need a financial plan that will get their stake up to $12.5 million (and the company up to $50 million) within three to five years. Which could mean driving earnings up to $5 million to $10 million within that period. So, do not show them a forecast that grows less than that and make sure you have built a credible financial plan to achieve these levels before approaching investors

By George Deeb
Source Crain Chicago Business