Many new business owners need to raise capital but are not sure how to value their business. This post covers a couple valuation methods for startup companies seeking to sell equity in their business
By Lisa daCosta
Valuing a private company is similar to valuing a publicly-traded one. The method is based on evaluating the company compared with its peer companies for growth prospects, profitability and valuation and the market forces in their industry—how strong is investor demand for that product or service. However, privately owned companies typically have their valuations reduced by 25-35% resulting from the lack of a liquid market for the private company stock and also for owning less than a controlling stake—called the minority interest discount.
For companies which are so new that they are not even generating sales yet and may be losing money, a potential investor can use the First Chicago Method, which was developed by a Chicago-based venture investment group. That method uses three to five year business forecasts, cast through the lens of a best, worst and base case sets of assumptions, and applies a valuation on those forecasts to determine a terminal valuation.
That company valuation is then discounted back to a present value, using the investor expected return, which could be in the range of 10 to 30 times the original investment value. Each scenario is given a probability percentage, applied to the present value, to arrive at a blended valuation today.
Dave Berkus, a well-known angel and venture investor, has described an alternative method to value a “pre-revenue” business. His model begins with the premise that the target company can achieve $20 million in sales within five years, given its particular market opportunity and how the company is addressing it. He then assigns up to a half million dollars in value for each of five critical operational elements including the soundness of the business idea, existence of a prototype, a quality management team, strategic relationships and product roll-out or sales plan.
Once a valuation has been determined, an owner must decide if funds needed represent too much dilution of ownership. Even when the business owner finds a willing investor, if the percent of the company to be sold or distributed today is large, and future fund raises will still be necessary, there is the potential that the founder will ultimately own so little of the company, he or she will lose interest and motivation to grow it.
On the other hand, the dilution of an early round may not diminish the ultimate financial success of a company at all. Looking at Dropbox and Instagram, both are valued at over a billion dollars now. During their first fundraising rounds, one founder raised $20,000 for 5% of the company, and the other raised $500,000 for 20% of his company. That Dropbox was valued at $400,000 and Instagram for $2.5 million after their first rounds didn’t matter to where they each ended up financially.
Have questions about startup valuations? Leave us a comment below.
Lisa daCosta is the Business Advisor for the Wyoming Entrepreneur Small Business Development Center in Teton County. Additionally, she provides market research and analysis to Wyoming businesses and entrepreneurs state-wide. Lisa has over twenty years of experience as a Wall Street investment analyst and in operational finance, serving across the spectrum from controller to CFO for a variety of small to mid-sized businesses in the West. Lisa understands the challenges of building a business and the expectations of investors and lenders. She earned both her Bachelor’s Degree in Economics and her Master’s Degree in Business at the University of Wisconsin and is also a Chartered Financial Analyst.