Over the past few weeks we have discussed various aspects of Sramana Mitra’s global virtual accelerator, the One Million by One Million initiative. In last week’s newsletter the focus was on bootstrapping, or how to self-fund the startup for as long as possible.
As hard as it sounds, bootstrapping your start-up business really may be the best way to proceed. If you find a way to finance your business yourself, you don't have to answer to any investors and you have total control of your business. Bootstrapping requires serious strategic thinking, planning and sheer guts. We included measures to fund the startup by means of factoring, using suppliers to fund the startup via trade credit and leasing equipment, and getting clients to shorten payment terms in your favour.
Many billion-dollar entrepreneurs find a way to grow without external financing so that financiers don’t control their destinies or grab a disproportionate slice of the wealth pie.
Try to avoid surrendering equity for as long as possible!
However, there comes a time when the business has to decide on establishing other sources of funding to exponentially grow the business and to springboard it to the next level.
A key issue at this stage in the life of the business is to establish the value of the business in order to attract funding and in essence, to place a value on the “share” of the company that is to be sold in exchange for that dearly needed cash.
How does an early-stage investor value a startup?
One of the most frequently asked questions at any startup event or investor panel, is “how do investors value a startup?” The unfortunate answer to the question is: it depends.
Startup valuation, as frustrating as this may be for anyone looking for a definitive answer, is, in fact, a relative science, and not an exact one.
The biggest determinant of your startup’s value are the market forces of the industry and sector in which it plays, which include the balance or imbalance between demand and supply of money, the recency and size of recent exits, the willingness for an investor to pay a premium to get into a deal, and the level of desperation of the entrepreneur looking for money.
As any newly minted MBA will tell you, there are many valuation tools and methods available. They range in purpose for anything from the smallest of firms to large public companies, and they vary in the amount of assumptions you need to make about a company’s future relative to its past performance in order to get a meaningful value for the company. For example, older and public companies are easier to value because there is historical data about them to extrapolate their performance into the future. So knowing which methods are the best to use and for what circumstances and their pitfalls is just as important as knowing how to use them in the first place.
Some of the valuation methods include:
- The DCF (Discounted Cash Flow)
- The First Chicago method
- Market & Transaction Comparables
- Asset-Based Valuations such as the Book Value or the Liquidation value
Rather than attempting to translate these valuation methods, let’s start tackling the issue of valuation by investigating what an investor is looking for when valuing a company, and then see which methods provide the best proxy for current value when they make their choices.
A startup company’s value is largely dictated by the market forces in the industry in which it operates. Specifically, the current value is dictated by the market forces in play today and today’s perception of what the future will bring.
Effectively this means that if your company is operating in a space where the market for your industry is depressed and the outlook for the future isn’t any good either, then clearly what an investor is willing to pay for the company’s equity is going to be substantially reduced in spite of whatever successes the company is currently having unless the investor is either privy to information about a potential market shift in the future, or is just willing to take the risk that the company will be able to shift the market. Obviously if your company is in a hot market, the inverse will be the case.
So, the next logical question is, how does an investor size the likely maximum value at exit of your company in order to do their calculations? There are several methods, but mainly instinctual and quantitative types. The instinctual methods are used more in the early-stage type of deals and as the maturity of the company grows, along with its financial information, quantitative methods are increasingly used. Instinctual versions are not entirely devoid of quantitative analysis, however, it is just that this method of valuation is driven mostly by an investor’s sector experience about what the average type of deal is priced at both at entry and at exit. The quantitative methods are not that different, but incorporate more figures to extrapolate a series of potential exit scenarios for the company. For these types of calculations, the market and transaction comparables method is the favoured approach. Comparables inform an investor how other companies in the market are being valued on some basis (be it as a multiple of Revenues or EBITDA) which in turn can be applied to your company as a proxy for its value today.
Knowing what the exit price will be, or having an idea of what it will be, means that an investor can calculate what their returns will be on any valuation relative to the amount of money they put in, or alternatively what their percentage will be in an exit (money they put in, divided by the post-money valuation of your company = their percentage). Before we proceed, just a quick glossary:
- Pre-Money = the value of your company now
- Post-Money = the value of your company after the investor put the money in
- Cash on Cash Multiple = the multiple of money returned to an investor on exit divided by the amount they put in throughout the lifetime of the company
So, if an investor knows how much % they own after they put their money in, and they can guess the exit value of your company, they can divide the latter from the former and get a cash-on-cash multiple of what their investment will give them.
Armed with assumptions about the value of your company at exit, how much money it may require along the way, and what the founding team may be willing to accept in terms of dilution, they will determine a range of acceptable valuations that will allow them to meet their returns expectations. This method is called the ‘top-down’ approach.
Naturally, if there is a ‘top-down’, there must be a ‘bottom-up’ approach, which although is based on the top-down assumptions, basically just takes the average entry valuation for companies of a certain type and stage an investor typically sees and values a company relative to that entry average. Note that one would not use the bottom-up average from one industry for another as the results would be different.
An investor is willing to pay more for your company if:
- It is in a hot sector as investors that come late into a sector may be willing to pay more.
- If your management team is highly effective, particularly as serial entrepreneurs can command a better valuation. A good team gives investors faith that you can execute.
- You have a functioning product, especially for early stage companies
- You have traction: nothing shows value like customers telling the investor you have value.
An investor is less likely to pay a premium for your company and may even pass on the investment if:
- It is in a sector that has shown poor performance.
- It is in a sector that is highly commoditised, with little margins to be made.
- It is in a sector that has a large set of competitors, with little differentiation between them.
- Your management team has no track record and/or may be missing key people to execute the plan
- There is no working product yet and/or you have no customer validation.
- You are going to shortly run out of cash
Some key questions to be asked in placing a value on any startup:
- What are the odds of your business surviving five years?
- What is the industry sector of your business?
- How much cash and other assets does your business have, including property and equipment?
- How much liability does your business have, including bill payables, loans and debt?
- How much revenue do you expect your business will produce this year?
- How much revenue do you expect your business will produce five years from now?
- How much operating profit (loss) do you expect your business will generate this year?
- How much operating profits do you expect your business will generate five years from now?
In conclusion, market forces right now greatly affect the value of your company. These market forces are both what similar deals are being priced at (bottom-up) and the amounts of recent exits (top-down) which can affect the value of a company in your specific sector. The best thing you can do to arm yourself with a feeling of what values are in the market before you speak to an investor is by speaking to other startups like yours, effectively making your own mental comparables table. There are factors you can influence to increase the value of your startup, and nothing increases your company’s value more than showing an investor that people out there want your product and are even willing to pay for it.