How to perform a back-of-the-envelope valuation of a business that's still relatively unproven
Sure, there are generally accepted ways to determine what an established private company is worth (BusinessWeek SmallBiz, 4/16/08). But for a relatively unproven venture, the process is really more art than science (some may even think it's magic or voodoo, or just plain craziness). To be sure, it's best to have a potential investor suggest a valuation and negotiate from there. To get a sense of how potential investors arrive at a valuation (and how to do one yourself), there's no need to learn Excel or crank out discounted cash-flow models. Instead, understand the following basic rules of thumb.
The estimated value of your company is called the "premoney" valuation. The "post-money" value is what your company is worth immediately after an investment is made. For example, imagine your company has a premoney value of $3 million. You snag a $1 million investment. The result: the post-money valuation is $4 million, and the new investors own 25% of the company (the $1 million investment divided by the $4 million post-money value).
Keep in mind that a premoney valuation is subject to much negotiation. Investors typically want to make at least a 10-fold return to compensate for the risk of investing in a new venture. To this end, they will want a good chunk of equity in the company, which can easily range from 20% to 50%.
To get your valuation closer to the 20% level, you need to offer strong drivers, including the following:
Your market is large (ideally more than $1 billion).
Your product will leapfrog the competition in performance and cost-effectiveness (BusinessWeek.com, 8/11/08).
Your venture requires relatively small amounts of additional capital to reach profitability.
There are beta customers and other positive signs of customer interest.
You have taken steps to protect your intellectual property with patents and copyrights (BusinessWeek.com, 5/12/08).
You have a management team capable of running the company beyond its startup phase (BusinessWeek.com, 7/28/08).
It certainly helps if your company is in a hot category. Investors can easily get caught up in the euphoria and throw money at wannabe-deals, which usually means an inflation of values. At the same time, though, the overall economic environment will likely have an impact. In light of the slowing economy, this is a big factor todayn—note the dearth of initial public offerings and merger-and-acquisition deals (BusinessWeek, 7/9/08).
It's also important to create a sense of urgency. For example, you should schedule as many investor pitches as you can within a few weeks. If you get several term sheets, you will have leverage in negotiations—since you can walk away from an offer.
While this option would be nice, it is still the exception. The most likely scenario is that your company will not be attractive to venture capitalists at this point and your main option will be angel groups.
Convertible Note Gambit
The problem: angels want 20% to 50% of a business for a relatively small amount of capital—say, $250,000 to $500,000. Compare this to a Series A financing, which can range from $3 million to $5 million. In other words, you will be giving up a big percentage of your company for a small amount of money in the angel round—but still need to do a Series A round, when you will have to give up another large chunk of equity.
Joe Platnick, director of the Pasadena Angels, says his group has focused on so-called convertible notes to deal with this valuation problem.
Convertible notes are a loan to the company, but the notes convert into shares of stock when the Series A round takes place. To entice the angels, the notes are typically discounted 10% to 25%. There may also be warrants attached to the notes, which allow the investors to buy more shares (at the discount). The upshot: much of the valuation discussion is deferred.
For the most part, the valuation process is really subjective and can change drastically, depending on timing. But this doesn't mean it's okay to push hard for a sky-high valuation. Based on figures from VCExperts' private equity database, average valuations for recent Series A venture capital deals were $12.2 million for the software/IT sector; $17.9 million for the industrial/energy sector; and $25.7 million for the biotechnology sector. Investors want to see that you generally understand the process and are realistic. If not, investors could take it as a red flag.