How to value your startup business for equity financing

Valuing a start-up business is like valuing a work of art. Beauty is in the eye of the beholder. The “artist” (startup founder) thinks the company “must be” worth at least $10 million. The “appraiser” (potential investor's accountant) finds the company's “book value” to be $500, but thinks it's probably worth only $399, so a 50% stake should cost $200. The investor usually values the company somewhere between the two.

As you can see, the valuation of a startup is the art of convincing investors of the potential value of a million-dollar idea with hard numbers and real research.

Three maxims to live by

Three maxims all startups should live by when valuing their idea/company and figuring out how much to give away:

• Don't be afraid to sell the equity if your plan is to raise money. If you doubt it, read From Alchemy to IPO. Ten percent of a $100 million is a heck of a lot more than ninety percent of a $100,000.
• Your company is worth whatever someone will pay. No matter what your internal feelings are about how great your company and idea may be, if the market says the company is worth $250,000 right now, then that's what it's worth. So if you want to raise $25,000, you must sell 10% of the company.
• Your company will become more valuable over time. Selling equity should be done in phases. If your business plan is well thought out, you can plan these “tranches” of capital. Perhaps in round one, you ask $1 per unit for your provisional patent, pending trademark, or great idea. In round three, after you have issued patents, registered trademarks, and have some cash flow, perhaps you ask $5 per unit.

The truth is that if you do your homework and can show where your numbers came from, show you understand competing products, and provide a rational basis for a market penetration analysis (i.e., what percent of that market you will capture and how and when you will capture it), you can tell an investor what your company is worth and probably get them to pay you that value.

Market comps and financial projections

So where do you get these numbers? You can't base them on past performance, because you have none. You can't use price-to-earnings ratios. You can't use a multiplier of trailing gross revenue. You don't have a track record yet. Now enters the speculative game of using market comparables (comps) and financial projections.

Anyone who has ever purchased a home is familiar with the concept of comparing one home to another and determining a rough price range based on recent and previous sales of comparable situated homes and properties. Companies can be valued the same way.

For products you can:

• Compare your pricing to that of competing products (you have to meet or beat their pricing—or make a significantly superior product),
• Estimate your cost to make your product, and
• Deduct this from the sales price to get a net revenue on a product basis, then
• Estimate the total market size, which usually requires online research
• Figure out your estimated market penetration rate based on your industry—this is perhaps the most difficult part. You may have to purchase some reports to get these numbers right.
• Multiply the result of the penetration by the revenue per product

Now you have some data to work with.

Next, you need to forecast annual penetration increases and put these numbers into a pro forma financial statement, which includes other costs. A good pro forma template can help, which you can find through the U.S. government here. With pro formas in hand, you can now graduate to the more traditional business valuation methods.

IRS Revenue Ruling number 59-60 states that earnings are the most important and controlling factor for the valuation of closely held operating companies. This means you should focus on the projected earnings in your pro forma and consider using one of the following three income approaches to determining the fair market value (“FMV”) of the company:

• Discounted future cash flows method
• Capitalization of earnings method
• Excess earnings method

Valuation is speculative

While the details of each method are beyond the scope of this article, remember two things:

• The valuation of any startup business is almost entirely speculative. This is something that you must disclose in detail to anyone from whom you might take money.
• There are very special and detailed state and federal regulations for taking money from other people to invest in a startup. Consult your attorney for details.

A final word of warning: Be careful when using online business valuation calculators. They are very generic, very optimistic, and barely scratch the surface of the factors involved in calculating value. For the best results, consult with a professional business lawyer.