Investment: How to Value a Startup
October 16, 2012 2 Comments
There are plenty of websites about valuing a startup using the Venture Capital Method, or Discounted Cash Flow, or Net Present Value. My experience is that none of these are all that relevant to Angel investment in Scotland. In fact, at the Turing Festival Brian Caufield at DJF Esprit (a well respected VC) said that they only use DCFs to sanity check valuations after the fact, not to calculate them in the first place!
I’m going to share some of the thoughts and rules I come across. Of course, the only thing that is certain about rules is that they all have exceptions, but I think it is still worth knowing the rules you might be trying to be an exception to..
Pre and Post Money Valuation
Pre and Post money valuation are all too often confused under the umbrella term “valuation”, but the two can be quite different. In simple terms, Post Money Valuation = Pre Money Valuation + Cash Invested.
For example, if an investor buys 25% of the equity of a business for £250k, then the post-money valuation of the business is £1m (since £250k is 25% of £1m). This means that the pre money valuation was £750k (the post-money valuation less the cash invested).
Some Rules of Thumb
- No pre-revenue company is worth more than £1m in the current market in Scotland. As pre-revenue companies will generally be looking to raise fairly small amounts of money, it probably makes little practical difference whether we’re referring to pre or post money valuation in this case, but strictly speaking this applies to pre-money valuation
- Investors will take 25-40% of the business in the first round. It doesn’t matter how much cash is involved, the investors will want a sizeable chunk of the company, but also want to leave the founders with sufficient equity to be incentivised to drive the company to success. The founders equity must be sufficient to survive dilution in later rounds of funding too. In practice, this means first round investors take 25%-40%.
For larger businesses, a common rule of thumb for valuations is to look at multiples of either revenue or profit. For example, it’s common in the enterprise software sector to see valuations of 3-4x revenue. As startups very often have no revenue, or at least no reliable, repeatable revenue, this isn’t directly relevant to valuation at the startup stage. However, multiples can be used with revenue projections from the business plan to start guessing at future valuation, which will be important when considering exits.
One of the best sources of valuation for a startup is to find a company that has done something similar and to see what their valuation profile was, especially exit valuation, and work back. Finding a convincingly similar company is the first challenge here as startups all have a degree of uniqueness, and a comparable is much stronger if it is in a similar location too. Using a Silicon Valley company as a comparable for a new venture elsewhere is not likely to be realistic – the whole ecosystem there is very different. For many startups, finding a realistic comparable is not possible.
Investors Want Returns
One of the biggest drivers of valuation is that investors want to make a return on their money that is appropriate for the level of risk they take by investing. Most UK Angel investors make their exits when their investee companies are sold to a bigger company. The ideal exit will come fairly quickly (3-5 years) and give the investor a big return (5-10x or even more).
Most exits for UK tech companies are not to global giants like Apple or Google (see The cabin crew will point out your nearest exit now…). Most exits are to smaller or regional players trying to grow through acquisition, or to customers bringing a technology in house. Investors will generally only put money into companies where they can see some potential buyers to give them an exit.
Imagine a company with a revolutionary cost-saving product is seeking £300k investment, for a post-money valuation of £1m.
The business plan projects that within a few years the company will take a handful of top tier customers and a few smaller ones and generate £1-2m revenue, and that might attract an exit valuation of a few times revenue – say £3-8m.
An investor would look at this business and have in mind the need for a £3m exit to get a 10x return – so it sounds like they can meet their objectives easily?
For that to be the case, there has to be someone in the market willing and able to actually PAY to acquire the company. That usually means a company with at least 10x the revenue, but not a global giant that would find such a small takeover distracting. An acquirer will need to have sufficient cash reserves for the deal, and is more likely to be a realistic exit option of they have a track record of acquiring companies of that sort of size. Ideally there will be a number of potential acquirers meeting the criteria, so that even if a few fail or merge there are still a number of options and with luck a couple can be encouraged to bid against each other.
Anything that founders can do to identify a number of plausible acquirers will help with valuation at the investment stage .
If the only potential acquirers aren’t likely to buy at the price the investors will want to sell at, then the business plan, funds sought and valuation will need a serious review.
Stage and Size of Investment
The following is a list of the different stages at which companies are likely to raise money (and the likely sources of money). It is slightly modified from a list that Brian Caufield (from VC DJF Esprit) showed at the Turing Festival in the summer:
- Concept – $50k (Friends, Family and Fools)
- Design – $100k (Angels)
- Product $350k (Angels)
- Market Validation $500k (Angels/VC)
- Market Scale $3m (VC)
- National Growth $6m (VC)
- International Expansion $20-$100m (VC)
- Preparing for IPO $20-30m (VC)
Given the previous generalisation that investors are likely to want 25-40%, this can be used to work out approximate valuations that are likely to be appropriate:
- Concept – $50k (Friends, Family and Fools) Valuation: $125-200k
- Design – $100k (Angels) Valuation: $250-400k
- Product $350k (Angels) Valuation: $875k – $1.4m
- Market Validation $500k (Angels/VC) Valuation: $1.25-2m
These numbers are in dollars from the US market, but I think they are still relevant in Scotland to give an indication of order of magnitude. A company looking for matching money for a SMART Feasibility study (in the Concept stage) is unlikely to be worth £5m.
Step Away from the Spreadsheet
The various rules of thumb listed above probably don’t answer the question “what is my company worth?” but I think they help point towards the fact that the answer won’t be found in a spreadsheet calculating discounted cash flows. Ultimately, a company is worth exactly what someone will pay for it, whether as an investor or acquirer.