How to value your startup

Do you have a great idea for a startup but feel overwhelmed by the funding options? You’re not alone.

Many fledgling entrepreneurs have a great idea and sound business plan but start scratching their heads as soon as money is mentioned.

Every startup needs money to grow so it is important that you value your startup correctly to secure the funding which will allow you to succeed.

In the beginning... 

Many entrepreneurs start off by choosing internal funding to give themselves the benefits of low transaction costs, flexibility and greater control. However, growth from this may be restricted, leading to under-investment problems.  

At times when investment needs are significantly higher than internal cash flows, entrepreneurs may need to resort to external funding, probably in the form of equity rather than debt, as their debt capacity is likely to be low.

If you choose external funding, there are various equity providers for small, young and high growth firms, particularly here in London. Given that such providers will provide cash in return for an equity stake, valuation of your startup becomes critical.

Valuation is different to pricing, which is what investors are willing to pay for the shares, as it focuses on the intrinsic value of the cash flows in place and from future growth opportunities.

In contrast, pricing may not be fully related to this valuation, as it depends on the behaviour of the buyer and seller, as well as events in the market conditions such as recent transactions.

Entrepreneurs needs to take these behavioural factors into account but should start by calculating the intrinsic value of their business. Since valuation is not an exact science and involves many disciplines, the objective is to arrive at a range of values, rather than a single number, on which the negotiations can be based.

To do this you need to assess fully the strengths, weaknesses, opportunities and threats of your startup. The critical factor driving valuation is the expected cash flows, which are the net profit to which depreciation and amortisation – regular payment of debts - is added. These items do not involve cash, and investments should be deducted.

The Venture Capitalist valuation method

I recommend that my students use the Venture Capitalist valuation method to forecast future earnings in the next three years.

This involves taking your current earnings and extrapolating them into the future, depending on the businesses and industry’s macro-economic strengths and expectations.

The higher the forecasted earnings, the better it is for the funding provider because such forecasts signal the confidence of the entrepreneur and constitute a monitoring benchmark.

Let’s say your forecasted earnings are £100,000. You need to then apply a particular Price to Earnings ratio (PE) of a similar quoted company or the average of the sector. (You can find this data in the financial press).

For example, for the Software and Computer Services, the current average PE ratio is 38. Therefore, the expected value of the business in three years’ time is £100,000 x 38 = £3.8 million.

The value of the business today is the discounted value of these £3.8 million. For the entrepreneur, the business is likely to have a cost of capital of 15 per cent, which can be just slightly higher than that of a similar but quoted comparable company. 

If we divide the £3.8 million by (1+15 per cent) by the power of three, we get a current value of £2.5 million. For capital of, for example, £300,000, the entrepreneur will give up 12 per cent equity stake in their company.

However, the finance providers may not be happy with a cost of capital of 15 per cent and will ask for 30 per cent. In this case, the present value of business will amount to only £1.7m.

For a capital of £300,000, they will ask for 17 per cent equity stake.  They could even ask for a much higher discount rate, say 50 per cent. In this case the business is only valued today at £0.9 million and their stake will increase to 32 per cent.

Undoubtedly, finance providers will also have additional roles of advisers or contact generators, which could be invaluable to the startup. 

However, entrepreneurs need to weigh these benefits against the costs of giving up part of the business and being subject to monitoring, decision sharing and constant information disclosures.