Most entrepreneurs treat their companies like it’s their babies. Meaning they think it’s the most unique and precious thing on Earth that everyone wants a piece of it. This attitude creates valuation problems, when entrepreneurs don’t know how to value their company, and therefore go with their imagination that is not based on facts.
Most often entrepreneurs value their company with the following formula: X : Y% = valuation
- X = amount of money they want
- Y = amount of equity they want to give away
The funny thing about this valuation is that it has no justification and does not reflect the real situation of the company. It’s simply a wish of what kind of deal the entrepreneur wants to have. Then they go with this valuation in front of investors to embarrass themselves and then get into an argument when they are shown the real value of their company.
What is the correct valuation of a start-up?
This is hard for the people who have absolutely no understanding of proportions. I have literally met people who think that a simple idea they came up with is worth hundreds of thousands or that a product developed for $100k is worth millions.
The real cost of a company in a pre-sale stage is a combination of the following:
- The total amount of funds invested in the project or cost of development, whichever is bigger.
- Salary of the founder(s) during the time they developed the project unless it’s included in the previous point.
- Intellectual property (if there is any).
- Additional fee for an investor for coming on board late.
- Founder invested $100k of his own money to pay for product development: Value: $100k
- Founder planned everything and worked on the project for 1 year: Value: $50k
- Intellectual property. Usually, there’s none as ideas are not unique, so we will leave this point empty.
- Fee for coming on board late, when everything is already done: Value: $50k-$100k
So, in this case, the total value of the company is $200k-$250k.
The revenue estimate or the prediction does not matter at this stage because they are based on the contingency that the company will receive an investment. In the case of a pre-revenue start-up, an investor most often has an option to hire people, build a similar product and own 100% of it. So the entrepreneur needs to come with a reasonable offer if he wants to get an investment in the first place.
For companies that have been in business for over a year, there is a simple post-revenue formula on how to calculate the value.
- 3–5 times multiplier on current yearly profit
- 0.5–1 times multiplier on current yearly revenue
Whichever of the above is bigger.
In this case, the amount of money you invested in the company or the intellectual property you have do not matter anymore. If you burned all your money, but still did not manage to get enough sales to at least match the amount invested in your company, then you will most likely fail, and no one should invest in your company. In case the company owns physical property or real estate, the value of the company can never go below the value of these goods, even if the revenue and profit are non-existing. Note that the above calculation does not apply to billion-dollar companies that dominate the industry.
- An extremely well-established and steady business with a rock-solid market position, whose continued earnings will not be dependent upon a strong management team: a multiple of 8 to 10 times current profits.
- An established business with a good market position, with some competitive pressures and some swings in earnings, requiring continual management attention: a multiple of five to seven times current profits.
- An established business with no significant competitive advantages, stiff competition, few hard assets, and heavy dependency upon management’s skills for success: a multiple of two to four times current profits.
- A small, personal service business where the new owner will be the only, or one of the only, professional service providers: a multiple of one time current profits.
Most common evaluation mistakes that start-up entrepreneurs should avoid
- The value of your company depends on the revenue and profit of your company, not the size of the market.
- Just because you call yourself a start-up, it does not mean that you are worth more than “normal” companies.
- Just because some start-up without a product in Silicon Valley got multi-million-dollar to invest, it doesn’t mean that your company will get it as well.
- If an investor overpaid for your company, it doesn’t mean that your company is actually worth that much. Most likely, he made a mistake.
- Getting an investment is hard. If you refuse a deal that in your opinion is bad, you may never get a new one and will be forced to shut down your venture. A bad deal is better than no deal.
- Asking valuation based on the future forecast is as stupid as a trainee asking for a salary of a CEO, just because he will be CEO in the future.