How Do I Value My Startup?

by Scott Edward Walker on September 1st, 2010

Introduction

This post was originally part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of my favorite websites for entrepreneurs).  Please shoot me any questions you may have in the comments section – or feel free to call me directly at 415-979-9998.  Many thanks, Scott

Question

I’m the founder of a mobile apps startup, and we’re starting to get some incredible traction.  I’ve been bootstrapping the venture for the last year, but I’d really like to raise about $2 million to scale this thing.  If a VC invests $2 million, what percentage of the company will he own?

Answer

It depends upon the value of your company prior to the investment (commonly referred to as the “pre-money valuation” or “pre”).  For example, if the pre were $4 million, the VC would get one-third ($2,000,000 divided by $6,000,000); on the other hand, if the pre were $1 million, the VC would get two-thirds ($2,000,000 divided by $3,000,000).

As you can see, the VC’s percentage ownership is calculated by dividing the amount of its investment by the post-money valuation of the company (which is equal to the pre plus the amount of the investment).

The real issue then is — how do you determine the value of your company prior to the investment?  Let’s look at that.

I come from the M&A world in New York, where the valuation of target companies was more science than art.  Indeed, targets were valued based upon a number of different methodologies, the most significant of which is the discounted cash flow method (DCF).  As discussed in this excellent article from the Darden Graduate School of Business, DCF basically estimates the net present value of the target’s future cash flow, discounted to reflect the Weighted Average Cost of Capital or “WACC” (which, in simple terms, is the risk).

In the startup world, however, DCF doesn’t work because there is little or no historical financial data and projected cash flow is thus pure speculation.  Accordingly, the valuation of startups is highly subjective and is more art than science.  To put it bluntly: your startup is worth whatever the market says it’s worth, which was starkly demonstrated during the dot-com bubble and subsequent crash.

So what does this all mean in practical terms?  It means you need to get out there and effectively pitch a handful of VC’s in your space and get them excited about your venture.  By doing so, you can, in effect, drive the market by creating a competitive environment and playing the VC’s off of each other.  This is akin to what investment bankers do when they’re selling a company: they create a competitive environment (or the perception of one) to drive-up the purchase price and to provide negotiating leverage.

As legendary investor John Doerr, a partner at Kleiner Perkins, notes in the video I posted on Monday, “Helping Entrepreneurs Succeed: John Doerr”: “Valuations and the way to negotiate them?  I think the best thing to do is to talk to two or three venture capital groups at once – at the same time; not ten, but three.”

That being said, you should be aware of the following caveats:

  • Creating a competitive environment and playing VC’s off of each other is very tricky and best done with the help of an experienced lawyer and/or advisor.
  • At the end of the day, you will still need to convince the VC’s that you can deliver a 10X return (i.e., that they will make 10 times their investment).  VC’s will thus take into account certain significant factors such as the quality of your management team, the size of your market, etc.
  • As I have previously discussed, startups often make the mistake of focusing too much on valuation.  Indeed, there are other important terms that affect the economics of a financing, including the liquidation preference and the size of the option pool.

Conclusion

I hope the foregoing was helpful.  And if you’re wondering how to get a meeting with a VC, I briefly discussed this issue in my post “Ask the Attorney: What Are the Most Common Mistakes Startups Make Dealing with VC’s?” (see #1).  In a nutshell, you need to hustle and build relationships so that you can get a “warm” introduction — i.e., an introductory phone call/email from a middleman or woman whom the VC trusts and respects; it takes tenacity and resourcefulness – qualities that every great entrepreneur possesses.

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