When selling a start-up to potential investors, you naturally have to get them excited about your team, your product, and your company. But eventually they will ask a question that often stumps the inexperienced entrepreneur: “What is your company’s valuation?” To answer that question, Martin Zwilling, CEO & founder of Startup Professionals, Inc., and Managing Partner of Southwest Software Ventures & and Consulting, offers these “Top Ten Techniques” for start-up valuation:

1. Place a fair market value on all physical assets (asset approach). This is the most concrete valuation element, usually called the asset approach. New businesses normally have fewer assets, but it pays to look hard and count everything you have. Be sure to include computer equipment, office equipment, furniture, tools, and the value of inventory or prototype products, including development costs.
2. Assign real value to intellectual property. The value of patents and trademarks is not certifiable, especially if you are only at the provisional stage. A “rule of thumb” often used by investors is that each patent filed can justify a $1M increase in valuation.
3. All principals and employees add value. Assign value to all paid professionals, as their skills, training, and knowledge of your business technology is very valuable. Back in the “heyday of the dot.com startups,” it was not uncommon to see a valuation upped by $1M for every paid full-time professional programmer, engineer, or designer.
4. Early customers and contracts in progress add value. Every customer contract and relationship needs to be monetized, even ones still in negotiation. Assign probabilities to active customer sales efforts, just as sales managers do in quantifying a salesman’s forecast. Particularly valuable are recurring revenues, like subscription amounts, that don’t have to be resold every period.
5. Discounted Cash Flow (DCF) on projections (income approach). In finance, the income approach describes a method of valuing a company using the concepts of the time value of money. The discount rate typically applied to start-ups may vary anywhere from 30% to 60%, depending on maturity and the level of credibility you can garner for the financial estimates.
6. Discretionary earnings multiple (earnings multiple approach). If you are still losing money, skip ahead to the cost approach. Otherwise, multiply earnings before interest, taxes, depreciation and amortization (EBITDA) by some multiple. A target multiple can be taken from industry average tables, or derived from scoring key factors of the business. If you have no better info, use 5x as the multiple.
7. Calculate replacement cost for key assets (cost approach). The cost approach attempts to measure the net value of the business today by calculating how much it could cost for a new effort to replace key assets.
8. Find “comparables” who have received financing (market approach). Another popular method to establish valuation for any company is to search for similar companies that have recently received funding. This is often called the market approach, and is similar to the common real estate appraisal concept that values your house for sale by comparing it to similar homes recently sold in your area.
9. Look at the size of the market, and the growth projections for your sector. The bigger the market and the higher the growth projections are from analysts, the more your start-up is worth. For this to be a premium factor for you, your target market should be at least $500 million in potential sales if the company is asset-light, and $1 billion if it requires plenty of property, plants and equipment.
10. Assess the number of direct competitors and barriers to entry. Competitive market forces also can have a large impact on what valuation your company will garner from investors. If you can show a big lead on competitors, you should claim the “first mover” advantage. In the investment community, this premium factor is called “goodwill” (also applied for a premium management team, few competitors, high barriers to entry, etc.). Goodwill can easily account for a couple of million dollars in valuation.

“Even if a given investor excludes some of the above components of value from consideration in your case, your credibility will be bolstered by the fact that you understand his business as well as yours,” says Zwilling. “In any case, the analysis will prepare you for the heavy negotiation to follow.”

Source: Startup Professionals Musings

Posted October 27th, 2009 under Intellectual Property Marketing

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