Crain's Cleveland Dealmaker Guest Blog - No Easy Answers to Valuing a Startup, but Unbiased Advice Should Help

No easy answers to valuing a startup, but unbiased advice should help

Blog entry: May 22, 2013, 4:30 am   |   Author: DOMINIC M. BRAULT
Given the rapid development of the Midwest venture ecosystem, the question — how do you value a startup? — is now commonly posed by local entrepreneurs, investors and advisers, among others. The answers vary widely since valuation of an early-stage company is absolutely more art than science.

In most instances, the entrepreneur wants to support a high valuation based on “goodwill” and the prospective opportunity, while an investor wants an appropriate valuation relative to their risk/return requirements and the reality of the frequency of failure. Although the market ultimately decides what the company is worth, a third-party, unbiased assessment from an investment bank, accounting firm or lawyer can help in most situations.

The science: There are several widely accepted approaches to valuing companies, such as the income approach, market approach and asset approach. Each one of these traditional methodologies can be used, although they are tough to employ for startup companies, since many startups are pre-revenue with zero to few predictable earnings. As a result, standard techniques applied to estimate cash flows, growth rates and discount rates may yield unreliable conclusions, and market comparisons can be difficult due to the absence of an operating history and divergences in risk and growth profiles.

Additionally, the cost to recreate the business (“smart money” would pay no more for an asset than its replacement cost) may not come close to justifying the “ask” due to “goodwill” (aka, the prospective opportunity and intangible assets) — a concept appropriate for revenue-positive companies. As a result, alternative approaches, such as the Venture Capital Method, are also utilized.

In the Venture Capital Method, step one is: Develop a reasonable set of financial projections, supported by the expectation of market size, adoption rates, pricing, volume, cost per sale and required overhead, etc. Step two: Calculate a future value of the total enterprise, typically at year five or beyond. Step three: Determine an investor's required rate of return (normally 5x to 10x the invested capital for early-stage investments, depending on the maturity of the business and the presence of early adopters, or customers using the product or service).

The art: Many qualitative considerations drive startup valuation. These include deal “hype,” founder investment, past successes of the founder, target market, assembled team, product stage and differentiation, initial traction, pace of customer adoption, scalability, current burn-rate (synonymous with negative cash flow), barriers to entry, intellectual property protection, board control and protective provisions, among others.

Anecdotally, we see early-stage pre-money valuations (or the valuation prior to an investment) in the $1 million to $5 million range. Oftentimes, when a subsequent financing round is planned in the near term, we see investors deferring the negotiation of valuation to the next round. Instead of agreeing on a valuation today, the companies use a note structure and negotiate a discount to the next round. And in terms of amounts raised, some companies plan to raise enough money to have at least a year of “runway,” look to give up between 10% to 40% of the company and expect to raise more capital later at a higher valuation.

Unfortunately, there is no easy answer to startup valuation, but there are plenty of opinions available. We suggest using several methods and obtaining as much unbiased advice. Entrepreneurs need it to know what kind of capital they need from investors and what amount of equity they're willing to trade. Investors need it so that can put a value on their investment to generate liquidity.

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