A few years ago the TV show Dragon’s Den allowed people to showcase their invention and ask a panel of investors for money. One of the most entertaining aspects of the show was valuation: at the end of their presentation, people had to tell the panel how much money they wanted (e.g. € 100.000) , and what percentages of shares or profit they were willing to share (e.g. 10%). Any viewer and the panelists would quickly compute from this the implied value of the enterprise after the investment (€ 1.000.000 in the example, since 10% of € 1 million is € 100.000). The implied values varied greatly for no apparent reasons, making valuation look like a magic art or just a guessing and bluffing game. Is this also true in the real world?
I am often asked to help people with startup valuation. I do so by discussing the available structured approaches to company valuation, some of which can also be used for startups. Since I am not aware of any complete guides specifically for startup valuation, I decided to explain some of the basics around startup valuation in this article.
Backward and forward looking methods
For valuation of companies, one can use backward looking methods (that do not rely on expectations) and forward looking methods (that do rely on expectations). For startups, it is best to use backward looking methods. These methods can be applied in a fact based and objective way that gives insights. Any method that needs future cash flows is problematic since it is often not possible to obtain a good enough estimate of future cash flows. For valuing a startup in the first round, a good method that combines usefulness and simplicity is the “add-the-assets-including-team-value” method.
For illustration purposes only, I have included a detailed valuation example based on this method below. This section is aimed at beginners. If this offends you, please skip this part and jump immediately to the conclusions.
Detailed example: Alice and Bob and the Widget company
In this example, Alice and Bob have an idea for a new widget. They need € 100.000,- from Carol, and have offered her 10% of the shares of their to be created widget company. Is the implied value fair to Carol?
First of all, it is important to distinguish pre-money and post-money valuation. In the example, the money asked goes into the company. Carol pays € 100k for 10% of company with € 100k in the bank, implying that the company with € 100k in the bank is worth € 1 million. This means that Alice and Bob value their widget company currently at € 900k. The question to Carol is thus: is the company worth € 900k?
One way to value a startup is to look all the assets that are brought into the company. One simply estimates the value of each component, adds up the numbers and you have the value of the company. Let’s use in our example three components:
- The initial idea for the new type of widget.
- The results so far: For instance a working prototype of the new widget and a list of contact details of 10 initial customers, and signed declarations of 2 customers to buy a widget.
- The promise of Alice and Bob to run this company in the next few years (‘the team value’)
The value of the first component, the widget idea, is best estimated at zero. There are many people out there with ideas. Many ideas also cannot be protected in any way, so the to be created company does not really own the idea. Zero sounds harsh but is often the right value that investors give to the idea.
The second component can be worth something. It is often easiest to estimate the value by estimating how much effort it has taken or will take, multiplied by a fair or generous hourly rate. If Bob and Alice for instance have 200 hours into the prototype and 400 hours in building customer relations, one could estimate the value at € 60.000. It is important to note that we do not value any previous effort of Alice and Bob here, but only the effort related to concrete results. The value only goes up if results are achieved.
Finally we have the team value. Supposing that Alice and Bob, in their business plan, propose to work for just € 1.000,- per month whereas professionals of their level normally cost € 5.000,- to € 10.000 per month. Assuming that they commit to be involved for at least two years, this means that the team value is between € 192.000 and € 432.000). As you can see, the team value dwarfs the other components. This is often the case: ideas are easy to find, but finding the right team to execute and idea is difficult and something investors are willing to pay for.
In the example, the high estimate for the total pre-money value is 0+60.000+432.000= € 492.000. The postmoney valuation is € 592k. If I were Carol and I wanted to invest in this company, I would ask for at least 17% of the shares (€ 100k / € 592k). What will really happen will depend on the situation: if there are many willing investors, one of them might do it for less and the deal will happen at a higher valuation. If Alice and Bob really want to have Carol on board and see her as an equal team member, they could also offer her 33%.
So what can we learn from this example?
- In practice, a typical reasonable post-money valuation in a first round for a company with 2-3 founders is between € 250.000 and € 1 million. There is no law of nature that forbids valuations outside this range, this will depend on the assets and circumstances of the company and the deal.
- Ideas are typically worth less than the team commitment.
- There is only team value if the management team pay themselves less than they could earn elsewhere. If they give themselves market levels salaries, there is no real commitment and no value.
- The past effort and sunk costs are not directly relevant for valuation, but can be relevant for valuing assets
Most companies have multiple investment rounds and valuations in the next rounds are often much higher than the “add-up-the-assets” method predicts. In these later rounds, the current cash flow and the risks that have already disappeared become relevant. But for first rounds, the add-the-assets method including the team value works well enough to get some value to start negotiating from.