Valuing a start-up business is like valuing a work of art…beauty is in the eye of the beholder. The “artist” (startup founder) thinks the company “must be” worth at least $10 million. The “appraiser” (potential investor’s accountant) finds the company’s “book value” to be $500, but thinks it’s probably worth only $399, so a 50% stake should cost $200. The investor usually values the company somewhere between the two.
As you can see, valuation of a startup, is the art of convincing investors of the potential value of a million-dollar idea with hard numbers and real research.
Three Maxims to Live By
Three maxims all startups should live by when valuing their idea/company and figuring out how much to give away:
The truth is that if you do your homework and can show where your numbers came from, show you understand competing products and provide a rational basis for a market penetration analysis (i.e. what percent of that market you will capture and how and when you will capture it), you can tell an investor what your company is worth and probably get them to pay you that value.
Market Comps and Financial Projections
So where do you get these numbers? You cannot base them on past performance…because you have none. You cannot use price-to-earnings ratios. You cannot use a multiplier of trailing gross revenue. You don’t have a track record yet. So, now enters the speculative game of using market comparables (comps) and financial projections.
Anyone who has ever purchased a home is familiar with the concept of comparing one home to another and determining a rough price range based on recent and previous sales of comparable situated homes and properties. Companies can be valued the same way.
For products you can:
Now you have some data to work with.
Next, you need to forecast annual penetration increases and put these numbers into a pro forma financial statement, which includes other costs. A good pro forma template can help, which you can find through the U.S. government here. With pro formas in hand, you can now graduate to the more traditional business valuation methods.
IRS Revenue Ruling number 59-60 states that earnings are the most important and controlling factor for the valuation of closely held operating companies. This means you should focus on the projected earnings in your pro forma and consider using one of the following three income approaches to determining the fair market value (“FMV”) of the company:
While the details of each method are beyond the scope of this article, remember two things:
A final word of warning: Be careful when using online business valuation calculators. They are very generic, very optimistic, and barely scratch the surface of the factors involved in calculating value. For the best results, consult with a professional business lawyer.
If you don’t already have a business attorney, you can find one at an affordable price through the LegalZoom Business Legal Plan.