Posted: April 28, 2014 by Avi Ram in Money, Startup

aviramThe valuation of a new startup determines the amount of equity in their company the entrepreneurs will have to sell to their investors. Determining the valuation is a black art rather than a science. In order to understand the “investment valuation” at funding the entrepreneurs must understand the funding process. This valuation should not be confused with some estimate of “current worth” of the company. Ask the question “If I tried to sell the company today, how much would I get?” and then compare that to the “Investment Valuation”. The “current worth” tells you what the company is worth today, the “investment valuation” some indication of the investor’s view of future value.

Entrepreneurial startups have little, if any, trading history so a valuation based on past performance is not possible. Similarly a valuation based on sector P/E ratios is not sensible because there are no results to apply a PE ratio to and in any case, these companies are often so innovative that there are no similar companies by which to judge a likely PE ratio.

Each startup is unique and so any valuation is inevitably a matter of judgment and negotiation. Future cash flows discounted back give some indication but to validate this, there needs to be judgment about the company and its management, the markets, the industry and a view of the world in say five years time. In short a review of the whole project, not a trivial undertaking. This is how sophisticated investors value a potential investment and it is important for entrepreneurs to fully understand how this is done.

Fund raising is a sales process. It is not a financial analysis; it is not a banking procedure; it is not a Board or Shareholder presentation. It’s a knock down, face-to-face trade. There are few rules and both entrepreneurs and investors are looking for the best deal they can get. In short the “investment valuation” will be determined by the sales and negotiating ability of the entrepreneur. They need to know who the competition is and how to counter their proposition. They need to be able to identify objections and be prepared to handle them.

What is the investor looking to buy?

1. They want to see a project that solves an identifiable business problem rather then see an elegant solution to a problem that doesn’t exist

2. They want to understand why your solution gives an “unfair” advantage in the market place, and that the company is positioned correctly both in the market and the industry

3. They want some sort of external confirmation of the efficacy of the solution.

4. They want to know all about the team, their skills, experience and motivation to deliver the project

5. They want to know what has been achieved so far

6. They want to know what is needed to get to cash self sufficiency, what investment will be spent on and what milestones can be used to measure progress.

The sales collateral is the business plan and the presentations to the customer, the investor.

It is very important that these are of the highest quality, rigorously reviewed and fully rehearsed.

The valuation of the company will be determined by:

1. They credibility of the management team

2. The chemistry between the entrepreneurs and the investors

3. The validity of the proposition and how it is presented

4. How well the entrepreneurs understand the needs of the investor

5. And on the negative side, how desperate the need appears to be

Based on all this the investor will take a view as to the future value of the company, the funds needed, the length of time to exit and the return required to reflect the risk. They may take into account prospective dividends, loan repayments and interest if loan capital is taken into the structure of the deal. They will also take into account the human factors associated with any negotiation.

BUT in the final analysis the valuation remains what the investor and entrepreneur agree after the negotiation.

  1. Steve Brunner, CPA, CVA says:

    Good article

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