It’s commonly said that business valuation is more art than science. If this is true, then the practice of valuing a start-up business is squarely in the domain of the artist.
Nevertheless, entrepreneurs need to put a value on their start-ups in order to raise money, and investors need to put a value on their investments to generate liquidity. Since neither entrepreneurs nor investors are known for right-brain artistic thinking, this article aims to provide some tips for left-brain thinkers to make sense of start-up valuation.
- You are what the market says you are. If investors are telling you that your start-up is worth $1 million, then that’s what it’s worth. You might think it’s worth more. You might even know it’s worth more because your company may have more than $1 million is liquid assets, or more than $1 million in receivables, or more than $1 million in sweat equity. But if you’re unable to raise money for your start-up with a valuation above $1 million, then you’ll have to accept the market valuation.
- But you can also tell the market what you’re worth. Although this might seem to contradict the point made above, it’s possible to tell the market how to value your company. After all, if investors think your start-up is worth $1 million, it’s usually because of something you’ve told them. By definition, start-ups don’t have a history of financial performance on which to base a valuation. Therefore, it’s up to the entrepreneur to develop a process for valuing the company based on comparables and financial projections.
- Comparables: Find out how much similar companies in your industry and geography are worth. You can use sites such as BizBuySell and BizQuestto determine how much businesses are selling for in your industry. If you have a high-tech or high-growth start-up, accountants and lawyers are among the best advisors to help you determine the market rate for comparable companies at your stage. In my experience, attorneys tend to overvalue star-tups, and accountants tend to undervalue start-ups, so you may want to talk to both before making a decision.
- Financial forecasts: Although it’s notoriously difficult to forecast revenue at a start-up, you’ll need to do this to determine value-and eventually to defend your valuation. For example, if you’re starting a pet food store, your valuation and financial projections will likely be lower than if you’re starting a speculative biotechnology firm.
- You’re not really worth anything until you’re profitable. If you’re not profitable, your business probably isn’t worth very much. That is, it doesn’t have as much liquidity as it would have if it were profitable. Many businesses cannot be sold, since there aren’t enough business buyers for every seller. Almost all unprofitable businesses cannot be sold for the same reason.
This makes valuation particularly challenging for a start-up. Since young businesses take time to become profitable, the trick of valuing start-ups is to focus on the future. First, determine how many years it will take to be profitable. A business with a long road to profitability will usually be worth less than one with a quick path to profitability. Next, determine how much comparable companies have been valued at when they reached profitability.
A company that could be worth $5 million at profitability will be worth some fraction of that number at the start-up stage, based on factors such as the likelihood of success, the time frame to exit and the quality of the management team.
It’s easy to get caught up in the excitement of valuing your company at the highest amount possible and forget that you’ll one day have to deliver on the expectations of investors. It’s also tempting to adapt your business model to maximize start-up valuation.
Be careful about overvaluing your start-up with faulty assumptions; it will only make your life more difficult-particularly if your investors have governance rights, such as positions on the company’s board.
Much like artists, entrepreneurs need to use creativity in valuing their start-up businesses. Traditional approaches to valuation based on book values and P/E ratios are akin to painting by numbers. If you want your start-up to be a masterpiece, you’ll need to use the right side of your brain as much as your left to determine value.