After “will you work for free?” the most common question I get asked is “what is my business worth?”. Neither question is framed in those exact words of course, but when someone asks for help on valuation they are asking about the value of their shares, the value of the business and the least equity they can give for investment.
The normal context for this will be trying to raise some equity finance, and I specialise in some of the hardest of all companies to work with – pre-revenue start-up technology companies. In some cases they are nothing more than a patent application and a clever man or women who has come up with an interesting idea.
There is no magic formula I’m afraid but there are some guidelines to coming up with a credible valuation for your business, and some common misunderstandings and “folk wisdom” to be avoided.
The simple truth is that a pre-revenue business is worth what you can get an investor to buy in at. And you will probably have to horse trade. The hard part is rationalising, or better, justifying your starting valuation. If you have no trading history don’t let anyone kid you into putting a lot of effort into a discounted cash flow (DCF) unless you have a 3 year supply of irrevocable, non-refundable purchase orders. The truth is that the discounts to be applied for the risk will be very high, and just by way of example if the discount is higher than 40% all revenues after the first year will be ignored. Given that a normal sales growth curve for an early stage technology business is a hockey stick, your lowest revenue in year 1 gets discounted by 40% and everything else is ignored. Probably not the valuation you were looking for.
Of course, valuation also determines dilution. This can be a very emotive issue for a business owner. I’ve known grown men turn down investment rather than let go of a few extra percentage points of the equity. In their minds there is a minimum percentage of shares they hold that they will not go below. And in some cases this is a very high number indeed. You may be better off going down the Lara Morgan route – keep your equity, fund the business another way and you’ll reap the rewards all by yourself at the exit.
To help entrepreneurs get over this mental obstacle, I like to focus on the exit. If you believe in your plan (and if you don’t, stop right here) then you can work out what the value of the company might be in 5 years time and ask yourself how much of that value would be your ideal target exit. Not a percentage – an amount. Looking at the bigger picture puts into perspective the dilution.
Venture Capitalists have formula for working out valuations, but they don’t work for start-ups either – there are too many interlinked factors to make a spreadsheet capable of working it out accurately. For private investors the valuation is closely linked to their knowledge of the sector and belief in the exit (which is in turn linked to their belief in being able to get the business there). So the truth is no-one has the “right” answer because there isn’t one.
So where do you start with valuation?
I used to say that any technology worth exploiting commercially, where there is a sizable market and scalable business, is worth at least £1m, Used to say, because the appetite for pre-revenue technology is now so reduced that £500K is probably a better starting point. You might try to argue that you’ve done three years unpaid work (sweat equity), but don’t expect it to affect the value much. Similarly, prior investment does not necessarily set the price. Just because your neighbour invested at a £4m valuation doesn’t mean the next investor will.
What really will establish value in the business is the team that present the business plan. Do they have the experience, the understanding and the ability to deliver on the business plan, to cope with the wrinkles and deliver a meaningful (substantial) exit? If there is any evidence of commercial traction – letters of intent, early sales (even discounted) – maybe a distribution agreement or brand association deal.
Of course, once you start revenue generating the valuation equation changes, but here in the UK, at the end of 2011, finding funding for pre-revenue technology based companies is harder than ever – its a bleak winter to come whatever the temperature.