Valuing Your Company
The valuation of your business is important, as it will determine the amount of equity or shares you provide your investors in exchange for their investment. You need to get the balance right to keep control over your company whilst providing enough incentive for investors to part with their hard earned money.
There are many ways to value an asset and the most common for private companies is the discounted cash flow method. Startup companies often do not have positive cash flow and some don’t even have revenue so there is no point using the discounted cash flow method to determine the value of a startup.
If you plan to use projected cash flow, this is fraught with danger, as you have to make a number of wild assumptions on things like the future cost structure, product pricing, margins, and customer acquisition costs of the business.
Here are a few ways to think about your company’s valuation:
Firstly, as an investor, it is important to keep the founders engaged in their business. If the investor takes too much equity and control, the risk is that the founders may lose interest and not be prepared to push through the hard times.
There is no value in a founder offering a majority equity stake to investors at startup stage, however it is important to secure the attention of investors by providing a meaningful amount of equity. If their equity amount is too low, then investors may not see much value in providing you with access to their network of contacts, customers, partners and distributors.
Both the founder and investors need to also balance risk. In financial terms, the greater the risk an asset has, then the higher the expected return one would ask for taking the risk in the first place.
From a founders prospective, if you give up too much equity you risk either losing control or having to accept a lower payout when you eventually sell your business. Here is one way to think about your risk as a founder.
Say you wanted to raise $1M and offered investors 20% of your company. You have an interested investor but she wants 30% equity in your business and she is not prepared to negotiate. If you honestly believe that the $1M in new funding will increase the value of your business by more than 30% as a result of more sales, more distribution channels etc., then it is a good deal.
On the other hand, if you have doubts of the potential value the investor could bring to your business, then maybe giving up a lesser amount of 20% may be too expensive.
So what is the right answer? Unfortunately there isn’t one, but hopefully we have provided you with some guidelines. If we consider the many thousands of funding rounds that occur, the vast majority are for minority equity shares in startups.
As a general guide, investors are seeking an equity range of between 8% to 30% in the businesses they invest. Obviously, it depends on the business, the industry, opportunity and, naturally, the overall funding amount.
With this in mind, it is important to consider the amount of funding you need and the amount of equity or shares you are prepared to provide investors to come up with your valuation. Pick a number that is realistic and one that you are comfortable with.
Smart and experienced investors will speak openly with you about your valuation expectations and if you have thought about it previously, you will be in a better position to discuss it.
Understanding pre-money and post-money valuation
Investors sometimes speak about these two terms and here are the definitions:
Pre-Money Valuation: This is the valuation before you raise money. It refers to the valuation of a company prior to an investment or financing.
Post-Money Valuation: This is the valuation after you raise money. It refers to the valuation of a company after an investment is made.
Say you wish to raise $500,000 from investors and offer them 20% equity. Your pre-money valuation is $2,500,000 (500,000/0.2) and your post-money valuation is $3,000,000 (2,500,000 + 500,000).
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