Valuing a start-up

I have had a lot of conversations lately with entrepreneurs about how to value their businesses. This is always an emotional topic but a very important one nonetheless. In this blog post, I will put forward three methods for valuing a start-up, all three of which I believe should come in to play for most businesses.

Method #1 - using financial metrics:

No duh, right? This is how you are supposed to value a business. This is the kind of stuff they teach in business school. When we look at public companies, we talk about their value in terms of their P/E ratio in an effort to collapse all companies into a common measurement where we can understand their value (price) relative to how much cash they generate on an annual basis (earnings).

However, start-ups do not have any E yet. Let alone earnings, they may not even have any revenue in the early days! Notwithstanding, it still makes sense to think about value relative to key financial metrics. I like to understand a company’s financial opportunity from both a tops down and bottoms up perspective. This is probably enough material for another blog post, but basically, entrepreneurs should be able to talk about their market opportunities from a tops down perspective and be able to demonstrate that they are attacking a large and growing market that is ripe for whatever disruption they are bringing into it. Likewise, they should be able to talk about their business strategyfrom a bottoms up perspective and demonstrate just how much of that market they will capture, when they will capture it, and at what level of gross margin. Tops down proves that the market is worth pursuing, and bottoms up is the litmus test that measures just how well the entrepreneur can pursue the market. The bottoms up approach should walk the thin line between ambition and realism, as entrepreneurs are so often requred to do.

So, for early-stage ventures valuing a company on financial metrics is almost always forward looking. Looking backward to trailing revenues (as is common with traditional companies) is unattractive to the entrepreneur because an early-stage company is typically in hyper-growth mode. However, looking ahead is entirely subjective. There are two key considerations:

1) What is the likelihood that the forward looking revenue can be attained? Answering this question demands an evaluation of the entrepreneur, the plan, the market conditions, the resources (i.e. cash, sales people, etc.) required to get the company to the sales milestone. The chief evaluator in this question is whoever is trying to value the company, most likely an investor or potential acquirer.

2) What type of multiple can be assigned to the forward looking revenue? This is really a market driven metric and it ranges from as low as 2x in bad times to 10x+ in good times. Check around with other entrepreneurs or advisers (call me!) to check on this metric and how it is trending. Also, consider your gross margin, not just your top line revenue. It is a pet peeve of mine when gross margin is ignored. If your gross margins are low, it does not make sense to peg your value to a forward looking revenue multiple, similar to what a company with high gross margins can get.

Admittedly, this is all very subjective, which is why it is so important for an entrepreneur to be able to articualte a plan to attack a large and growing market and also to incite confidence in others that he or she is the one to do the attacking. 

Method #2 - using strategic metrics:

All of us in the start-up ecosystem love “strategic value” because it basically means that some companies are willing to pay well beyond what makes financial sense because the asset is so strategic to them. That is the positive side of strategic value. The negative side is that there is almost always a limited universe of players who will view the company in such a way.

As a result, strategic value is a great thing to leverage when selling your company, but it is a much harder thing to leverage when financing your company. Sure, entrepreneurs can bring in strategic investors to a round of financing, but they need to be well aware of the timing and impact of such a move, especially if it means that business opportunities with another strategic partner are limited as a result. If the entrepreneurial company’s strategic direction can remain open and unencumbered, then bringing in a strategic investor can be a great move.

Within the strategic value framework, especially with respect to acquisitions, there are three ways to think about assigning value:

1) Financial assets: you may hear this referred to as an “accretive” acquisition - i.e. one that has an immediate impact on the acquiring company’s bottom line. The valuation method here will be more similar to the financial metrics described above, although the acquiring company may think about costs they can strip out of the target business as well as scale they can achieve because of their established sales & marketing infrastructure, branding, etc.

2) Technology assets: oftentimes, the entrepreneurial company’s advantage is that it can develop technology and products faster and better than large companies. A “technology” sale proves that out as the superior technology of the smaller company becomes part of the product offering of the larger company. This can be a great outcome for an entrepreneurial team, especially if going to market would have been difficult for the smaller company due to cost, competitive pressure limiting access, etc. The valuation exercise here is to assess how much further investment is needed to prepare the technology for commercial success inside the larger company and then to weigh that cost against the financial upside (again using the financial valuation methods described above).

3) People assets: another key differentiator for entrepreneurial companies is their ability to attract intelligent and creative people who are excited to attack problems on the bleeding edge of the market. This is incredibly valuable to large companies as well, especially once the entrepreneurial teams have amassed market knowledge and domain expertise. Therefore, large companies will sometimes acquire companies to get access to their employees. This is especially true in times like this when hiring advanced engineers is difficult and competitive. One caveat: the acquirer is valuing the people much more than the company or the assets it owns (i.e. technology, products, etc.) and that is reflected in what they are willing to pay. These acquisitions are typically good for the employees (salary, bonus, long term incentives like stock options, etc.), but they are not as good for the shareholders (i.e. the acquirer is not really willing to pay up for the company’s stock).

Method #3 - using practical metrics:

Everything above needs to be tempered with a level of common sense and practicality. We are at a point in the market where certain companies - i.e. Facebook, Twitter, etc. - are able to raise money at astronomical valuations based on very forward looking multiples (in the case of Facebook) or highly differentiated strategic value (in the case of Twitter). Those kind of extremes do not apply to 99% of entrepreneurial companies.

When entrepreneurs think about the value of their company, they need to consider the business objectives of those who are buying in. For example, when raising a round of venture capital financing, the venture investors need to own enough of the company to be incented to spend their time, continue to invest capital as needed, etc. and the need to buy in at a price where there is reasonable upside potential for them. This is the practical governor that kicks in when entrepreneurs think about valuing their companies, even when things are going great and the valuation methods described above point to a big number.

In summary, companies are ultimately valued on the cash they generate. Start-ups are not yet at a point where that is a reasonable metric, so valuation is an art more than a science, and the key in understanding value is to assess the liklihood of how much cash can be generated, when it can be generated and for whom (i.e. for the current company, for another company that may acquire it someday and for its investors). Beauty is undoubtedly in the eyes of the beholder, and the best entrepreneurs know how to paint the most attractive picture, accenting both their financial and strategic highlights, all while keeping practical considerations in mind.