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Business Valuations for Startups

There are a lot of common factors that go into valuation methods for startups, but it all comes down to management, the idea, the industry and the economy.

Global Influencer

Global Influencer
Global Influencer

I really enjoy the Dragon’s Den and Shark Tank for it entertainment value. Entertainment value? Certainly!

We’ve all seen the rube telling Shark Mark Cuban that he wants $500k for 5% of his dog collar company. Cuban says, “so your valuation is $10M” at this point O’Leary pipes in, “I hope you have lots of sales”. Sadly, the entrepreneur is in ‘pre-revenue’ with no sales and little more than a hope and prayer to get his deal.

The deal goes nowhere but both Sharks making the entrepreneur the fool entertained us while everyone agreed how sad it was that the pitcher was so unprepared.

These VC’s rattle off multiples and the entrepreneurs push for future projections and at the end of the day most viewers are amused but are left with an idea that there must be a mystical way to value start-ups only the elite know – Yes and no!

Why is the valuation so important? The valuation determines the percentage of ownership the investor gets for investing in the start-up. They want the number high and the entrepreneur wants to give away as little as possible.

Raising investment money from Angels or VC’s is a heck of a lot different than finding a buyer for an existing business. If you’re trying to sell a family business the determination of value is simple, it’s either a multiple of sales or profit using EBITDA (a company’s net earnings, before interest expenses, taxes, depreciation, and amortization are subtracted). Valuating start-ups is a whole different ball game.

There are numerous valuation methods but most like to compare the start-up to others in their industry and do a multiple of cash needed. There are a lot of common factors that go into each method but it all comes down to management, the idea, the industry and the economy.

I had the pleasure to introduce a cocky start-up founder to the Vancouver Angels group.He knew he needed $500,000 to finish his software development and while he had a Minimal Viable Product (the MVP) he didn’t want to give away the farm or anything more than 25% to an angel.

That is a bit of a risk because with no sales the 4x multiple would mean that the business is worth $2M. In our quest for an investor we used the Berkus Method, typically used of high tech start-ups, where you assign values (up to a max of $500k) for each portion of the business that is crucial to its success.

We had a very innovative idea, great management and advisors, multiple proprietary IP’s and a working software model (a MVP). We assigned $500k to each of those four primary factors and had our model in order to ask the angels for $500k. The presentation went well and at the end our assumptions were proven correct with four offers from different investors for our needed half million.

I loved Dave Berkus’ model because of its simplicity. The Bill Payne model or Pre-Money Valuation Method For Pre-Revenue Start-ups is much more robust and extensive. It’s also called the Scorecard method and assigned values are given to Berkus’ four factors plus other factors like comparability to others in the industry, size of the opportunity, competitive environment, scalability and what will the need for future money look like. The Sharks know all these but try to keep it simple using the Berkus method.

The Venture Capital method developed by a Harvard Business School professor is one that looks at the Terminal value of the opportunity in 4-7 years. It’s based on a post-money valuation plus expected ROI. VC’s like our shark buddies want between 10-30 times return on their money because they are shouldering all the risk.

The VC Method or, as it is also called, the First Chicago Method “is a business valuation approach used by venture capital and private equity investors that combines elements of both a multiples-based valuation and a discounted cash flow valuation approach.” Wikipedia

A start-up founder is sort of at the mercy of the investor in the end. The guy with the money usually calls the shots (ask my last partner). One can look at those twenty-minute scenes on TV when the deal is negotiated as we gasp in awe but typical negotiations go on for months. Don’t be fooled by the television, once the cameras stop rolling the due diligence, renegotiations and demands from both sides will make or break the investment just like in the real world.

At the end of the day securing an investor’s money, or not, comes down to a few soft details of the deal like:

  • The sophistication of the entrepreneur and the investor
  • The economy
  • The founder’s need
  • Timing
  • Is the start-up being courted by others?
  • The confidence levels of the parties

It’s unlikely that a start-up founder is going to be on the same level of sophistication as the investor so one would hope the founder has a couple of good advisors on his side.

The economy is always that foreboding essence that is the white elephant in the room but a bull or a bear market will certainly make things easy or tough.

If the founder has a really good MVP then the need for money factor may not be so valuable a consideration. The founder who walks in the meeting of investors with desperation etched in his brow will no doubt get a worse deal that if he has his act together.

Need is also knowing when to look for money. Timing can mean diluting your self to oblivion or having a successful investor/founder partnership.

I’ve been in meeting where the founder is arrogant to the point of obscene because everyone in the room knew he was being courted by other investors. A great position to be in but taking care not to incur hard feelings may result in investments down the road when other factors aren’t as rosy.

Confidence levels come with the culmination of the other factors being favorable or not to the founder. I have been fortunate to be involved in deals where mutual respect made the investor/founder partnership a positive experience for everyone. I can’t imagine working with a VC or other investors who took advantage of a founder making their work life miserable.

It comes down to a lot of advice for other aspects of a start-up that I give – know what you want, know who you want to work with have loyal advisors and have faith in yourself.

Gary is CEO of Bizzo Management Group Inc. in Vancouver. He has mentored over 1000 business leaders, investors and entrepreneurs. London-based Richtopia placed Bizzo on the Top 100 Global Influencers in the World for 2018.

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