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Determining Business Valuations for Startups

How do investors value non-revenue generating companies with disruptive potential?

Global Influencer

Global Influencer
Global Influencer

I presented a business as an Investor Sponsor to the #Vantec Angel Investor Network group this week. Having known the CEO for some time the presentation was not a problem but when the team got together prior to the event we discussed the issues facing a startup when dealing with a group of dozens of angels in a room.

The management team in place was impeccable and strong. The idea and scalability of the business again was outstanding. The money sought was according to the Berkus theory of developmental valuations in line with the formula. The nagging thoughts were about the valuation of the startup.

The startup was creating a disruptive force in an existing market. This innovation would save B2B customers thousands of dollars in personnel wages and time that their unique proprietary algorithm could take seconds to complete.

The angel forum, however, prior to our presentation suggested that with the money requested as an investment the pitching company also needed to include a percentage of the company they were willing to give to investors. This was reasonable but didn’t seem right to us. Like most startups we were also not quite sure how to evaluate it as there were no sales.

The celebrity investors we see on TV’s Dragon’s Den give us the impression that an investment is based on a multiple of revenues, i.e. if you ask for $1MM for 20% return to investors then the company is worth $5MM and must have sales to reflect that amount.

This may seem legitimate if the business has been in revenue mode for a couple of years or more but doesn’t work for the startup that has gone through development, mainly with sweat equity, beta testing and employees who are also doing without salary in the true sense of bootstrapping in return for a payoff when the unicorn awakes.

So the conundrum at the Angel Forum was what was the valuation and what percentage were we willing to part with? Obviously, we wanted to part with as little as possible. We expressed the amount we needed, $500,000 and left the thought of an angel percentage in the air. The David Berkus model suggests that a great idea is worth $500k, a great management team is worth another $500k and a Minimal Viable Product (MVP) is worth another $500k. Hmmm, that gives us a developmental valuation of a company worth $1.5MM USD. Now we have a starting point!

So, if we are asking for $500k then an investor may expect a 30% investment in our company. However, there are other things to consider including the disruptive nature of the business, the intellectual property as part of the software, the market forces at work in the industry and a few other nuances that are at play to decide the real worth of the new startup. In our particular company we knew that the big market players were buying up ancillary businesses to keep them out of the market. Note to self: find an M&A company quickly!

While the Berkus’ model may seem logical to a startup and paved the way for a very reasonable valuation according to the angels present, a wise man told me “don’t play your cards to investors quite so fast, see what interest there is in the market and wait for an investor to make an offer.” Wow – it made so much sense!

The investor seizing the moment and the excitement of the opportunity may see potential and exploitative opportunities that we haven’t even perceived. The investor for whatever reason has found synergy in our dream and believes enough in it to invest. Let him/her make us an offer. Then we can negotiate.

There are several different methods of determining the valuation of a startup most of which are in favour of the investor. Now, it seems to me that investors typically make huge earnings from inventive startup founders and there really needs to be quid pro quo in negotiations of money for ownership.

A complicated formula that I like as much as the Berkus model is the Venture Capitalist model developed by Professor Bill Sahlman at Harvard Business School in 1987.Essentially it’s the estimated exit amount divided by the investor’s hopeful return on investment, let’s say 20X for a hi-tech company. Take that number and subtract the amount the company is seeking, now multiply by 70% to account for dilution and you have the valuation of the business pre-revenue. Both formulas, with my calculations for our scenario, amounted to nearly the same result – $1.5MM.

Valuations are only guesses and it always comes down to how badly the investor wants into the investment and how badly the company needs the money. They never are an indication of the real worth of the startup.

It’s funny because I told my young founders not to go into the meeting with big expectations. I told them that other opportunities would present themselves and that there was always another offer around the corner. I told them to be a bit arrogant without being standoffish and to have fun. They had fun; the presentation went off great and was well received. By the time I got back to my seat offers had begun to come our way. Wow!

It always comes down to three basic assumptions when seeking venture capital. You need three things; a great idea, good management and money. If you have two of the three you can find the third.

Now, what was our robust use of funds plan?

The saying that there is no such thing as a free lunch is very much true for Robinhood.