How to do company valuation

Pre-money valuation is hard. It’s a total guess. And, if you’ve been paying attention to this blog lately, you probably know that I’ve been helping to create another company. This one has the most promise of any other I’ve built yet. Although I’m not going to reveal the details of the product/service quite yet (which is generally against my current business principles, but hey, I’ve got partners this time and some heavy logistics to work out), I do want to describe some of the things I’ve been learning along the way.

Now, I’ve founded companies in the past and sold them successfully. However, I’ve always used my own money to build them, which works out pretty well because you get to sell it however, whenever, and for whatever you think it’s worth.

When you start looking at pulling in outside investment, though, things change a bit. So, here’s the formula we worked with, for better or worse.

Side note: if you know anything about this arena and find fault in how we did things, feel free to say so. I’d love to learn more, and I know my readers would respect the info as well. Although I talked to some smart folks to come up with this, I don’t have it all figured out.

Here’s a few known variables regarding expected ROI:
1. VCs expect 5-10x their money within 3 years.
2. Angels expect 5x their money within 5 years.

We changed ours a bit because we’re bashful. We wanted our angel investor to get 5x in 3 years. So…

3. Our growth rate for revenue at year 3 is about 130% annually.
4. Let’s assume our angel wants 5% of our company.

  • Start with an exit year (we took year 3).
  • Take the expected revenue that year ($20M) and multiply it by what percentage ownership our angel wants (5%). $20m x 5% = $1m
  • Our angel expects a 5x return within these 3 years, so let’s back that out to today by: $1m / 5 = $200k.
  • That $200k is what we would expect they would invest today to get 5x their money in 3 years. So, the rest is pretty easy if they want to own 5% of the company. $200k / 5% = $4m.
  • So, today our company would be valued at $4 million.

Now, these numbers are pretty fictional. So, let’s just say we we didn’t want to estimate quite so high. We thought that was a bit presumptuous, just as a hunch. So, we recalculated the numbers based on profit instead of revenue. For our model, let’s just say that got us closer to a $1.2m valuation, which seems a bit closer to expectations.

Anyway, that’s how we did our pre-money valuation. If you’re doing anything else, then forget everything I just said and go listen to these guys chat about cap tables. They know what they’re talking about.

[tags]finance, money, corporate, valuation, company, pre-money, estimate, angel, vc, venture capital[/tags]

Nate Ritter lives in Austin, Texas (U.S.), popularized the #hashtag and creates web applications for a living. He also does miles and point hacking to enable cheap travel for his family. More here →

7 Comments on "How to do company valuation"

  1. nate says:

    Here’s another great write-up regarding Startup Funding by my friend Ben Yoskovitz. You should read it.

  2. John says:

    Just a couple of points:

    1) Angels invest earlier than VC’s and as such should expect a higher multiple than VC’s. Why would they want or except less ?

    2) As a startup, all revenue estimates are wishful thinking – particularly revenues that are 3 years away. Valuations are therefore wishful thinking and should not be relevant in any calculation. What I have found to be a more appropriate “valuation” can be calculated by looking at a) a Founders estimate of how much total investment is needed before break-even / exit and b) how much of the company the Founder would like at break-even/exit and how much the Founder is willing to let the Angel own (or the Angel demands to own) at break-even / exit. These figures will allow the Founder to work backwards to an appropriate ownership position for all parties at the time of the Angel investment (and thus a theoretical valuation.

    Note that my comments are really aimed at very early stage startups who have achieved very few milestones and are dealing with Angel investors.

  3. Dima says:

    As far as I know, VCs use much simpler formula. They figure out how much money will it take to get to the first meaningful milestone, know that founders will not work hard if more than 20-40% of the equity is taken in the first round, and calculate the “valuation” from these numbers.

  4. Nick says:

    You have confused Revenue with Valuation. In year three is the company worth $20M or has revenue of $20M. It is very strange they are identical.

    If you change $20M Revenue in year 3 to $20M Validation in year 3 then it is correct.

    The company is worth $4M now and five times more in three years $20M. However much they invest it is 5x growth. The question is still how do you go from year 3 revenue to year 3 value.

  5. nate says:

    John, I don’t believe the angels expect higher multiples on their money because they generally get a good deal in terms of the % of the company they get for the money they shell out. Other than that, I’m not so sure, but those are the numbers I’ve been told by multiple VCs and angels.

    Nick, as John said, valuation is a complete guess. Therefore, I can’t say with any certainty that the company will have a 2x or 3x multiple of revenue to equal a $40-60M valuation. So, I use revenue. Obviously valuation of a company which has been standing for a few years has a very different calculation for valuation. But this early, we based our valuation off a 1x multiple of revenue.

  6. Roz Lemieux says:

    Thank you! As a first-time investment seeker (not first time entrepreneur), this is the first article I’ve found written in plain English about valuation. Very, very helpful.

  7. Carlos says:

    1. Bill Payne has survey results of average pre-money valuations for every geographic region in the country. Silicon Valley is the highest.
    2. Dave McClure’s 5 “million dollar points”. Basically you get $1M valuation credit for having any of the following:

    1. Market
    2. Product
    3. Team
    4. Customers
    5. Revenue

    3. If you have Revenue, you can use your run rate, and some revenue multiple comparable to your industry, and stage. I wrote an answer giving the revenue multiples of venture backed companies here:

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