One of the often asked questions about raising money is how you arrive at a valuation. If you’ve got any business background at all, you’ll be looking for some way that you can justify a number. You’ll want to forecast future revenues and then take the Net Present Value of the future cash flows. Or you’ll at least want to try to find an appropriate earnings multiple to multiply your year 5 projected profits by. In reality, this is all entirely pointless. Your projections are a guess. There is way too much uncertainty in doing a start-up to be able to use any of these techniques. Any good angel or VC investor that you deal with will know this and won’t even waste their (or your) time trying. (And if they do try, it should send warning signals that they may not be right for you!)
So, how then do you think about valuing a brand new company. It comes down to the simplest of market economics. It’s what you’re willing to sell at and what they’re willing to buy at.

Nothing helps explain something like a real-life example. With our last company we did two rounds. For the first round, we put a stake in the ground and asked who was willing to invest. We said we thought that it was worth £750k and were looking to raise £100-150k to build a prototype. We had 6 investors say they were willing to invest on those terms. We had two others who’d invest if the price was £600k. We ended up lowering the valuation (for all investors) to maximise the amount raised and to get all 8 investors in. It was that simple.

The second round we did similarly except that we agreed the price with our lead investor (the first investor who agreed to invest in that round) up front. We said we would raise £400-£600k at a pre-money valuation* of £1.4M. Once we had agreed it with the lead investor we could go to other potential investors and put the deal to them. Eventually eight other angels came in and we sold 30% of the company for £600k. (Note: entrepreneurs often say “we gave away x% of the company for £y … investors tend to hate this. You are selling the x% for £y!)
Whilst there are no hard and fast rules in setting a valuation, there are some basic rules of thumb that are very useful to bear in mind.

Rules of Thumb

There are two rules of thumb worth taking note of.

1. You’re going to sell 30-40% of your company

In almost all cases you will end up selling 30-40% of your business in any given round of financing. The unsatisfying but real reason for this is it tends to feel fair to both sides. It leaves you with enough of an incentive to build the company but it leaves investors with enough of an upside potential to invest.

Exceptions to this rule of course exist. If there is significant demand from investors in your equity because things are looking really good, of course you can sell far less. If you can sell 2% of your company for $200M then all power to you. Or, if you’re still very early stage and want a significant chuck of money, you may end up selling more. (Although I would say if an investor is asking for more than 50% be wary – not because of majority rights – but because he or she may be trying to take advantage and they aren’t really illustrating that they want to form a positive long-term partnership with you.)

The other important point to raise about this rule of thumb is that you’ll likely end up selling 30-40% of your company irrrespsective of how much you’re looking to raise. Therefore, it is always worth trying to raise more. You will likely have under-estimated costs and over-estimated revenue and so take on as much cash as you can … especially if you’re going to sell the same amount anyway

2. “Make me a $50M company or don’t waste my time”

The second rule of thumb relates to Venture Capitalists (VCs). Typically, VCs want to see at least $50M of revenue in your year five projections. The main point here is that not that VCs will believe your projections and that you’re going to make $50M in year five but that they want to see ambition. They want to believe that you are going for a big exit. A $10M exit may be great for you but it’s small fry for them. They want to invest as much money as possible and they want to get as high a return on that as possible. If your company isn’t going to be that big then stick with angel investors.

In summary, valuing a company is all about working out what sounds reasonable and then suggesting it to people. As with all things, the better your company/idea is, the more competition you can get for your equity, and the less you’ll end up selling. Because of this, managing the financing process can be as important as what you’re selling.

* Terminology: pre- and post money

It’s important that you understand the terminology that people use to discuss valuations before going and talking to investors. It’s not complicated but you do need to understand the difference between pre- and post- money valuations and what that means for the % you’re selling. Pre-money refers to how you value the company as it is today. Post-money refers to what the value of the company value will be once you have added in the cash from the investors. Very simply, it is:

Pre-money valuation + cash invested from the current round of financing = Post-money valuation

When you talk to investors you normally give the pre-money valuation and tell the potential investors a range that you are looking to raise.
For instance, “we’re valuing the company at £3M and we’re looking to raise £1M to £2M.”

This means the post-money valuation will be £4M to £5M.

To work out how much the investors will get you divide the investment by the post-money valuation in this instance, it is between

£1M / £4M = 25%

And

£2M / £5M = 40%

In an Executive Summary or business plan you will normally write down how much you are willing to raise but not put a valuation. You should, however, have numbers in your head before you speak to people. If you have a lead investor in place, you may then think about including the agreed valuation in the documentation that you’re sending out.

 Flickr photo courtesy of eb78

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