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A startup valuation is the process of estimating the value of a startup based on its tangible and intangible assets.

Common Startup Valuation Methods Explained

Ever wondered how Angels and Venture Capitalists evaluate the viability of a startup? How much do they invest? Or how do startup founders know the size of investments they qualify for? This is the world of startup valuations.

In this article, we will discuss the need and importance of valuation for startups and explore some common methods used in this process. Let’s start with the basics.

Startup Valuation

A promising startup is founded on a brilliant idea that aims to fill a gap in market needs. From its inception, a startup goes through several stages of growth and expansion towards realizing its true market potential. But no progress is possible without timely financial investments. Investments in turn cannot happen unless the startup is estimated for what it is worth based on its current status and future potential. Startup valuation methods thus are the foundation for attracting the much-needed funding for a startup.

What is a Startup valuation?

A startup valuation is the process of estimating the value of a startup based on its tangible and intangible assets. Analysts focus on its future growth potential as well. Investors and founders use various metrics to arrive at a near-exact estimation. But it is important to realize that a valuation for startups is a tricky process. A lot is based on projections and industry benchmark comparisons, especially in the case of startups in the pre-revenue stage.

A startup is a founder’s baby. Naturally, founders tend to overestimate their valuation and demand higher investments. While pitching to investors, one must note that a high valuation for startups must be complemented with a promising growth potential. As far as investors are concerned, they are looking for their next highest ROI. A high value startup without a realistic growth plan will fall short of their expectations. Plus, startup valuation figures must grow exponentially with every funding round. A high flying first round followed by a downsized funding round does not reflect well on a startup’s performance.

Why is it important to estimate the value of a startup?

Investments are the lifeline of every startup. Engaging any resource to enrich the company will come at a cost that a startup in its early stages is not equipped to bear. The next logical step is to approach investors for the required funds. An investor will fund a startup only if they see a scope of big profits in owning their equity. The Valuation of startups thus is the baseline used by investors to evaluate startup funding proposals.

Startup valuation methods vary with their stage of development. Different qualitative variables and statistical analytics are applied based on the position of a startup in its lifecycle. Before moving further into the nuances of startup valuation, let us look into the 4 basic stages of a startup and the extent of investment one can expect at each stage:

  • Stage I – This is the ‘seed’ stage when a startup is still an idea backed by a talented founding team all set to take it further. In some cases, they might have managed to create a prototype as well. But a seed-stage startup will not have assets and minimal or no revenue. They have just bootstrapped themselves into the market. A typical seed-stage investment is in the range of $250,000 – $2,000,000.
  • Stage II – Otherwise referred to as the ‘Round A’ or ‘Series A’, a startup by now definitely has a prototype and has generated some revenue in sales. With a Minimum Value Product (MVP) and some early adopters, investments at this stage are around $2,000,000 – $15,000,000.
  • Stage III – This stage is also known as the ‘Round B’ or ‘Series B’. By this stage, a startup has proved its business viability and aims to expand profits based on established business models. Investments backing stage III startups are in the range of $15,000,000 – $50,000,000.
  • Stage IV – Otherwise known as the ‘Series C’ round, a startup by now is generating multi-million dollars in revenue. A scale-up at this stage will either lead to an acquisition or IPO. Advanced metrics and valuation models are required at this stage to estimate the startup valuation.

As we see, startup valuation methods vary based on the stage of business development. Founders must strive to get it right from the start as every stage is a stepping stone to the next. Founders must be well equipped with suitable strategies to justify their company valuation before approaching investors. Apart from evaluating their own company, a keen understanding of competitors and industry benchmarks is also required to arrive at a justifiable valuation.

A realistic valuation of startups contributes to the transparency between investors and founders. Since startups by nature are a risky venture, investors have the right to know what they are getting into and founders must be valued for the business they are building.

Difference between startup valuation and mature business valuation

Valuation models for startups differ from those used for mature businesses simply because of their limitations with tangible data. Mature businesses are publicly listed and have considerable statistics supporting their operations, investments, reliable decision-making capacity, and revenues. Their performance reflects stability and makes it easy for investors to analyze their profit potential. The value of such companies can be easily estimated using the EBITDA formula that calculates the value based on the company’s earnings before interest, taxes, depreciation, and amortization.

EBITDA = Net profit + Interest + Taxes + Depreciation + Amortization

However, startup valuation methods for a pre-revenue company cannot involve just one linear formula. It demands a comprehensive judgment of several factors, most of which are determined by market forces. Let us take a look at some aspects that affect the valuation of a pre-revenue startup:

  • Traction – Since a startup does not have much to show in revenue, investors look for product adaptability. The more users, the better. Brownie points for lower cost of customer acquisitions. Needless to say, a dynamic cost-effective marketing strategy is important at this stage. Investors are more likely to fund if they are convinced about the startup’s growth potential on a limited budget. It simply indicates a higher ROI for the investor. Hence, a viable, scalable, cost-effective business idea increases the startup valuation.
  • Reliable founders – The startup founding team is the face of the company. The merit of the product/service aside, investors look for an experienced founding team with diverse skill sets equipped to holistically grow the company. For instance, a tech startup with a promising patent will need strong marketing inputs to create a brand out of it. Similarly, founders with prior entrepreneurial experiences are an asset. Thus valuation for startups will be higher if they have a skilled, committed, and experienced founding team.
  • Prototype – This is a game-changer. No matter how great a business idea is if the startup has managed to create a prototype with early adopters to show, their valuation increases considerably.
  • Industry needs – Startup marketplace is presently dominated by AI and tech industries. This is where the money is. Investors tend to value a startup higher if they are catering to a profitable industry. Similarly, the demand for the product/service also matters. If there are more providers of the same product and lesser investors, the market will be highly competitive resulting in a lower valuation of a startup in this sector.
  • Profit margins – Investors have a primary agenda – quick profits. Despite all the above four factors showing a high, unless the business as a whole promises a high-profit margin, the valuation of a startup will decrease.

Now that we have seen how the valuation of startups depends on its stage in the business lifecycle, in the next section we will discuss another aspect that is vital while evaluating any startup. Founders, and more importantly investors, have to be mindful of these criteria before deciding on their investments.

Pre-Money Valuation vs. Post-Money Valuation

Results from startup valuation methods sway investor decisions. An expert valuation indicates the investor’s equity percentage on funding a startup. In the initial stages, the returns will be small, but eventually when the startup goes public or is acquired, even the smallest equity percentage will fetch a massive return. For ease of calculations, startups are considered in two stages, pre-money and post-money.

What are the pre-money and post-money valuation of a startup?

Pre-money valuation is the value of a startup before the present round of funding, while the post-money valuation is the startup value after it will receive a fresh funding round. It is important to note that the post-money valuation shows an increased equity value of a startup, not its actual bank balance. The post-money valuation is comparatively easier to calculate as:

Post money valuation = Investment dollar amount /Percent investor receives

For example if the investment dollar amount is $2M and the investor’s demand is 10%, the post-money valuation for the startup will be $2M / 10% = $20M. However, the balance sheet will show an increase of $2M in cash.

Pre-money valuation = Post money valuation – Investment dollar amount

In continuation to the example above, the pre-money valuation in this case will be $20M – $2M = $18M

Further, to understand the per-share value at pre-money valuation:

Per-share value = Pre-money valuation / Total outstanding shares

As we see, apart from factors such as competitors, industry benchmarks, and scalability, investors will consider the pre-money and post-money valuation metrics as an important component of their various startup valuation methods discussed in brief in the next section.

Common Startup Valuation Methods

Despite several qualitative indicators, unless the startup reaches a mature stage in business, there is not much data available to base calculations on. Especially for a startup in the pre-revenue stage, a lot of it is estimated projections. However, here are some common startup valuation methods that come handy at different stages in the lifecycle of a startup.

Venture Capital Method

This is one of the methods to arrive at the pre-money valuation of a pre-revenue startup. In this startup valuation method, first the terminal value is estimated. Terminal value is the expected value of the startup during the harvest year, the year when the investor plans to exit. From this point, the pre-money valuation is calculated using the following formula:

Post money-valuation = Terminal value / Anticipated ROI

ROI = Terminal value / Post-money-valuation

Where Pre-money valuation = Post-money valuation – Investment

Scorecard Valuation Method

Otherwise known as the Bill Payne valuation method, this is a common valuation model for startups used by Angel investors for pre-revenue startups. The idea is to find the average valuation of all pre-revenue startups in the target company’s market and compare it to the pre-revenue valuation score of the target company.

Here is the scorecard with its corresponding value:

  • Management team 0 – 30%
  • Size of the opportunity 0 – 25%
  • Product/Technology 0 – 15%
  • Competitive environment 0 – 10%
  • Marketing/Sales channels/ Partnerships 0 – 10%
  • Need for additional investment 0 – 5%
  • Others 0 – 5%

For example, if the target company’s score is x, the assigned factor for

  • The management team will be 0.3*x.
  • Size of opportunity will be 0.25*x

…and so on. The total score of the target company is the total of all the 7 factors. Finally, this value is compared with the average pre-money valuation of all pre-revenue companies in the target company’s industry.

Comparables Method

This is quite a simple and straightforward startup valuation method. It involves choosing a reference metric from a similar company in the market and comparing the target company’s value with it. For example, if a competing business is valued at $2,000,000 and they have 100,000 early adopters of their prototype, this means that each prototype is valued at $20. Investors will use this as a benchmark to value the target company.

Risk Factor Summation Method

This valuation model for startups aims at risk assessment of the target pre-revenue startup. It is similar to the scorecard method and uses the following 12 elements to evaluate its risk status:

  • Management
  • Stage of business
  • Funding/capital risk
  • Manufacturing risk
  • Technology risk
  • Sales and Marketing risk
  • Competition risk
  • Legislation/political risk
  • Litigation risk
  • International risk
  • Reputation risk
  • Potential lucrative exit

The following values are assigned to each of these elements

  • -2 ………….Very negative
  • -1…………..Negative for scaling the startup and carrying out a successful exit
  • 0 ……………Neutral
  • +1………….Positive for scaling the startup and carrying out a successful exit
  • +2………….Very positive

The pre-revenue startup valuation will increase

  • By $250,000 for every +1
  • By $500,000 for every +2

And the pre-revenue valuation will decrease

  • By $250,000 for every -1
  • By $500,000 for every -2

Cost-to-Duplicate Method

This startup valuation method as the name suggests is based on the idea that a company is worth only as much as it takes to duplicate it. This valuation tool considers only the tangible assets of a startup at the time of the valuation and estimates how much it would cost to replicate all of it.

The problem with this method is its myopic view of the startup’s real potential. It does not consider the intangible assets of a pre-revenue startup such as its brand, hotness of the industry, or its future market potential. Hence this method is only used as a lowball estimate of the business.

Discounted Cash Flow Method

This method of valuation for startups estimates the future cash flow of a pre-revenue startup. Based on this, the investor’s ROI is calculated. Furthermore, financial analysts apply high discount rates to neutralize the risk factors based on their assumptions about the business and emerging market trends. This is not a very reliable method as a lot of the projections are based on assumptions.

Valuation by Stage Method

This method addresses the basics of how startup valuation works. It is based on the business stage of the startup and provides a range of possible investments at each stage. Further along a company is in its lifecycle, the more stable it is, the lesser the risk of investments. Here is a brief of possible investments based on the company stage:

  • Company value estimated – $250,000 – $500,000
  • Promising business plan – $500,000 – $1M
  • A promising business plan backed by a strong management team – $1M – $2M
  • Has a prototype/viable technology/final product – $2M – $5M
  • Has built strategic partners and built a strong customer base – $5M and above.

The Book Value Method

Otherwise known as the asset-based valuation method, this valuation model for startups considers only tangible assets of the company, similar to the cost-to-duplicate method. Since such valuations use statistics of the startup’s current status, it is mostly used to evaluate startups going out of business.

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HOW DOES EBITDA AND REVENUE AFFECT YOUR STARTUP?

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When a startup starts making revenue, it is unable to keep all its earnings. There are several expenses that a company has to pay to keep operating. When these costs are deducted from the revenue earned, the cash left is divided among the business shareholders.

The income statement is a testament to a company’s income and expenses spent in a specific period. The top of the financial statement states the revenue generated by the company, and the net earning is listed at the bottom. So, the income statement is crucial to understand the difference between EBITDA and the revenue of a firm. Each line of an income statement represents the money the startup has earned at two different stages.

EBITDA vs. Revenue

The difference between EBITDA and the revenue of a startup is essential for varying purposes. While the former is a metric of a company’s profitability that can be used to measure the efficiency of a firm, the latter is the sole representative of the company’s income in the first place.

While the general public pays a great deal of attention to a company’s income, the analysts, business owners, investors, managers, and moneylenders pay close attention to the metric EBITDA. The metric helps determine how cash flow is generated from the company operations, which, in turn, helps them understand the financial health and investment potential that the company has.

What is Revenue?

A startup’s revenue is the total money it generates from its business operations without deducting any expenses associated with those sales. It is the pure amount of money that the company generates.

As revenue is the primary income coming into a firm by selling its products and/or services, no expenses are deducted from it. Hence, it can be seen sitting at the very top of every income statement of a firm.

There are different sources from which a company can earn its income:

  • Products sale
  • Rent
  • Charge of services
  • Commissions, etc.

Other sources include dividends on company-owned securities and interest earned on the money the company has loaned. Thus, any money earned by a company qualifies as its interest, usually reported 1 or 3 times a year.

To sum it up, revenue is the business generated by the company (accrued income and cash) before expenses are brought into the picture within a specific accounting period. The other terms used to denote revenue are income and gross sales.

Who uses revenue calculation?

Revenue calculation is mainly used by personnel like Chief Financial Officer, Sales Manager, and Chief Revenue Manager. Besides, the general public finds it easier to measure a company’s revenue as a scale than the EBITDA metric.

Formula and example of revenue calculation

The income of a company can be calculated with the help of the following formulae:

Income = Total no. of consumers * Average price of company services or products

OR

Income = Total no. of units sold * Average price of company services or products.

For example, if a customer signs a one-time annual deal with a company for $24,000, then the monthly income will be $2,000, and the yearly income for that year will be $24,000.

What is EBITDA?

It may seem like a technical or unfamiliar term, but like income, it is a metric to measure a company’s earning power, i.e., its profitability. It stands for ‘Earnings Before Interest, Taxes, Depreciation, and Amortization.’

It is a tool more nuanced than revenue to understand a firm’s ability to generate cash flow from its operations by adding back the expenses indirectly tied to the company operations to its net income.

Company costs like depreciation and amortization are added back to the revenue as they are non-cash expenses. They are recognized as expenses on an income statement of a company, but they do not need to be laid down as actual money.

On the other hand, taxes and interests require cash payments but come under non-operating expenses that remain unaffected by the company’s primary activities. These, too, are added back to the metric.

Who uses EBITDA?

This metric is commonly used for analyzing a business’ performance. Hence, it is mainly used by experts like financial analysts, chief financial officers, accountants, business owners, and investors.

Why do companies use EBITDA?

Companies, as well as analysts, investors, and accountants, prefer the metric over other tools because it solely measures a firm’s operational profitability. The costs that are deducted from income to evaluate it are linked directly to the firm’s operations. These costs include rent, salaries, research, and marketing costs borne by the firm. Thus, EBITDA primarily indicates a firm’s operational efficiency and financial strength.

So, financial analysts and investors use the Earnings Before Interest, Taxes, Depreciation, and Amortization metric to compare the operational health of companies with varying capital structures.

Drawbacks of EBITDA

The metric does not qualify for the standard metric of financial performance called GAAP, an acronym for Generally Accepted Accounting Principles. Due to its non-GAAP measurability, the calculation can widely vary from one firm to another.

In the preference of EBITDA vs. revenue, it is often not uncommon to notice firms emphasize the former over the latter. The former is more flexible and has the ability to distract financial experts from crucial problematic areas in the account statements of companies.

Moreover, investors have to keep an eye on companies when they start reporting EBITDA more distinctively than they ever did. Such practices can essentially signal a red flag to investors as there can be instances of firms borrowing money heavily or undergoing rising development and capital costs. In such cases, Earnings Before Interest, Taxes, Depreciation, and Amortization can mislead investors in assessing a company’s actual financial performance.

  • Ignores Costs of Assets

EBITDA is not the representation of cash earnings or the cost of assets. One primary limitation is the assumption that a company’s profitability directly affects sales and operations. It does not acknowledge the contribution and the importance of assets and financing in the upkeep of a company.

  • Ignores Working Capital

The metric also does not include the cash required to maintain company inventory and to replenish working capital. For instance, in the case of a tech company, the EBITDA calculation does not take into account the expenses related to current software development or the development of the upcoming products.

  • Varying Starting Points

While the metric calculation might appear simple enough, various companies use different earnings amounts at the start of the metric analysis. It is prone to produce changing values on the financial statements. Even if we consider the anomalies in the calculation that result from taxation, interest, amortization, and depreciation, the earnings figures are still not reliable.

  • Obscures Company Valuation

The worst of all its drawbacks is there’s a possibility of distorting the company image. Through EBITDA, companies may appear less expensive than they are. If stock price multiples of the metric are taken into account, rather than bottom-line earnings, they result in lower multiples.

Formula and example of EBITDA

EBITDA is a valued tool that determines the capability of a business to generate cash flow from its operations. Thus through the metric, the company’s performance can be measured.

EBITDA = (Revenue — Expenses) + Amortization + Depreciation

It measures the actual business earnings before operating expense deductions and accounting.

More than one working formula can be used to deduce a company’s Earnings Before Interest, Taxes, Depreciation, and Amortization. Another famous formula that is used starts with the net income at the bottom of the income statement. The metric then adds back to its figures the tax, interest, amortization, and depreciation entries. So, the formula stands to be:

EBITDA = Income + Interest + Taxes + Amortization + Depreciation

For instance, if the net income of a firm X is $200,00 and owed $30,000 for taxes, $10,000 for interest, $5,000 for amortization, and $7500 for depreciation, then the figures would be:

EBITDA = $200,000 + $10,000 + $30,000 + $5000 + $7500

= $250,000

The EBITDA value of company X for a specified time would be $250,000.

Difference between Revenue and EBITDA in startup valuation

Even though cash is the lifeline of any business, revenue is more significant as it generates cash flow in businesses. But revenue and cash are not the same. One major distinction is that a firm’s revenue is the amount accrued, whereas the reported cash is that the amount received.

So, when a company makes a sale, it gets added to revenue, even without the customer paying. As revenue is at the top of an income statement, its fluctuation might influence a company’s net income.

Business owners and accountants use EBITDA values to compare their business standings to that of similar firms. Besides performance assessment, it is beneficial for analyzing capital-intensive companies as they can take large debts to sustain themselves.

Furthermore, moneylenders and business investors prefer EBITDA over revenue for startup valuation. The former can be less manipulated with financial and accounting methods. Besides, it helps reveal the financial status and cuts away the factors business managers and owners exercise discretion on.

So, to answer the vital question of why companies use EBITDA instead of revenue, the former is more successful in producing cash flow figures. It is calculated by investors and lenders to foretell how well a business will operate by paying its expenses and maintaining or boosting its net income. Through the metric, a company can be evaluated before it makes a sale.

EBITDA and Revenue

In the discussion of EBITDA vs. revenue, financial analysts put significance over both parameters. Revenue is the net money a company generates, whereas EBITDA is the figure at the bottom of a company’s financial statement. More specifically, the metric shows the total figure with income and expenses — subject to the owner’s discretion — depicting a company’s ability to generate cash.

As EBITDA does not qualify under GAAP, it might not be available in most finance statements of a company. But if it’s included in an income statement, it would appear way below the revenue item line.

Simply put, the primary difference between EBITDA and revenue of a company will be that the former figure will always appear lower than the latter in an income statement as operating costs like Cost of Goods Sold (COGS), General and Administrative Expense (G&A), etc. are deducted from revenue.

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WHAT DOES COMPANY VALUATION MEAN?

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This guide provides the concept of company valuation, the methods of valuation, and also the benefits of company valuation.

Whenever there is a discussion about funding a company or an entrepreneur and company financing, it always turns into a topic of company valuation. Figuring out the worth of your company is almost like determining the value of a child. Though it is not exactly the same, a company can be seen as a child in the eyes of an entrepreneur, something that needs constant nurturing and care to grow.

INTRODUCTION

In case you haven’t had your company’s valuation assessed over the last 12 months, it is vital that you have it done. A company’s valuation offers the owner with the actual facts and figures that show the value of a business in terms of its income, assets, and market competition.

This is the information that every company should have with them, and they should check it annually to see the growth of the company from year to year.

Not sure why this is something important? Well, that is what this article is all about, letting you know the ins and outs of the company valuation process.

WHAT IS A COMPANY VALUATION & WHY IS IT IMPORTANT?

Company valuation is a process where the economic value of a company is determined. With the help of the valuation, you would be able to determine the fair value of a company. These include determining the sales value, establishing partner ownership and also closing deals. The owner of a company usually visits professional business valuators for getting an objective estimate of the business’ value.

There are numerous reasons as to why a company valuation is needed, but one of the leading reasons is when a business wants to sell a portion or all of its operations. Another reason is when a company wants to acquire a company or merge with another company. The process of finding the value of a business involves evaluating all aspects of the business and using objective measures.

The methods of valuation can vary among industries, businesses, and valuators. But some of the most common methods of valuation include similar company comparisons, discounting cash flow models and the review of financial statements.

To understand briefly about the various methods of valuation, the following terms should be kept in mind:

LIQUIDATION VALUE

This is the overall money that the business gets if the assets of the business were liquidated and the debts were paid off. This is also a method for the company valuation that is considered by some companies.

BOOK VALUE

As shown on the balance sheet, the book value of the company is the value of the shareholders’ equity in the business. This value is calculated by subtracting the cumulative liabilities of the business from the total assets that it has.

DISCOUNTED CASH FLOW (DCF) METHOD

This method of valuation is based on the predictions of future cash flows of the company. These are then adjusted in a way that helps to determine the current market value of the company. The main focus of this method is that it also takes inflation into consideration when calculating the present value of the company.

EARNINGS MULTIPLIER

The earnings multiplier is a method of valuation that can be utilized to obtain an accurate image of the value of a business. This is because the profits of a company are a much more reliable indicator of its financial success as compared to the sales revenue of the company. This method of valuation adjusts the future profits against the cash flow that has the potential to be invested at the prevailing interest rate over time. In short, the current P/E ratio is adjusted for accounting the current interest rates.

TIMES REVENUE METHOD

This is one of the methods of valuation where the stream of revenues produced by the business over a specified period is applied to a multiplier. This multiplier is based on the economic and industry environment. For example, a tech company may have a value of three times the total revenue. On the other hand, a service firm might only be valued at 0.5 times the total revenue.

MARKET CAPITALIZATION

Out of all the methods of valuation, this is the simplest method for company valuation. The process is simple, by multiplying the share price of the company by the total number of outstanding shares. Let us say for instance that Microsoft Inc. traded at $86.35 on January 3, 2018. And with a total of outstanding shares of 7.715 billion, the company’s value would be $ 86.35 x 7.715 billion = $ 666.19 billion. Even though these are some of the common methods of valuation, the list of the valuation methods used today is endless. Some other methods include the asset-based valuation, breakeven value, replacement value, and many more.

Moving ahead, company valuation is also essential for tax reporting. As per the IRS (Internal Revenue Service), the company has to be valued based on its actual and fair market value.

REASONS FOR COMPANY VALUATION

Are you aware of how much your business is worth at any given moment? This is a valid question for your company and one that shouldn’t be answered with a “ballpark” guess. Obtaining an accurate company valuation is a very crucial aspect of an ongoing business strategy, and should be kept up to date with monthly accounting and annual valuations.

Below shared are some of the main reasons why there is a need for company valuation.

COMPANY VALUATION TO SEEK INVESTORS OR ADDITIONAL CAPITAL

For different stages of a business, there is always a different type of investor for it. For instance, if you are at the startup stage, you may need a startup angel investor. In the initial stages, you cannot show patented equipment or technology that has a quantifiable or logical value, nor can you show a historical P&L. So, the company valuation here is based entirely on the founder’s vision for the company, along with the value of that market category or segment of the offering, the assessment of the market need, etc.

These kinds of angels who lead in the earlier stages usually demand a percentage of the company that they want in exchange for the funding they are offering. They would create a terms sheet that would permit you to earn or purchase all the equity back based on their terms.

In case you are a mature business and you are entering the next stage of the funding cycle, the tangible parts of the business like the profitability trending, sales reports, market sizings, audits, financial instruments, and more will likely be used for the company valuation. At this point, the investor is more interested in making sure that the business, its value or the cash flow would be the best collateral against their investment (mostly when the owner is not going to change any time soon.)

Many of the investors, like the banks, have a list of items that you would need you and your CPA to review that would show the financial health of the company and its estimated company valuation. Ensure that you know all about these documents, and remove any abnormalities in your financials before investors ask to see these documents. A CPA can normally help you with this process.

COMPANY VALUATION TO BRING IN PARTNERS OR TO SHARE EQUITY

Doing deals is another place where the shareholders of a company have a subjective and emotional view of value. And the very first step is to determine the company value through the right methods of valuation. After that, it is essential to decide on how the shares would change the game – earning shares instead of salary, additional investment, and others is an entirely different venture.

This logic becomes complicated in a service business since there are less fixed assets and the value of the enterprise is subjective. Hence, for the valuation, you would need experienced consultants in the specific business type or sector and who have relatable business examples to help them figure out the company’s value. Moreover, if you want to hire a CPA, it is better to hire the larger CPA firms that have a separate department just for this work.

Mostly, shareholders tend to have agreements done to avoid the discussions that are uncomfortable. But after the value has been reached, it is the right time to have more heated discussions about negotiations before the deal is made with independent people representing the shareholders.

With this, everyone would be able to start the new partnership without anything left out, and with the appropriate considerations. This would also help them to grow the value of the company collectively, rather than to just argue about the details of the equity exchange.

COMPANY VALUATION FOR A SALE

At the moment a company is about to be sold, there is a different group of experts who are needed for the company valuation. And of course, you would need all the financial documents, ideally those have been audited by the experts for your company. Moreover, the advisors for small companies could be consultants or brokers that are proficient in your sector. But if you have a big company, you would need investment bankers to help you in your deal.

These investment bankers usually have their own methods of valuation, protocols, formulas and would pitch you regarding their plan to assist you with a sale. This plan would also include their rough estimate to determine the valuation. As a matter of fact, it is crucial to have advisors who can assist you with both the investment value and the fair market value of your company.

The Fair Market Value sale would have the ‘multiples’ on your profit and revenue or comparables of other similar companies sold. Moreover, your cash, assets and other objective figures would be calculated as well. In the area of investment, the value of the business is observed in association with the considered value or gain of the buyer from the acquisition.

Let us understand this better with an example. A company has the fair market value of $50 million. This company got a strategic buyer who benefited by removing several deals and a key competitor that stood between them, adding key accounts the business had, and assisted them in adding geographic coverage where they had no footprint. After all this, the company had an investment value of about $80 million. With this example, hopefully, you might have understood the difference in investment value and fair market value.

BENEFITS OF HAVING A COMPANY VALUATION

Other than the reasons why you need a company valuation, there are many benefits that come with it. Here are the five main benefits of company valuation:

ACCESS TO MORE INVESTORS

When your company has been in the market for at least a year and you still need investment for it, the investors you reach out to would ask for a complete company valuation report. It does not matter if you need the investment for the growth of the company or if you want it for overcoming a financial disaster, you need the company valuation for the investments you are looking for.

The investors would want to understand why you need the amount and how exactly they would gain it back. Their return would be figured out only when they know the actual value of the company. In short, the investors focus more on how they would get a return from the investment they are offering as well as where their investment is going.

So, if you have the company valuation ready and it has reached the ears of an investor, it would help you get a lot of attention and open deals by a potential investor who feels that the funds would help increase the value of the company more than it is. In short, it is a benefit to always have an updated company value under your sleeve.

BETTER DURING MERGERS/ACQUISITIONS

In case a corporation asks that they want to buy your company, and you agree to sell it, you would need to show the person the company valuation that you had conducted recently for knowing the actual worth of the business.

Other than this, it is also important to show them how much the company has grown since it began, how many assets withholdings there are, and how the company would continue to grow along with the actual market value of the company from the starting years till now.

The reason it is essential for you to get the actual value is that many large corporations usually try to get other businesses or merge with other companies with as little money as possible. When you know what the company valuation is, you would be able to negotiate your way to get the actual worth in any selling or merging agreement.

After you learn about the value of the company, and if you are offered with a value that is less than what your company’s worth is, reject the deal or you can volunteer to enter a negotiation agreement. This would eventually assist both the sides to come towards a comfortable arrangement.

GET A TRUE COMPANY VALUE

You might already have a slight idea of what the worth of your business is from the financial figures like the company bank account balances, total asset value, and even the stock market value. But this is not all that is used for the calculation of the company valuation. There is a lot more to it. Hence, it is important to have a professional valuator for getting the company valuation done.

To have your company’s actual value is genuinely one of the benefits of company valuation since it would help you decide if you should sell your business or how much you should sell your business for. It would also help you see the company income and the valuation growth over the course of the previous years. Potential investors, as well as buyers, usually look for these things in a company before a deal is stricken.

BETTER KNOWLEDGE OF COMPANY ASSETS

It is important to get the actual value of the business since estimates are not only considered. There are a lot of benefits of company valuation, some of which include that the owner can easily get proper business insurance coverage, how much to sell the company for, and how long it might take to grow to an estimated value.

In the end, the company valuation would help the company produce profits and easily make the successful and right deals in the market.

WHY SHOULD EVERY COMPANY HAVE A VALUATION?

Still now convinced that you need a company valuation done with any of the methods of valuation?

Well, here is a checklist of reasons why it is better to know the value of your business.

IF YOU DON’T GET THE COMPANY VALUATION DONE, SOMEONE ELSE WOULD.

Yes, that is right! And even though it seems like a relief that you would not have to waste your time on it, it may be a bad thing in the end. If you are looking for a loan from the bank or any investor, they have their own methods of valuation that they work on. They may conduct a valuation process and get the value of your business, but if you indulge to cross-check with it, you would not have any valuation done to check their numbers. And that is why it is important that you have it done yourself.

In the same way, if you want to leave or sell your business, the IRS would end up getting the company valuation done. And since the IRS takes taxes from a company’s revenue, their valuation would be higher than what you might get or otherwise.

YOU CAN QUESTION A POTENTIAL BUYER’S VALUATION.

Again, the company valuation that you have done would have a different value as compared to an investor that is joining the company. Even though we expect the investor to come in with a lower value, it is not that simple. The reason why buyers or investors come with a lower value is since they believe that it would attract the seller to them during the due diligence period.

Or, it might also be provided in an expectation that a little of the company valuation would be recovered via the earn-out provisions in the agreement. All this might seem to be a bit cheap, but the best way of having a grip on the investors or buyer is by knowing the actual value of your company.

YOUR RETIREMENT DEPENDS ON IT.

If you haven’t come across this point till now, it is important to know as well. Every business owner should have a retirement plan since you aren’t going to work forever. And if your business is your retirement plan and you have not done the company valuation, it is difficult to figure out the true value left over for your retirement.

Let us take for instance that you would hand over your company to someone else, and expect a return every month. Or you want to sell off your company at retirement. And in this case, your final value of the company is $3 million, but you only get it at $2 million. You may end up sacrificing your happiness and financial health due to poor negligence.

IT’S USEFUL IN KEY PERSON PLANNING.

Let us say that you have an important person who you want to share your success with. But this person is not a successor owner, and you still want to share some financial incentives with this person. With the help of the sales, profits and other annual measures of the business, you would get the actual growth of the company, and this would help you have the right idea about the future.

In case you get a company valuation done, you would have a baseline value to utilize in prolonged compensation arrangements, like stock appreciation rights (SAR) and phantom stock plans. In short, there is no possible way to measure the growth of your business if you do not know where you are starting.

YOU MAY GET CHALLENGED IN COURT.

Sadly, a lot of businesses have been caught off guard when a company valuation issue reaches the court. There was a case where the family business went all the way to the supreme court since the family objected over the correct valuation to buy out a sibling.

On the other hand, there was a case where a business owner had used a book value to buy out the other family members. The IRS ignored each of the valuations and utilized an earnings-based, higher company valuation. Like these, there are many cases in the court where the IRS end up securing a multi-million dollar penalty from many of them. Hence, you lose everything you worked so hard for.

CONCLUSION

As soon as your company valuation is completed, it would be easier for you to set new goals to increase your company’s value in the coming years. Until now you might have understood that it is important to set some time aside to compare the previous year’s company valuation to this years’ to see where you have improved and how you can do this more in the future.

There are many methods of valuation, but the three main types of valuations used would be discussed in the next article. It would be good if you took the advantage of getting the company valuation done on time so that you do not have to suffer what you worked for due to negligence. In short, knowing what every element of your company is worth is priceless information for every business owner to have.

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INTRODUCTION TO COMPANY FUNDING

Getting a small business loan or pitching to an investor to fund your new business may seem like a remarkable feat for new entrepreneurs.

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Getting a small business loan or pitching to an investor to fund your new business may seem like a remarkable feat for new entrepreneurs. While they are often essential to get your startup off the ground, it can become overwhelming with the number of options, minute details, terms, interests payments, bills, and the possible rejection due to a bad presentation of your business plan.

Nonetheless, financing does not always have to be that complex. Before you begin to move down the road, it is crucial to know where you are going and what you are getting into. And this guide helps you with just that!

INTRODUCTION

Every startup company often spends a lot of cash on purchasing equipment, hiring staff and even renting an office before they can work smoothly in their business. Other than this, startup companies need to adapt and grow to beat the competition in the market. And in most cases, these companies would require company funding for it.

For every entrepreneur who has just started their journey and is trying to understand the world of startup financing, they should be aware of the roles of the different types of investors and how they see new startup companies. At first, these new entrepreneurs may not see the full picture of a company’s life cycle and when investors enter to provide company funding.

And it is termed as “seed” since it is the initial company funding for the business, until the company has the ability to get cash on its own, or until the company is ready to obtain more investments.

Seed capital comes in various forms like family and friend funding, crowdfunding, and angel investor funding. This brief guide is a summary for what any startup founders need to know about seed funding and seeing their company grow.

WHAT IS COMPANY FUNDING?

Company funding is the money that investors offer to a company. In general, there are two types of financing that a company obtains; equity (stock) and debt (bonds/loans). And when a company receives it, they then use this cash for the operating capital. With this funding, shareholders and bondholders expect to earn returns from what they invested in the company in the form of stock appreciation, dividends, and interest. The growth and amount of revenue the company can gain will determine which type of company funding will be the best in the end.

Confused? Let us get a bit more into the details.

COMPANY FUNDING EXPLAINED IN DETAIL

Obtaining fixed assets or capital like the machinery, building, and land requires a large amount of capital upfront, so most companies usually raise funding for purchasing these assets. In short, the two primary routes to receive this company funding are:

  • Raising capital through debt; or/and
  • Raising capital through stock issuance.

To explain the idea better, normally a company is able to issue common stock by issuing extra shares to additional investors or via an initial public offering (IPO), in the case of bigger firms. In both cases, the cash obtained from investors is utilized to fund capital initiatives. So for offering company funding, investors usually expect a return on what they invested (ROI). This is called the cost of equity for the business.

The ROI can be offered to investors by expertly handling the resources of the company to increase the worth of the shares or by just paying dividends. However there is a drawback to this source to raise funding, as issuing these extra shares reduces the holdings of the current shareholders as well. In short, these shareholders would have less voting rights and ownership of the company.

The other way to raise funding is by issuing corporate bonds to investors. As soon as the bond is issued, they get in effect the amount that is borrowed from the investors as semi-annual coupon payments until the bond is completely paid off.

The coupon rate that is applied to the bond outlines the cost of the debt for the issuing business. Along with this, bond investors have the chance to buy a bond at a discount, while the actual value of the bond would be compensated when it matures. For instance, an investor who buys a bond for $1,500 would get a payment of $2,000 when the bond matures. This difference in amount is how debt investors earn money on their investment, which will be paid off by the company once it starts to grow

OTHER OPTIONS FOR COMPANY FUNDING

The methods mentioned are not the only method available. You can also raise funding via debt by taking loans from commercial lending institutions or banks. These types of loan are considered as long-term liabilities on the balance sheet of the company and this debt decreases as the loan is paid off over time.

You would also need to pay the interest on the loan as the cost of taking the loan from the bank. However, as the interest the company needs to pay to the lender is deemed as an expense for the company, the tax on the company profits would be reduced as well.

Even though a company is not required to give any payment to the shareholders, it has to pay all the coupon and interest payment to its lenders and bondholders. And this is one reason why raising funding via debt is much more expensive when compared to obtaining company funding via equity. Nonetheless, if the company goes bankrupt and the assets are liquidated, the creditors would be given the payment first before the shareholders are paid.

There are many companies that offer company funding to businesses, such as venture capitalists. However, these companies usually focus on a specific industry like the healthcare industry or tech companies, and also focus on funding a particular stage of the business, like the startup stage of a company.

WHY IS THIS IMPORTANT FOR YOUR COMPANY?

Most startups that come into the market need funding, and if there weren’t any method to raise funding for these companies, they would fail soon after starting. The amount of money needed for a company to be successful is more than what the founders, their family, and their friends usually can finance.

It is common for high growth companies to burn capital to sustain their growth before they get to a profitable level. And yes, there are some companies that fortunately self-fund (bootstrap) themselves, but these companies are exceptional ones.

Due to this, most startups make every effort to raise funding. The good news is that many investors are sitting out there hoping to invest in the right startup.

But there is huge competition to raise funding where the process is usually highly deflating, complex, arduous, and long. Nonetheless, this is a path that each company has to follow at least once. But when is the right time to raise funding for your business?

WHEN TO RAISE FUNDING FOR YOUR COMPANY?

Investors usually write checks when they believe in your company’s idea and find it compelling. They are persuaded that the founders and the team can realize their vision and if they feel that the probability of the plan has high potential, they will put their money in the idea. So, when you are ready to tell this story, you can raise funding at exactly the right time.

Though it is easy for almost every founder to have a reputation and a story, they would also need to have the product, idea and a little amount of customer traction. Fortunately, technology has enhanced considerably, where a mobile app or a sophisticated web product can be developed in a short amount of time and at a low cost.

That is not all. Everything has become easier due to technology and investors providing the company funding need to be persuaded. Normally they are not only looking for a simple product that can be seen, used or touched. You would also have to let them know what makes the product great for the market and what is the actual growth of the product for the future.

In short, it is better for the founders to raise funding when a product matches the market’s needs and has the potential for wide use due to the high market opportunity. Along with this, they would also have to determine who the customers are. So, to obtain the company funding, the founders have to have a project that impresses investors.

HOW MUCH FUNDS TO RAISE?

Preferably, it is better for you to raise the money for covering all the startup costs, match your breakeven level and reach the profitability, so that there wouldn’t be any need to raise funding until the company is running and making a profit. In case you succeed in this, you would find it easy to raise company funding in the future as you have proven you have a good idea and a company to support it.

With all this said, some startup companies would need a follow-up seed funding. Their main objective needs to be to raise funding that is needed until their next “fundable” milestone. This milestone comes typically after 12 to 18 months.

Also, you need to know that the amount of funding that you choose to raise would also determine what variables you are trading off, like the progress that the amount of money would bring, dilution, and credibility with investors. In case you succeed to give up just 10% of your company during the initial round (seed round), it would be great. But most of the rounds frequently require a 20% dilution, and it is advised to avoid a dilution of more than 25%.

It is recommended to create several plans with different amounts of company funding raised. This is so that if you raise a lesser or higher amount, you would have everything necessary to run the company. The only difference would be the time that the company takes to grow with the company funding obtained.

BETTER EXPLAINED WITH AN EXAMPLE

One of the best ways to get the optimal amount in your seed round is to decide how many months of the company’s operation you would want to fund. Let’s say that you are opening a software development company, and an engineer charges $4k per month as salary. If you want 5 engineers to work with you and you want to fund them for 18 months, you would need to have at least 4k x 5 x 18 = $360K. You just need to see what you want for the company and for how long would you be funding the company in this case.

Now getting back to the actual question: How much are you raising? The answer is simple where you are raising company funding for N months (where N can be between 12 months to 18 months) and would need $X (where funds can be between $500k and $1.5 million). In short, you can have multiple ranges of X and versions of N, giving you the possibility for different growth situations.

Every company needs a different amount raised, and the variation in the amount raised for every company can be enormous. However, what you need to focus on is the funding which usually ranges from a few thousand to several million.

REAL WORLD EXAMPLE OF FUNDING

Let us take an example of the famous Amazon that was founded by Jeffrey P. Bezos and generates about $61 Billion as revenue in a year today. Amazon started in Bezos’ garage and holds the title of the world’s largest online retailer now.

Amazon Stats:

  • Industry: Online Retailing
  • Annual Revenue: $61 Billion
  • Number of Employees: 97,000

How Amazon Got Started

It was in 1994 when Bezos came up with the idea to quit his job and start an internet company, due to the sudden popularity of the internet amongst people around the globe. But things didn’t work out for him immediately. He prepared a list of 20 top products that he could sell online and decided that books were the best choice. And that is when things took a good turn, where this was just the beginning for Amazon at that time.

Amazon’s Funding

The seed funding was from his parent’s personal savings, where they didn’t even know what the internet was at that time. They had basically put a bet on their son. Moreover, Bezos had told them that there was a 70% chance that he might lose the complete investment, but they still invested a few hundred to thousand dollars in his idea.

After that, Bezos needed more funding in the second year, and Amazon had raised a series A from the Kleiner Perkins Caufield & Byers of about $8 million. As you may know, that was not the end of it. Amazon went public in 1997 to raise more funding and by 1999, the investment that Kleiner Perkins Caufield & Byers made had a return of over 55,000%.

When Bezos had to raise funding for the company, Amazon had sales that were up to $20,000/week. And since then, the company has become one of the biggest corporations in the world, and is now focusing on long-term growth and global dominance. As you can see, Amazon is a perfect example of how a small one man startup, through the years, can become a big corporation which can change the market completely.

CONCLUSION

The important thing to keep in mind about company funding is that paying back lenders and dealing with them can become a nightmare if everything is done carelessly. If you are doing it right, you will see your business grow. The pros and cons to search for the external capital comes back to the ROI (return on investment).

Hence, it is crucial to evaluate the ROI. You would need to use the investment to grow the company and generate revenue. The same rule is applied to raising debt or equity. You need to know how to grow your business with it.

So, if you have decided that you need outside company funding, the next thing is to determine what type of financing you need. Do you need debt financing (various forms of small business loans) or equity financing (money from investors)?

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