“What is the valuation of your company?” I asked the co-founder. “We think about $50 million today, before the next round of funding. That seemed fair to us” was his reply. “So how did you get to that number?” was my next response. “Well, we did an MBA type of discounting of net income and guessed at the discount rate.” That told me these founders were not prepared to enter the rooms of investors looking to put money into their excellent startup idea. They would get fleeced.
Liquidity event. That is what venture investing is all about. Convert paper into cash. Real money. If not, all that the investors will hold is wall paper. Worthless. The shares must turn magically into cash at a point in time known as the liquidity event. That is what an IPO is all about. Or an acquisition by a public company. Buy a word of caution: If your company is acquired by another startup, you are not yet public. That is not a liquidity event.
So start your valuation work at the most valuable liquidity event: the IPO. Pick your company’s IPO value. Base it on sales, not net income. That is what IPO investors do. Use a multiple of sales that is similar to companies like yours in your industry. I use handy industry tables from Schwab. It is a bit of extra work, but worth it. Worth millions.
With the IPO value pegged (the liquidity event), then start pricing your company for each of the years prior to the IPO. Set the company value so that the ROI for investors (percent per year ROI, and the multiple of $1 invested compared to the IPO value) is what they expect for each year prior to IPO. If you don’t know those ROI expectations, try using QuickUp (http://www.nesheimgroup.com/). It has the standard ROI expected by professional venture capitalists.
When you are done, you can tell a seed round investor, or any later investor, what to expect in ROI for that round of funding. Then you can return to discussing how to get to those wonderful sales in the year of your IPO. That is where you should be talking. Get the valuation stuff over with, and focus on the business. Your goal is to get to IPO within five years, build an outstanding company and become a gorilla of a new category. Then your valuation will be justified.
LESSON OF THE DAY: Do your valuation homework before you start to raise your next round of financing. You can read more about doing this in Chapter 9 of High Tech Start Up and Chapter 22 of The Power of Unfair Advantage . Do not let the investors set your valuation. Become a black belt at it!