Valuation: What Are You Worth?

Before we begin, I want to disclose that this article is more of a thought process rather than a hard and fast rule on valuation. The topic in and of itself has produced hundreds of literature, articles and thesis, all varying in the philosophy and methodology in valuing an early stage company. I advise business owners not to get too tied up with valuation and instead focus on building customers, revenue and ultimately profit. You only have to look at the imploding valuations of Facebook, Fab.com and other at one time hot companies to realize valuating a company is more of an art than science. Having said that, knowing how much your company is possibly worth in the market place provides you with better negotiating power when dealing with investors.
According to Wikipedia, valuation is the process of estimating what something is worth. I would like replace the word “something” with “someone”. When an entrepreneur first gets an idea about a brand new business or revolutionary product, it usually stems from a problem they are trying to solve. The next step for the entrepreneur is to discover how big the problem is, or in other words, is there a marketplace for the product. If the problem is large enough to commit money and resources, the next question becomes how much is this idea worth; the valuation.
Any major investor will tell you that ideas are worthless and it’s all about the execution – come back later when you have something tangible. The tricky part is that in a very early stage startup, nothing is really tangible. You do not have annual returns, ratios, or assets, just projections and your passion. In my business, Smart Money Entrepreneurs, we formed a company in a market/industry that had not yet fully formed, which made the process of valuing our company much more difficult.
In this article, I will review two methods which investors like to value a company. In a previous article {insert link here} I briefly touched on how you as a business owner can do a simple calculation to estimate your company’s valuation. I would recommend reading that article to understand the basics before you proceed.
Type 1: Cash Based Valuation
The first type of calculation revolves around financial projects, estimated sales, and growth prospects of a company. These companies are generally generating revenue and have paying customers. Most have been operating for about a year or two and are growing significantly. To evaluate the situation in this example, let’s take two real life examples.
Warby Parker, a New York based firm that sells Boutique-quality prescription eyewear and sunglasses raised $36.8 million in funding (as of November 2012) of a $40 million target. The company annual sales were estimated to be just over $3.5 million dollars for 2012, with a profit of about 1.75 million or a 50% gross margin. That valued the company at about 10 times annual revenue.
Let’s work backwards and break this down, keeping in mind Warby Parkers previous investments.

Before Warby Parker raised the $36.8 million in funding, they had raised $12 million in 2011 with sales just at or above $1million. Again, investors believed the company was worth 10x projected revenue during this $12 million round of funding. Before the $12 million investment, Warby Parker has raised 1.2 million in seed capital.
This means that for each funding round, investors believed Warby Parker was increasingly valuable at a rate of 10x the previous annual revenue. As the company began to grow, attract more customers and sales, investors believed there was tremendous value. Where do these projections of 10x annual revenue come from? They come from the current (realized) sales growth and projected (unrealized) sales growth. However every business at some point in its life cycle levels off as there is no such thing as unlimited growth, although some investors want to believe it.
Personally I believe Warby Parker is the classic story of an overhyped, overvalued company that will eventually lead investors picking up the pieces. Yes, Warby Parkers sales are increasing, yes, they are very popular; but like the most popular high school senior who is graduating in a few months will soon learn that in college, that there are other big fish in the sea. Other brands have begun to mimic Warby Parker both domestically and abroad. Other big players, Lens Crafters, Vision Monday, and other major eye glass distributors can easily mimic Warby’s Model. Those who are interested can check Vision Monday’s numbers and see online sales of glasses have stabilized, meaning no more growth. This fairytale of 10x revenue growth year over year will end very badly; the question becomes which investors will wind up holding the short end of the stick.
If you cannot tell by now, I am not a fan of overblown valuations that are based upon unrealized future projections as there is no telling what the market will do. If you look at the companies in the major private and public stock market, the majority of company’s miss their projections year after year, indicating that this valuation method, although most frequently used, Is not all that reliable. So from here, we look at valuation method #2.

TYPE 2: “Market Driven Valuation

Your company is worth is what the market or investors will pay for it. If you are reading this and think that is a vague and arbitrary statement, you are correct. Think about your investors as customers. If you price a product at $99 and the maximum a customer is willing to pay for that product is $30, you have two choices; add more features to increase value or accept the customers maximum price point.

This is essentially the same scenario with investors. If you remember from my previous article, I like to calculate valuation for a really early stage startup based upon the following two questions:

– How much are you looking to raise?
– How much equity are you willing to give away?

Based upon these two questions, we can arrive at an estimated valuation based on simple math.

For our purposes, let’s assume we will raise 1.2 million, giving away 30% of a company. You take 1.2 million/30% and you get an estimated valuation of 4 million.

This allows us to have a good base to further explore the company’s valuation based upon a series of questions. For each positive and negative attribute, we will assign a weighted value/percentage to the valuation.

Let’s begin:

Question #1
Weight: 75%

Does the Founder/CEO have the expertise in the industry/business?

Note: This is by far the most important metric. Investors want to invest in entrepreneurs who have the desired expertise or domain knowledge.

Question #2
Weight: 30%

Is this the entrepreneur’s first startup or is he/she a serial entrepreneur?

Note: This metric although important is not as relevant as the first. Many entrepreneurs fail in their previous startups before they hit it big. Investors love to invest in serial entrepreneurs who learned from their other startups because they will not likely make the same mistakes twice.

Question #3:
Weight: 60%
Is the founder a serial entrepreneur who has successfully sold (exited) his/her previous companies?

Note: This metric is very important as investors believe if an entrepreneur has successfully sold his company once, he/she can do it again.

Question: #4
Weight: 30%
Are the gaps in the management team essential or non-critical to the operation of the business?

Note: Ie. If you are building a tech company and you do not have a lead engineer or developer and you do not know how to code yourself, this is a big negative in the eyes of the investor as it relates to question #1 about not having the appropriate expertise/knowledge

Question: #5
Weight: 20%

Note: Does the Entrepreneur have “Skin In The Game”, meaning how much of your own capital have you invested in this business:

You may have noticed that the total weights do not equal 100%, nor are they supposed to. The weights are an indicator of how important that specific metric is to an investor when valuing your early stage business.

To come up with your valuation for a very new startup, follow the instructions below:

For questions 1-4, if the answer was “NO”, subtract the weight percentages from the initial $4 million valuation. If the answer was yes, add the weight percentage to the initial $4 million valuation.

Ie. If you answered “NO” for the first question, that valuation immediate drops from $4 million to $1million.

For question #5, reverse the process.

At this point, when you approach an investor, you should be better prepared to present a more accurate and realistic valuation for your company and ultimately be closer to receiving that che

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