Lets make some necessary assumptions here: you have a great business idea, enough traction or experience to attract investors, investors that agree with your forward moving vision and you have managed the process of raising capital in a way that has led you to the coveted next step: valuation.
Valuing an early or pre revenue business is very subjective. Although there are many different methods and schools of thought, the reality is that no one constant or universal method is used. In deals of all sizes, on fact remains: in a literal sense, your company is worth what someone will pay for it.
Oftentimes business owners value things like time and sweat equity. While all these things are personally very valuable, they do not often factor into a formal valuation by an investor. For companies with revenue, it is not uncommon for a valuation to be based on one of two methods. Multiple of EBITDA (earnings before taxes interest depreciation and amortization) and a multiple of revenue.
If your company had 500k in EBITDA and the investor is willing to pay a 4.5 multiple on EBITDA the business would have a value of 2.25 million dollars. Conversely if you had 2 million dollars in revenue (even while taking an operational loss) and investors valued your company at 2x revenue your company would be worth 4 million dollars. Early and seed stage companies are often expected to take a loss and in turn a multiple of revenue valuation is more common.
Outside of a revenue or EBITDA methods the valuation process is a lot more intuitive. Some larger investors like venture capital groups may work the valuation of a pre revenue company backwards. They often start with a projection of future earnings compared to a ROI target and derive a starting value. Less sophisticated investors may use any number of methods.
Since it’s difficult to predict how your particular valuation may materialize, I always like to ask new business owners this: Is it better to have 100% of nothing, or 50% of something? Those who find importance in that 100% ownership category will have a very difficult time raising money. It’s always helpful to remember that your capital raise is just one step in your total product deployment and hopeful success. Too often, business owners get hung up on valuations that in turn can reduce forward moving opportunities and distract from the real task at hand – growing the business.
Because of the flexibility in valuation methods in early stage business I always recommend business owners take a ‘negotiated’ valuation approach. When raising capital through a more formal process like a private placement memorandum you will have to place a per-share value on your company. If this per-share value is out of the range of a potential investor they may simply not get back to you under the idea that you have a hyper inflated sense of company value. When taking a more negotiated approach a business owner still shares all the sale, product, team, projection and strategy information but then leaves the valuation process up to the investor. If the investor is interested they will get back to you with a Letter of Intent that will include a valuation. From this point you can negotiate through whatever variance you see in valuation. Using this method you do not frighten any potential investor with value shock before being given the opportunity to sell the project.
Take it from me, save your self the time and cost becoming a financial analyst and expert in valuation and dedicate that time to the continued growth of your business. Go in to price negotiations open-minded and leave your initial value expectation at the door. If you do not like the value offered to you find a better one. If there is no better one, accept the forces of the market and move forward.
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