Skip to main content

How to Value a Start-up

How do you value a start-up business, especially when it's seeking investment? Well-established companies can be valued in a number of ways, but traditionally you would multiply their latest reported annual earnings (sometimes called EBITDA or PBT) by a multiple known as a PE (Price/Earnings) Ratio. Google's is currently 32 and General Motors is 13. The multiple might be large if the company is in a growth sector like technology, or if the company has a solid history of growth that buyers of their stock believe will continue. The multiple might also reflect the size of the company which is an indicator of stability and probability for steady profit, and therefore dividends (something you should never expect from a start-up). There may also be speculation that the company might be an attractive acquisition, which might temporarily push the PE ratio higher until the rumour is either dismissed or proved. On the other hand, if a company has a history of falling profits, then its multiple will be conservative, but if lots of people believe it's about to improve, maybe by appointing a new CEO, by acquiring another company, or perhaps by signing a new deal, its multiple might increase.

If the company is already trading shares on a public exchange, then its valuation is done for you. Just multiply the number of shares issued by their price and you have its value. But what if the company is not being publicly traded and you have to work out what it might be worth?

People buy businesses for their future, not their past. Whilst the past gives a good indication of future financial performance, the future is actually about guesswork and estimation. And the world is awash with 'experts' prepared to sell you their opinions. But at least they've usually something to work on.

However, when you are considering the value of a start-up who by definition does not have a past, the future is very hard to calculate. So it's pointless trying to apply the same sort of science that experts apply to companies with a history of trading, you have to use a more artistic approach. Quite simply you have to work out what both the buyer and the seller of shares thinks is a fair price. And that can be either incredibly easy - you both guess and your guesses aren't too far apart - or incredibly difficult - your guesses are far apart.

But even if the company itself does not have a history, there are some things you can find out from the past. You can look at what companies operating in similar markets have managed to achieve. You can look at the track records of the principals. You can possibly buy research about the market or perform your own to apply predictions based on trends. But at the end of the day you're usually left with these factors:

  1. The business will have produced a Business Plan. In it you will find a graph or spreadsheet that looks like a hockey stick. It will start with a tiny number and end up with a massive one. The tiny number is the only one you can rely on. Ignore the big ones on the revenue side and look only at the expenditure numbers. These are not guesswork and can/should be pruned dramatically. From this alone you can work out how long the company can survive on a sliver of revenue plus your investment before it decides a) to find more investment, b) to struggle on (because they still believe there really is a way to make money, which is unlikely since the evidence is weak), c) to give up.

  2. The founders will have spent a certain amount of money already. This includes modest wages that they haven't taken as well as other contributions from useful people like software developers who probably will have exchanged what they should have charged for what is known as Sweat Equity. The amount already invested will not be a large number compared to what the company is probably now seeking, but the founders are the ones who took a massive risk with their careers and savings by starting the business in the first place. By the time they approach investors, they've probably already re-mortgaged their homes, maxed their credit cards, tested their marriages and borrowed to the hilt. One type of start-up investor you won't see these days is banks. Early investors in start-ups are usually known as the 3Fs - Family, Friends and Fools. All of this early investment symbolises personal hopes and dreams. You cannot, and should not underestimate its equity value. But it clearly wasn't enough otherwise they wouldn't be asking you for a lot more now.

  3. Inevitably you will find that some of the original founders will have parted company with the business - either because they couldn't put any more money in and needed to start earning a living again, or because when that hockey stick didn't materialise, founders started blaming each other. So when you meet the business, the remaining principals will still need to be incentivised to carry on, and their erstwhile partners will probably need to be paid off to release their equity. Don't forget the principals left in the business will have been through hell to get to the point where they're asking you for money. Most businesses, especially tech, don't start with a plan to raise money. Most think they'll grow organically without outside help. Few will of course. 

So my simple checklist for would-be investors in start-ups (known as Business Angels) is:


a) Will it survive if I invest?

b) If it does, can it be sold for a lot within 10 years?

c) If a) and b) are Yes, then how much can I afford to lose if I’m wrong?

d) What’s the biggest percentage of equity I can achieve without becoming a disincentive to the principals?

e) Once involved, how can I use my experience and connections to increase the chances of a) and b)?


Forget all the fancy valuation mathematics based on no history and wishful thinking forecasts. Go on gut instincts and an assumption you'll lose your money.

Happy investing!

Comments

Popular posts from this blog

Phillips screws - yes I'm angry about them too

Don't get me wrong. They're a brilliant invention to assist automation and prevent screwdrivers from slipping off screw heads - damaging furniture, paintwork and fingers in the process. Interestingly they weren't invented by Mr Phillips at all, but by a John P Thompson who sold Mr P the idea after failing to commercialise it. Mr P, on the otherhand, quickly succeeded where Mr T had failed. Incredible isn't it. You don't just need a good idea, you need a great salesman and, more importantly, perfect timing to make a success out of something new. Actually, it would seem, he did two clever things (apart from buying the rights). He gave the invention to GM to trial. No-brainer #1. After it was adopted by the great GM, instead of trying to become their sole supplier of Phillips screws, he sold licenses to every other screw manufacturer in the world. A little of a lot is worth a great deal more than a lot of a little + vulnerability (watch out Apple!). My gromble is abo

Addictions. Porn, Drugs, Alcohol and Sex. Don't prevent it, make it safer.

In 1926 New York, during Prohibition, 1,200 people were poisoned by whiskey containing small quantities of wood alcohol (methanol). Around 400 died, the rest were blinded. The methanol they drank was in the moonshine they had bought illegally. In fact it had been added by law to industrial ethanol in order to make it undrinkable. Prohibition existed to protect everyone from the 'evils of the demon drink'. However, people still wanted to enjoy alcohol. So bootleggers bought cheap industrial alcohol and attempted to distill it to remove the impurities the state had added, but the process wasn't regulated. The state was inadvertently responsible for the suffering - although it was easy for them to blame the bootleggers and to justify escalating the war. This didn't stop the bootleggers. In fact it forced them to become more violent to protect their operations, and even less cautious about their production standards. Volumes of illicit alcohol, and therefore proportionat

The Secrets of Hacker Golf

Social media is awash with professional golfers selling video training courses to help you perfect your swing, gain 50 yards on your drive and cut your handicap. They might help a few desperate souls, but the rest of us hackers already know everything we need to complete a round of golf without worrying the handicap committee or appearing on a competition winner's list. What those pros don't realise is that for us hacking golfers who very occasionally hit shots that if you hadn't seen how they were hit, end up where the pros might have put them, we already know everything we need to know - and more. Unlike pros who know how to time the perfect swing in order to caress a ball 350 yards down the centre of a fairway, we hackers need to assemble a far wider set of skills and know-how to complete 18 holes, about which pros have no comprehension, need, or desire to learn. Here are some of them: Never select your shot until after you've hit it. A variation on this is to alway