There are many contentious issues that come up in venture capital rounds and other business deals, but few are so consistently debated as valuation. When establishing how much a company or asset is worth, there are many issues to be considered -- and interested parties may have significantly divergent views. A financing or corporate lawyer from Priori's vetted network can help you understand what's at stake and negotiate a fair valuation.
A valuation is an estimate of the current worth of an asset or company. Generally, arriving at a valuation requires using both subjective and objective criteria. Objective factors often used to arrive at a valuation include capital structure, projected future earnings and market value of assets. Subjective factors often used in valuation include factors like management team strength, competitive advantage and market dynamics. Because valuation relies on a mix of objective and subjective favors -- and, of course, because the valuation is so important for determining the financial dynamics of an investment -- negotiating a company’s valuation is often a contentious part of getting a deal done.
Methods to Calculate Valuation
There are many ways to calculate a company’s valuation, but many investors use the three methodologies below:
Discounted Cash Flow Method
The most common and most thorough way to value a company is using the discounted cash flow (DCF) method. DCF estimates the value of the company based on its expected future cash flows, discounted to the present. To complete this analysis, an estimate of future cash flows from the investment is calculated based on current assets, earnings and projections. Then a reasonable discount rate is calculated based on the riskiness of the company’s cash flows and interest rates in capital markets.
Valuation based on comparing a chosen metric with benchmark companies -- industry peers, competitors or an alternative set of comparable companies -- is often used as to supplement a DCF analysis. This valuation methodology begins with a calculation of the ratio between two key variables related to the company. The same ratio is then calculated for a set of benchmark companies for which the valuation is available and then the relationship between the ratio and each company’s valuation is calculated. The relationship between the ratio and the valution for each company is called a “multiple." Once these benchmark multiples are determined, the multiples are analyzed -- often to determine the high, low, mean and median multiples of the benchmark set. Finally, the company’s implied valuation range is determined by multiplying the company’s ratio by some set of the benchmark multiples -- often by the high, low and mean multiples.
Comparable Transactions Method
The comparable transactions method is similar to the multiples method in that it begins with an analysis of a benchmark data set of comparable transactions. While this methodology may draw on a range of factors in the precedent transactions, often the analysis looks to determine the relationship between overall transaction valuation and the EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) of each company at the time of the transaction -- often called an EBITDA multiple. Once the EBITDA multiples of the benchmark transaction set are determined, the multiples are analyzed -- often to determine the high, low, mean and median multiples of the benchmark set.
Finally, the company’s implied valuation range is determined by multiplying the company’s EBITDA by some set of the benchmark EBITDA multiples -- often by the high, low and mean EBITDA multiples.
Early Stage Valuation
When determining the valuation of an early stage company or investing seed money in a startup, the standard methods of calculating valuation are not as effective. Accordingly, investors take a range of approaches for valuing early stage companies.
Early stage startup valuation is often described as more of an art than a science. Despite that, there are predictable factors that will influence the ultimate valuation of your company.
Comparable Transactions. Much of your company’s valuation will be a comparison with similar startups. For example, a new social media app may be compared to Snapchat and Twitter, both to see if it is differentiated enough to achieve success and to see about what level of financial success it may have.
Reputation. The reputation of the company and its founders matters a lot. Some of this will be based on perception upon meeting you, so first impressions count.
Growth and Traction. Your valuation may be based on how much success you’ve had with your limited attempts to launch your product. A product that is already building a user base is often valued higher than a totally untested product.
Revenue. Any revenue you have will be taken into consideration. The impact is difficult to predict as early revenue can serve as both a deterrent to fast user growth and proof of growing profitability.
Market. Market saturation, opportunity and distribution channels are also generally considered in arriving at a valuation.
Sometimes equity investment -- and the attendant valuation -- isn’t practical at the earliest stages of a startup. Instead, in some situations, investors opt to use convertible notes to invest in seed rounds or provide other early stage financing. Using this investment vehicle, valuation is delayed until later date—usually during a round of funding specified in the convertible note investment documents. Because investors are taking on the risk of an unspecified valuation when using convertible notes, these early stage investors usually get special assurances, warranties or discounts.
Depending on the particulars of your situation, the legal costs associated with drafting and negotiating the required documents for a financing can run a broad range. When you hire a lawyer through the Priori network, hourly rates start around $185 per hour for a financing lawyer but can range significantly higher based on certain types of experience. In order to get a better sense of cost for your particular situation, put in a request to schedule a complimentary consultation and receive a free price quote from one of our lawyers.
Why does the valuation of my company matter?
The pre-money valuation of a company is incredibly important, because it ultimately determines what percentage of ownership you award to investors in exchange for capital. If your company is valued at $1,000,000, an investment of $200,000 means that your new investors have a 20% ownership stake in your company, but if your company is valued at $2,000,000, an investment of $200,000 means that your new investors have just a 10% ownership stake in your company.