Unless you've got a Scrooge McDuck money pit you can dive into and draw out a couple of million at will, your business will likely need to raise some...
Valuing businesses is an art, not a science. And it’s often considered a dark art at that – there’s no magic formula.
The TV show Dragon’s Den provides an irresistible example of what happens when optimistic founders present what they believe to be a well-worked valuation that simply isn’t realistic. We all know how that tends to work out.
For founders seeking funding, taking a robust approach to valuations is sensible. The real world isn’t like Silicon Valley where a group of Big Tech executives can rock up to a café, draft a basic plan and raise millions at pre-seed.
We've put together this guide for startups embarking on their fundraising journey. But remember, every business is different and it's worth looping in an accountant or specialist if you're unsure.
When do I need a valuation?
If you plan on seeking investment, setting up a share scheme, devising an exit strategy or you're preparing for a merger or acquisition, you need a business valuation. A valuation can also influence strategic decisions and provide a benchmark for performance.
This guide covers investment valuations. But if you're interested in getting a valuation sorted for your share scheme, talk to our experts.
Valuing your startup: two precursors
Valuations tell investors what you think your business is worth. It gives them an understanding of why you’re asking for the level of investment you’re asking for and what sort of equity you’re offering in return. Robust valuations also illustrate that you know your way around your figures!
Firstly, let’s start by saying that investors have a wide range of strategies which vary with their investment thesis, risk appetite, instincts and preferences.
There’s no one-size-fits-all approach for valuing a business with the purpose of seeking investment.
The business is worth what someone will pay for it, after all.
Even so, when it comes to determining the value of your startup, there are two fundamental components to explore: defining your fundraising goals and deciding how much of your company to offer to investors.
Let’s take a look at those before exploring specific valuation methods.
Determining your fundraising goals
The first step is to identify your fundraising objectives and answer, “How much money do I need?”
Peter Pham, the cofounder of Science, an incubator in Santa Monica, California, told Silicon Valley Bank:
A valuation is really based on how much money the founders think they need.
Sometimes, you can simply get away with just pitching a number and providing a valuation. Your business’s valuation justifies a) how much money you’re looking for and b) how much equity you’re willing to give away.
If your vision and product captivates the investor and they think it’s a great opportunity, that might be all they need. However, that’s a risky approach for most.
While this may be true, it’s probably more sensible to take a robust approach to valuing your business, especially for first-time founders.
Additionally, while it might be tempting to raise as much capital as possible, many advise raising enough for the next 12 to 18 months. The rationale for a 12 to 18-month financial runway is that you can re-enter the fundraising cycle six months before exhausting your funds.
This also means avoiding frequent fund-seeking efforts that distract from your core business activities and underestimating the costs involved with fundraising. And ideally, your startup will exhibit substantial growth within this period to attract new investors.
So how do you work out how much you need? Consider the following key aspects:
1. Minimum requirement and desired investment
Identify the minimum funds you need to keep your business operational and an ideal figure for propelling business activities without constant fear of running out of money.
2. Operational cost
Determine the cost required to achieve your Key Performance Indicators (KPIs).
3. Buffer funds
It's always prudent to reserve some funds for unexpected expenses.
4. Upper limit
Understand the level of investment that might increase pressure due to high expectations from investors. Keep expectations realistic.
Once you’ve got a ballpark figure for how much you want, you’ll need to consider how much equity to offer in return. This is the transaction between you and investors – an exchange of risk and reward for money.
How much equity to offer
Secondly, you’ll need to consider how much equity you will offer investors.
For angel or seed-stage rounds, founders typically offer between 10% and 30% of the company's equity. This range isn't arbitrary – it aligns with early-stage investors' expected return on high-risk, high-potential investments.
If your startup succeeds, investors anticipate a significant return on investment, and if it doesn't, they expect a meaningful influence over crucial company decisions.
However, if you’re looking to offer 30%+ equity or an investor wants that level of equity, your company's valuation could be too low, or you are attempting to raise an excessive amount too early in your journey.
Let’s dive into some valuation techniques and methodologies.
Valuation methodology 101
Let’s move on to the nitty gritty of valuing your startup. As mentioned, your business’s value justifies your funding hopes and the equity you’re willing to part with.
Valuation methods generally depend on whether a business is generating revenue or not, and revenue-generating businesses, as we’ve seen, are easier to value.
The EBITDA approach
EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortisation.
For profitable startups with a consistent income stream, understanding EBITDA is foundational to working out a robust valuation. It's a measure of a company's operational performance. Here are the components that form it:
The bottom line of an income statement, net income represents the company's profit after deducting all expenses, including business operations, taxes, interest, and cost of goods sold.
Self-explanatory – tax deducted from the pre-tax income.
The cost incurred by an entity for borrowed funds, i.e., the interest payable on any borrowings such as bonds, loans, convertible debt, or lines of credit. With that in mind, while EBITDA is the most well-known approach, it's not appropriate for companies with lots of debt since their Interest costs are significant.
This applies to tangible assets like machinery. Businesses depreciate long-term assets for both tax and accounting purposes.
Similar to depreciation but is used for intangible assets like patents and copyrights. The EBITDA is typically calculated using this formula:
EBITDA = Net Income + Taxes + Interest Expense + Depreciation + Amortisation.
Let's work through an example. Suppose you have a company with the following financial information for the last fiscal year:
- Total Revenue: £1,000,000
- Cost of Goods Sold (COGS): £400,000 (doesn’t apply to all businesses)
- Operating Expenses: £200,000
- Depreciation: £50,000
- Amortisation: £20,000
First, calculate Operating Profit (also known as EBIT - Earnings Before Interest and Taxes) by subtracting the COGS and Operating Expenses from Total Revenue:
Operating Profit (EBIT) = Total Revenue - COGS - Operating Expense
Operating Profit = £1,000,000 - £400,000 - £200,000 = £400,000. Then, add back depreciation and amortisation to get EBITDA:
EBITDA = Operating Profit + Depreciation + Amortisation
EBITDA = £400,000 + £50,000 + £20,000 = £470,000. So, the EBITDA of this company for the last fiscal year is £470,000.
EBITDA as a valuation tool
EBITDA is a proxy for a company’s cash flow from its core business operations, disregarding the impact of taxation and non-cash expenses.
However, to forecast the business’s value into the future, it has to be multiplied – sometimes known as the market multiplier. This indicates how quickly your business could grow.
The EBITDA multiplier is typically determined by the industry average, recent transactions in your sector, or the multiples of publicly traded companies in the same industry. It reflects the market's valuation of similar companies.
A major 2023 analysis found that EBITDA multipliers vary between around 4x, at their lowest, to over 13x, at their highest. Industries with higher multipliers, such as the technology industry, exhibit stronger chances of future growth.
For example, consider a Software as a Service (SaaS) business with an EBITDA of £1,000,000.
SaaS businesses often estimate their value with an EBITDA multiplier of approximately 10x. Thus, the startup's valuation would be between £10,000,000 and £14,000,000.
Real-world scenarios often require considering additional factors such as industry growth trends, company-specific risk factors, competition, and strategic value to a potential acquirer.
The revenue multiple valuation method
Also referred to as EV/Sales, this method determines a company's value based on its sales revenue. It's beneficial when a company is not yet profitable, as is the case with many startups, but has meaningful revenue. And for companies with a recurring revenue model, like most SaaS businesses.
Here's how it works:
1. Identify the multiple
Firstly, you need to find a suitable revenue multiple. Similar to the EBITDA method, this is typically based on the multiples of similar companies within the same industry, also known as "comparables" or "comps". If similar companies are typically valued at, say, ten times their annual revenue, then 10 is your revenue multiple.
2. Calculate the valuation
Next, apply this multiple to your company's revenue. If your company has a revenue of £2 million, you'd multiply that by your revenue multiple of 10 to arrive at a company valuation of £20 million.
This method says that, based on what the market is willing to pay for similar companies (i.e., a value of 10 times revenue), your company would be valued at £20 million.
Non-revenue generating businesses
Now we enter into the real dark arts of valuing non-revenue generating businesses.
What do you do if you don’t have revenue figures, limited forecasts, and negative cash flows, as is typical in early-stage startups?
In this case, your business analysis as a founder and past experience is invaluable. For instance, founders who successfully exited with past businesses are more likely to secure investment without a minimum viable product (MVP).
This is often the case in Silicon Valley, where, say, an ex-Meta executive joins up with a bunch of other top Big Tech scientists and raises a massive pre-seed round based on pure speculation. It’s a good bet for investors.
Regardless of your experience, as a founder, it’s highly advantageous to understand how an investor might value your business if you can’t convince them using revenue figures.
Investors and VCs use the following non-revenue-generating valuation methods.
Consider a business with assets but no revenue – you can’t say it’s worth nothing, as it would cost something to duplicate.
The cost-to-duplicate method is a simple, grounded approach that looks at the physical assets of a startup.
The logic behind this method is to calculate how much it would cost to build a similar company from scratch. This includes costs for physical assets, intellectual property development, and capital equipment.
Imagine a tech startup that has spent £500,000 on developing proprietary software over two years. You could use the cost-to-duplicate approach to start their startup valuation at £500,000.
While it provides an excellent foundation, this method tends to undervalue the potential and intangible assets, such as future growth prospects and the workforce's talent.
Venture capital method
The venture capital (VC) method was developed in the 80s. Since then, VCs across the globe have adopted it with some slight variations. This method requires forecast revenues, and it's best suited to pre-revenue early-stage startups.
It involves estimating the startup's future value using financial forecasts and then discounting it to its present value by applying a discount rate that reflects the potential risks for the investor.
The workings behind it:
Post-money valuation = terminal value / anticipated ROI
Pre-money valuation = terminal value / post-money valuation
The terminal value is the anticipated selling price of the business in the future and the anticipated ROI is the projected return for the investor.
For example, if a startup is projected to be worth £10 million in five years, and the VC requires a 10x return on investment, the VC would value the startup at £1 million today.
Scorecard valuation method
The scorecard method uses established criteria specified by the VC.
This works when the company has advanced beyond the seed/idea phase but still carries startup-like attributes.
For instance, its financial history is sparse or non-existent, it's yet to receive external investment, its product or service is in development, and it’s not yet generating positive cash flows.
The scorecard valuation systematically assesses the business. Here are some commonly included components of the scorecard:
- Management team quality (0 - 30%): Is the team fully assembled? Do they have relevant experience?
- Market potential (0 - 25%): How large is the potential revenue or impact?
- Product or technology (0 - 15%): Is the intellectual property clearly defined? Has the product gained any traction?
- Competitive landscape (0 - 10%): Are there significant barriers to new competitors?
- Marketing and sales channels (0 - 10%): Have you established any important partnerships?
- Future investment requirement (0 - 5%): Will funding be needed from angel investors or VCs?
- Miscellaneous factors (0 - 5%): For example, are there any geopolitical considerations that could impact your business?
While scorecard methods are relatively hard to execute from a founder’s perspective, it’s still useful for systematically evaluating a business’s strong suits and pitching them to investors to justify a valuation.
Business valuations can be complex, but it depends on the business in question.
It goes without saying that larger, more complicated startups operating in risky high-growth industries are trickier to value, and require more speculation on behalf of investors when the figures aren’t there.
The valuation methods discussed are tools, and each startup will require a customised approach as no two startups are the same.
Ultimately, the value of a startup is what an investor is willing to pay – it’s an art, not a science, and one person’s piece of rubbish is another person’s Picasso.
How Vestd can help
Our in-house specialists provide valuations for customers on Standard and Guided plans to help them set up their company share schemes. Our valuations team can also support customers with 409A valuations for a small additional fee.