Valuing A Company

I know the basics of finance (buy low, sell high), but the world of startup valuation and financing is a mystery to me. Recently, I took a seminar entitled “Startup Finance: Valuation” from Startup Saturdays that was really great! The absolute best part was the Q&A that happened between the students and instructor (I don’t have his name unfortunately), who absolutely knew his stuff and clearly has experience with this field. By the end, we understood why Snapchat is valued at $3.5 billion.

Since I’m working on my project, Visioneer Studios, with a partner who wasn’t at the seminar, I summarized my notes for him and also sent them to a friend who is considering getting funding to expand his successful software business. That friend called to say my notes were the clearest explanation he’d seen of valuation, which motivated me to share them with you. However, even if you read this blog post, I would highly encourage you to sign up for their seminar. I will also disclaim that these are from my notes, I could be wrong about some points (please tell me if I am), I am not a financial advisor, this is not financial advice, etc.. Here are my summarized notes:

1. Shares

  • Every investment is based on shares.
  • When you start your company, you determine how many shares you as a founder get. In general, more is better (within reason), as you typically figure that a share is worth $1. That’s because worst-case, the shares are worth $0. A slightly-better-than-worst case is that they’re worth $1. Of course you hope they’re worth $10, 100, etc.
  • 10m shares is a very common initial number for startups (so in my case, with 2 founders, we could setup a C corp right now with 5m shares for each of us. But we should gauge investor interest before starting to setup the C corp, as if we don’t have anyone bite, we won’t have to pay the filing fees and minimum tax).
  • It’s in the founder’s interest to make the founder’s shares not subject to a reverse stock split. Reverse stock splits can be used to remove board members and to lower the value of your investment (remember, more better).

2. Figuring out the company’s value

  • The value is always based on what you have/can do right now (pre-money), not what you can do if you get the investment (post-money)
  • If you’re at a point where you have an idea/rough prototype but there is no way to execute on it without the investment, your valuation will be quite low. $2m is relatively common assuming your idea isn’t dumb.
  • The cash flow statement is key if you can be (or are) executing.

3. Cash flow statements

  • Essentially build a model of your business based on what you can do right now. For each year, you will have 3 parts. Top part is cash in (e.g., how much do you make). Bottom part is all expenses (salaries, benefits, facilities, equipment, travel, taxes, etc.). Net (in — out) at the bottom.
  • Model out an appropriate number of years, and initially aim high for the duration. The VC will reduce this/negotiate it with you. Cash flow statements can range from 3-30 years. Longer ones are generally better for your valuation. For example, without funding, it might take you three years and some small expenses to make a product, but you think you’ll see income in year 4. A 3-year plan would show you have a negative value, but a 5-year plan would show you having a positive value, and a 10-year plan should be even more positive due to more sales.
  • You will need to be prepared to defend this statement and duration. For example, since we’re looking at content/feature films, which lasts and continues to provide income over time, we could more easily justify a longer plan than an app-based startup trying to claim people will still be buying the same App Store app in 30 years.
  • Note that each year is a “future value,” what the company’s worth in that year, not what it’s worth now. This value needs to be adjusted into “present value,” what it’s worth now. This often uses the bond rate, and Excel has a built-in function (PV) to calculate this. In 2012, the bond rate was 1.2%, so a 30m value in 8 years might be worth 29m now.

Excel’s PV function, PV(rate, nper, pmt, [fv], [type])

Rate: discount rate. Use the bond rate, not the bond yield, which was 1.4% in 2012
Nper: Number of payments in a year, so this would be the year at the current future value (e.g., year 1 would be 1, year 2 is 2, etc.)
Pmt: Payment made each period: 0
Future value: The future value you’re predicting you’ll make that year
Type: 0 (payments at the end of the period)

Excel returns this value as a negative value, and you’ll need to flip it for the next step.

  • Add up the present values for every year your business plan predicts. That’s your current value.

4. Pre/post money

  • Pre-money value is your value (from your cash flow sheet) at the present time, pre-money shares are the current shares outstanding.
  • The share price is constant during an investment round and is just value / outstanding shares. So if we have a $10m valuation from our cash flow statement and we have 10m shares outstanding, our share price is $1/share ($10m / 10m shares).
  • For a given investment, you need to figure out how many shares to issue, and it’s investment/share price. So if we take a $4m investment with a share price of $1/share, we’d need to issue 4m new shares.
  • Post-money value is your pre-money value + the investment, $14m in this case.
  • Post-money shares outstanding is the number of pre-money outstanding shares (10m) plus the new ones issued (4m, giving 14m shares total).
  • When you go into the next round of financing, the only constant is the number of shares you had at the end of the previous round. The pre-money value is re-calculated from your new cash flow statement and the process repeats.

5. Exit goals

  • A good exit is why people invest, and there are three primary options for a startup. It’s good to have your exit goal in mind, and it’s good if there’s more than one option (e.g., a buyout or you go public).
  • High-yield dividend: Fairly unattractive to a VC. At 3-4% returns (common), it takes ~20 years to double your money. At 10%, takes 7 years.
  • IPO: Can be expensive to setup ($15-30m) — Now subject to market volatility.
  • Buyout: Most common and attractive — receive some mix of stock and cash from the purchasing company

Once you’re done with this article, I’d highly recommend David Weekly’s Intro to Stock & Options for Tech Enterpreneurs and Startup Employees (via Andre Pang).

This post was originally on Medium