The Daily Dose

George Deeb is the Managing Partner at Chicago-based Red Rocket Ventures, a startup consulting and financial advisory firm based in Chicago. You can follow George on Twitter at @georgedeeb and @RedRocketVC.

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One of the questions I get, more often than not, is what is the appropriate valuation of my business. This is typically in conjunction with an upcoming financing or pending takeover offer. And, the answer is quite simple: like for anything, your business is worth what somebody is willing to pay for it.

The methodologies applied by one buyer in one industry may be different from the methodologies applied by another buyer in another industry.

Here are some key drivers on how to value your business, in a way that will make sense to you, and will be in line with investor expectations.

Supply and demand

To start, let’s not forget about the obvious: the natural economic principles of supply and demand apply to valuing your business. The more scarce a supply (e.g., your equity in a hot new patented technology business), the higher the demand (e.g., multiple interested investors competing for the deal, and driving up your valuation in the process).

If you cannot create “real demand” from multiple investors, “perceived demand” can often work the same when dealing with one investor.

Never have an investor think they are the only investor pursuing your business, as that will hurt your valuation. And, before you start soliciting investment, make sure your business will be perceived as new and unique to maximize your valuation.

A competitive commodity business, or a “me too” story, will be less demanded, and hence, will require a lower valuation to close your financing.

Your industry

Related to the above is the industry in which you operate. Each industry typically has its unique valuation methodologies.

A next generation biotech business would get priced at a higher valuation than yet another family diner or widget manufacturer. As an example, a new restaurant may get valued at 3-4x EBITDA (earnings before interest, taxes, depreciation, and amortization) and a hot dot com business with meteoric traffic growth could get valued at 5-10x revenues.

So, before you approach investors with valuation expectations, make sure you have studied the valuations acheived in recent financings or M&A transactions in your industry. If you feel you do not have access to relevant valuation statistics for your industry, engage a financial advisor that can assist you.

Your stage of development

Where you are in your stage of development is a key driver in determining valuation. I like to break-out startup growth into four stages, not too dissimilar to four years of high school education: freshman, sophomores, juniors and seniors.

• Freshman are a piece of paper to beta site (bootstrap financed—raise $50K to $500K).
• Sophomores are beta site to full production site with initial users (seed stage angels—raise $500K to $1MM).
• Juniors have achieved a full proof of concept around their business, with rapid user or revenue growth, approaching up to $1MM in revenues (Series A venture capital—raise $1MM to $5MM).
• Seniors have grown to multi-millions of revenues and are ready to materially scale their businesses with a  significant capital raise (Series B venture capital—raise $5MM to $50MM).

Which each stage of your growth, your valuation is moving up along the way.

The valuation techniques

In terms of techniques investors use to value your business, investors will study things like:

• revenue, cash flow or net income multiples from recent financings in your industry
• revenue, cash flow or net income multiples from recent M&A transactions in your industry
• a discounted cash flow analysis of forecasted cash flows from your business.

As mentioned earlier, these multiple ranges can be very wide, and vary substantially, within and between industries. As a rough ball park, assume EBITDA multiples can range from 3x to 10x, depending on your “story.”

Forecasted earnings growth is typically the #1 driver of your valuation (e.g., a 25 percent annual net income grower may see a 25x net income multiple, and a 10 percent annual net income grower may see a 10x multiple).

If there are no earnings yet, with your business plowing profits into long term growth, then revenue multiples or some other metric would be used. Revenue multiples for established businesses are typically in the 0.5x-1x range, tech grow companies can be in the 1x-3x range, and in extreme scenarios, can get as high as 10x for high flying dot commers with explosive growth.

But, that is, by far, the exception to the rule. And, if there are no revenues for your business – unless you are a biotech business waiting for FDA approval or some new mobile app grabbing immediate market share before others for examples – raising funds for your business, at any valuation, will be very difficult. Investors need some initial proof of concept to get their attention.

Worth mentioning, private company valuations typically get a 25 percent to 35 percent discount to public company valuations. While at the same time, M&A transactions can come at a 25 percent to 35 percent premium to financing valuations, as the founders are taking all their upside off the table.

Make sure you adjust for these when comparing to any public market data.

Rule of thumb

At the end of the day, the investor will have a very good sense to what a business is worth, and what they are willing to pay for it. As they see deals all the time and typically have their finger on the market pulse.

So, collect a few term sheets from multiple investors, and compare and contrast valuations and other terms, and play them off each other to get the best deal. As a rule of thumb, expect to give up 25 to 35 percent of your equity, in each equity financing you make.

As an example, a seed stage sophomore raising $500K may be valued at $2MM post-money. An expansion stage senior raising $10MM, may be valued at $25MM post-money, as examples.

Back into a valuation that gets your investor a 10x return

Most importantly, you need to put on the hat of your investor in setting valuation to get them excited about your startup vs. the hundreds of other startups they see each year.

Investors are looking for that next 10x return opportunity, so make sure your five year forecasted financials will grow large enough in that time frame to afford them a 10x return.

As an example, if you are worth $5MM today post-financing, and the new investor owns 25 percent of the company ($1.25MM stake), they are going to need a financial plan that will get their stake up to $12.5MM (and the company valuation up to $50MM) within five years, without any dilution from subsequent financings.

This could mean driving EBITDA up to $5 to $10MM within that period. So, do not show them a financial forecast that grows less than that, and make sure you have built a credible sales and marketing plan to realistically achieve these levels before approaching investors.

There are too many nuances to valuing a startup business than I could do justice in this short post, but hopefully, this gives you a good sense to the high level issues in play.