What's Your Biz Worth?
Valuing a new biz is more art than science. Here are three steps to pricing your startup while keeping it real.
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It's commonly said that business valuation is more art thanscience. If this is true, then the practice of valuing a startupbusiness is squarely in the domain of the artist.
Nevertheless, entrepreneurs need to put a value on theirstartups in order to raise money, and investors need to put a valueon their investments to generate liquidity. Since neitherentrepreneurs nor investors are known for right-brain artisticthinking, this article aims to provide some tips for left-brainthinkers to make sense of startup valuation.
1. You are what the market says you are. If investors aretelling you that your startup is worth $1 million, then that'swhat it's worth. You might think it's worth more. You mighteven know it's worth more because your company may have morethan $1 million is liquid assets, or more than $1 million inreceivables, or more than $1 million in sweat equity. But ifyou're unable to raise money for your startup with a valuationabove $1 million, then you'll have to accept the marketvaluation.
However, this isn't always true. If you raise money fromrelatives and friends rather than professional investors, it'spossible that your company has been overvalued or undervalued (morelikely, overvalued). For example, if you persuade your father andyour rich aunt to purchase shares in your business at $20 pershare, it doesn't mean that future investors will pay more than$20 per share-even if your business grows and prospers.
2. But you can also tell the market what you'reworth. Although this might seem to contradict the point madeabove, it's possible to tell the market how to value yourcompany. After all, if investors think your startup is worth $1million, it's usually because of something you've toldthem. By definition, startups don't have a history of financialperformance on which to base a valuation. Therefore, it's up tothe entrepreneur to develop a process for valuing the company basedon comparables and financial projections.
- Comparables: Find out how much similar companies in yourindustry and geography are worth. You can use sites such asBizBuySelland BizQuestto determine how much businesses are selling for in your industry.If you have a high-tech or high-growth startup, accountants andlawyers are among the best advisors to help you determine themarket rate for comparable companies at your stage. In myexperience, attorneys tend to overvalue startups, and accountantstend to undervalue startups, so you may want to talk to both beforemaking a decision.
- Financial forecasts: Although it's notoriouslydifficult to forecast revenue at a startup, you'll need to dothis to determine value-and eventually to defend your valuation.For example, if you're starting a pet food store, yourvaluation and financial projections will likely be lower than ifyou're starting a speculative biotechnology firm.
3. You're not really worth anything until you'reprofitable. If you're not profitable, your businessprobably isn't worth very much. That is, it doesn't have asmuch liquidity as it would have if it were profitable. Manybusinesses cannot be sold, since there aren't enough businessbuyers for every seller. Almost all unprofitable businesses cannotbe sold for the same reason.
This makes valuation particularly challenging for a startup.Since young businesses take time to become profitable, the trick ofvaluing startups is to focus on the future. First, determine howmany years it will take to be profitable. A business with a longroad to profitability will usually be worth less than one with aquick path to profitability. Next, determine how much comparablecompanies have been valued at when they reached profitability. Acompany that could be worth $5 million at profitability will beworth some fraction of that number at the startup stage, based onfactors such as the likelihood of success, the time frame to exitand the quality of the management team.
It's easy to get caught up in the excitement of valuing yourcompany at the highest amount possible and forget that you'llone day have to deliver on the expectations of investors. It'salso tempting to adapt your business model to maximize startupvaluation. Be careful about overvaluing your startup with faultyassumptions; it will only make your life moredifficult-particularly if your investors have governance rights,such as positions on the company's board.
Much like artists, entrepreneurs need to use creativity invaluing their startup businesses. Traditional approaches tovaluation based on book values and P/E ratios are akin to paintingby numbers. If you want your startup to be a masterpiece,you'll need to use the right side of your brain as much as yourleft to determine value.
Asheesh Advani is president of CircleLending, aloan administration company that facilitates personal loans,small-business loans, and mortgages. He and his company havewritten the Small Business Financing Guidefor startups andhave helped small businesses in more than 30 states launch andfinance their growth.