You can be on Entrepreneur’s cover!

Price Points: Six Steps To Valuing A Tech Startup Here are six key steps that should give entrepreneurs a good idea of how to look at valuing their startup when trying to raise funds.

By Amir Farha

Opinions expressed by Entrepreneur contributors are their own.

You're reading Entrepreneur Middle East, an international franchise of Entrepreneur Media.

Shutterstock

There are hundreds (if not thousands) of posts on the subject of valuation, specifically related to tech companies given the hype surrounding recent valuations and acquisitions that we are seeing in this space, and the fact that there are no real assets involved in these businesses and a lot of the emphasis is on the future potential. There are also several methodologies that one can use to conduct a valuation, including the Discounted Cash Flow method (DCF), Comparables method and The Berkus Method (and many more). Here, I've tried to simplify the process into six key steps that should give entrepreneurs a good idea of how to look at valuing their startup when trying to raise funds.

STEP ONE : IDENTIFY THE TOTAL ADDRESSABLE MARKET
The Total Addressable Market (TAM) provides an indicator of the potential size of the business in the future, and is something that we look at in detail when we invest in startups. We always look for bottom-up sizing, rather than top-down because it provides a much more realistic and measurable indicator of size. An example of a top-down analysis is: the size of food and beverage spend in MENA is US$10bn and if I can capture 2% of that market, my business can reach $200m in sales. As you can see, it's very subjective and macro in nature, without going into the actual market that one can sell to. An example of a bottom-up analysis is: if I am selling real estate listings to brokers and there are a total of 10,000 real estate brokers in my market, of which 1,000 real estate brokers are sellable, where I can charge them $1000/month, then my addressable market is $12m.

It's clearer and more measurable in description, and it provides a realistic estimate of what your business can generate "if all goes to plan." Once you've identified the TAM and with that, the potential size of the business, you are on your way to building the foundation of your valuation.

STEP TWO: FIND COMPARABLE COMPANIES

When looking for comparable companies, they do not have to be in the exact same sector. What's important is that they possess a similar business model to the company you are building. For example, if you are building a software-as-a-service business, then it would be useful to look at companies such as OpenTable, Sales Force, Dropbox, Box and others. You need to look for data related to sales, earnings before interest, taxes, depreciation, and amortization (EBITDA), and valuations -or market capitalization/enterprise value if you are looking at public companies- of public or private companies. Typically, early stage companies are loss-making, and so sales can be used as a proxy even though it's not a real driver of value (compared to EBITDA, given that EBITDA is a closer proxy to cash flows and inherent value). The next step would be to take an average of the Price/ Sales or EV/Sales, and EV/EBITDA ratios for those companies, and attach a discount rate to account for the liquidity risk, market risk and other factors related to the market you're in. For MENA, at least a 30% discount rate is appropriate. You will then arrive at your multiple, which will be important when assessing the valuation.

STEP THREE: DEVELOP VALUATION SCENARIOS
The idea here is to determine projections of your business over a five to seven year period. We like longer horizons at BECO, given that we are a holding company, not a fund, and therefore do not have a finite life. Your projections should have already been built ahead of this exercise. The important thing is to understand how big the business can be, both in terms of sales and EBITDA (since as the company matures, it should become profitable and reach somewhat stable margins).

Develop at least three different scenarios for these projections- we call them "Poor," "Good," "Great," and sometimes we include a "Home run" scenario. These different scenarios allow you to account for execution risk and potential issues with market-uptake or other things that can impact the growth of the business, and therefore the overall outcome. Once the projections are complete, the next step is to use the sales and/or EBITDA figures and attach the multiple created in the previous step to come up with valuation scenarios. For example, in the "Good" scenario, your company will generate $20m in year six, and companies similar to yours trade at 5x sales. If you apply a discount rate of 30%, you will have an average ratio of 3.5x sales, and therefore a valuation of $70m.

STEP FOUR: FACTOR IN THE REQUIRED RETURN

The return profile is essentially driven by the stage of the business, since they are a determinant of risk and therefore return. Earlier stage companies require a higher rate of return for investors, since there are various risks that are prevalent in those growth phases. These include market risk, product risk, growing pains, execution risk and others. We have minimum return profiles for the different stages, based on research we've conducted on the market. This factors in the risk and also the holding period of each stage, since earlier investments are held for longer periods. In summary:

  • Seed stage = 15x or > 70% IRR (seven year holding period)
  • Late seed = 10x or > 60% IRR (six year holding period)
  • Series A = 8x or > 50% IRR (five year holding period)
  • Series B = 5x or > 40% IRR (four to five year holding period)
  • Series C = 4x or > 30% IRR (3 to 4 year holding period)

With these expectations, and the previous steps complete, we have created all the variables required for us to reach an indicative range on valuation.

STEP FIVE: BUILD A CAP TABLE

When looking to invest in a startup, the first thing we do is build a capitalization table, which shows the different funding rounds that have been raised by the business, the investment and the number of shares (with percentages) owned by each shareholder. Once the historical cap table is built, and you've reached the current shareholding, you need to insert the new funds required and provide an assumption for the valuation. This should help generate a price per share for investors. Once we have established a working model, we would then make an assumption on the number and sizes of the future rounds required (since we invest early, there is likely to be a further two or three rounds of funding). The future rounds, if all goes well, will be done at higher valuations, but will also dilute all shareholders including the investor. When we invest, we assume that we would at least participate on a pro-rata basis (meaning we would invest the required amount that will keep our shareholding at the same level).

As a rule of thumb, entrepreneurs should give up anywhere between 15% and 33% in the earlier rounds of funding (15% is just enough to give investors skin in the game, and 33% can indicate that the entrepreneur is not that excited about his/her business because they're giving up a significant chunk).

STEP SIX: TEST SCENARIOS TO REACH A FAIR VALUATION
So now we have our model, with expectations of the future size of the business and implications on future rounds to the investor's shareholding. The next step is to link the two together. The idea here is to pick a valuation scenario, typically the "Good" scenario, and then projection the investors shareholding of that valuation (after the future funding rounds and dilution). So, if you are looking for $1m in funding at the late seed stage, we would need to get $10m in the next six years. If your business is going to reach $70m, but requires two rounds, with each diluting the investor's shareholding by 20%, the investor requires ca. 14% upon exit in order to generate $10m. The cap table will allow you to project the dilution and impact of future rounds. Therefore, if you know you have two rounds with 20% dilution, and you work back to the existing round to set the shareholding that ends up with 14% after the future funding, the result is ca. 20%, implying a pre-money valuation of ca. $4m and post-money of $5m.

In truth, we care about valuation, but we care more about execution. We love backing entrepreneurs that can demonstrate real passion, desire, ambition, experience and domain expertise that give us the belief that they can build large and successful ventures.

Amir Farha

Co-founder & Managing Partner, BECO Capital

Amir Farha is an entrepreneur, angel investor, startup advisor, and mentor. He has looked at early stage businesses from every angle, starting with a Swedish corporate VC firm based in London, followed by a stint at what was then the first seed capital fund in the MENA region, the Arab Business Angel Network (part of Dubai International Capital), before becoming an entrepreneur himself. Farha has invested in and confounded a number of local businesses, including Toolman, a property maintenance businesses; Purple PR, a boutique PR company which he successfully exited in 2012; and Tandem Partners, a startup and small business advisory firm in which he pled over 80 companies plan and grow their businesses. Farha is a co-founder of BECO Capital, and he currently sits on the board of two portfolio companies.
Thought Leaders

How To Improve Your Soft Skills and Emotional Intelligence in 7 Easy Steps

Using these simple but effective approaches will help a person in their business, life and relationships.

Women Entrepreneur™

Rayne Founder Sarah Jones On How To Build Solutions That Address Real Market Needs

"Embrace failure as a learning opportunity- because not every idea or decision will lead to success, and that's okay."

Business News

This Tech CEO Just Got $4.2 Billion Richer Overnight

As Nvidia's stock soars so does Jensen Huang's personal fortune.

Leadership

Doing Leadership Right: How To Avoid The Traps That Lead To Being A Bad Boss

The majority of bosses have not yet learned the skills to give meaningful, genuine, and timely appreciation to their people.

Finance

"We Got Funded!" Tunisia-Born Clusterlab Secures US$600,000 In A Pre-Seed Funding Round With The Aim To Advance Arabic Artificial Intelligence Tech

ClusterLab is on a mission to revolutionize how Arabic content is created and consumed by leveraging the power of artificial intelligence to ensure it is more accessible and engaging for users worldwide.

Entrepreneurs

The Business Of Funny: How Dubomedy Co-Founder Mina Liccione Redefined Comedy In The GCC

As Dubomedy approaches its 16th anniversary, co-founder Mina Liccione explains how her entrepreneurial venture has unabashedly redefined comedy in the GCC.