Milestone 2
Get Financial Ready
4 steps to figure out exactly how much capital you should raise and create your milestone chart and funding requirements to reach each milestone.
Step 1: Establish your risk mitigating milestone chart.
A "risk mitigating milestone" is an event that when completed, makes your company more likely to succeed. For example, the “risk mitigating milestones” of a new software company may be:
Designing a prototype
Getting successful beta testing results
Getting the product to a point where it is market-ready
Getting customers to purchase the product
Securing distribution partnerships
Reaching monthly revenue milestones
The key point when it comes to raising money is this: you generally do NOT raise ALL the money you need for your venture upfront. You merely raise enough money to achieve your initial milestones. Then, you raise more money later to accomplish more milestones.
Use the following table to create your Risk Mitigating Milestones Chart:
Item | Milestone to Achieve | Required Funding | Expected Result
...
...
...
Note:
Set 3-5 big future company milestones that will propel business growth in the coming 18 months.
Estimate capital amount required to achieve these 3-5 milestones.
Estimate the results: growth in sales ($/%), users growth post-investment (#/%) etc.
Startup Growth Calculator
The Startup Growth Calculator is a great online tool built by Trevor Blackwell, a founding partner at Y Combinator, to help startups determine how much money they need to raise to reach breakeven—or profitability. Once you reach breakeven, you have an infinite runway and can control your own funding destiny.
Step 2: Build a robust financial model to support your funding requirements.
The financial model provides prospective investors with insights into the company's financial performance, growth potential, and the potential returns on their investment. Key components including:
Revenue Projections: Outline how the company expects to generate income over the forecast period.
Expense Projections: Detail the anticipated costs associated with running the business.
Cash Flow Analysis: Project the company's ability to generate and manage cash, indicating its liquidity.
Sensitivity Analysis: Assess how changes in key variables (e.g., sales, costs) may impact financial outcomes.
Valuation: Determine the company's estimated value, often based on various valuation methods like discounted cash flow (DCF) or comparable company analysis (CCA).
Return Metrics: Provide potential investors with an understanding of the expected return on investment (ROI).
Financial Model Template
Download Capital2u Financial Model Template powered by eFinancialModels here.
Financial Model Checklist
To strengthen the credibility of your financial model, it should be a reflection of your business model and the milestones you are going to achieve with the round of funding you raise:
Basis of projections should be what you have actually achieved to date.
Only focus on what is going to drive significant value to your business.
Avoid overly optimistic projections, it should be realistic and aligned with your driving assumptions.
Your assumptions should demonstrate the depth of your knowledge about your industry.
Step 3: Establish a comprehensive capitalization table detailing ownership structures.
The cap table lists all the major shareholders and their proportional ownership of all shares issued by the company. It is the easiest way to map out your company’s ownership structure.
Cap Table Template
Download the Cap Table Template here
Step 4: Determine a realistic company valuation and collect information to defend it.
Investors are weighing you up against other investment opportunities they may have - when you are talking to them you need to make sure the investor is getting value, or they won’t buy.
However, If you undervalue your business, you will give away more than you should. Overvalue it, and you’ll turn off investors.
To do it right, both art and science are needed. Science: cash flow projections, revenue growth and the value of company assets. Art: determining the appropriate valuation approach to convince your investors that your business is worth a certain amount.
The Fundamental
There are 3 fundamental ways to measure what a business is worth:
Asset approach
Market approach
Income approach
The set of methods you choose to determine your business value depends upon a number of factors:
The complexity and value of the company's asset base.
Availability of the comparative business sale data from the market.
Business earnings history.
Availability of reliable business earnings projections into the future.
Availability of data on the business cost of capital, both debt and equity.
Business valuation model = key assumptions + choice of methods
If you are able to convince your investors that your business is worth a certain amount, then your business valuation works. You had made the right assumptions at the outset and picked the business valuation methods that made sense to your investors.
Valuation Methodologies
Common valuation methodologies to identify the value of a business including:
Discounted cash flow valuation (DCF)
Comparables approach (Market Comps)
Rule of thumb method
Discounted Cash Flow Valuation
The Discounted Cash Flow (DCF) valuation method is a widely used income-based approach in business valuation. It involves estimating the present value of future cash flows generated by a business. In simple terms it aims to arrive at the value today based on the cash flows of tomorrow.
How it Works:
Step 1: Cash Flow Projections: Begin by forecasting the future cash flows the business is expected to generate. This projection usually covers a specific period, often 3 to 5 years.
Step 2: Discount Rate Determination: Identify an appropriate discount rate or the required rate of return. This rate reflects the risk associated with the investment and is often calculated using the Weighted Average Cost of Capital (WACC).
Step 3: Discounting Cash Flows: Discount each forecasted cash flow back to its present value using the discount rate. The formula is:
PV= CF / (1+r) n
PV is the present value of the cash flow.
CF is the future cash flow.
r is the discount rate.
n is the number of periods into the future.
Step 4: Terminal Value Calculation: Estimate the business's terminal value, representing its value at the end of the explicit forecast period. This is often calculated using the perpetuity growth model or exit multiple method.
Step 5: Discounting Terminal Value: Similar to step 3, discount the terminal value back to its present value.
Step 6: Sum the Present Values: Add up the present values of the forecasted cash flows and the terminal value. This gives the total enterprise value.
Step 7: Adjust for Debt and Cash: Adjust the enterprise value for any outstanding debt and add any excess cash to arrive at the equity value.
Step 8: Determine the Per Share Value: If needed, divide the equity value by the number of outstanding shares to determine the per share value.
Step 9: Sensitivity Analysis: Perform sensitivity analysis by adjusting key variables (e.g., discount rate, growth rate) to assess the impact on the valuation.
Step 10: Final Valuation: Summarize the results and present the final valuation conclusion.
The DCF method involves making various assumptions, so it's crucial to critically assess the inputs and consider potential risks and uncertainties. It's often beneficial to use multiple valuation methods for a comprehensive assessment.
Market Comps
Market Comps valuation method is an example of the market-based valuation approach. It uses the trading metrics and ratios of other (similar) companies to derive a value for a business. Market Comps can also be used as a reality check for other valuation methods such as DCF.
How it Works:
Step 1: Identify Comparable Companies: Begin by identifying companies similar to the target business in terms of industry, size, growth prospects, and other relevant factors.
Step 2: Gather Financial Information: Collect financial data of the comparable companies, such as revenue, EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), and other relevant financial metrics.
Step 3: Calculate Valuation Multiples: Determine key valuation multiples, such as Price-to-Earnings (P/E), Enterprise Value-to-EBITDA (EV/EBITDA), or Price-to-Sales (P/S), based on the financial information of the comparable companies.
Step 4: Apply Multiples to the Target Business: Apply the selected valuation multiples to the corresponding financial metrics of the target business. For example, if the average P/E ratio of the comparable companies is 15 and the target business has an Earnings Per Share (EPS) of $2, the implied valuation would be 15 x $2 = $30.
Step 5: Adjust for Differences: Make adjustments to account for any differences between the target business and the comparable companies. Factors such as size, growth rate, risk, and market conditions should be considered.
Step 6: Sensitivity Analysis: Similar to the DCF method, perform sensitivity analysis by adjusting key variables to understand the impact on the valuation.
It's important to note that Market Comps provides a relative valuation, relying on the market's perception of similar businesses. However, differences between companies should be carefully considered, and adjustments should be made to enhance the accuracy of the valuation. Additionally, recent and relevant transaction data should be used for a more reliable assessment.
Rule of Thumb
The Rule of Thumb method is a quick and simple way to estimate the value of a business based on industry-specific rules or guidelines. While it is less precise than other valuation methods, it can provide a rough estimate for businesses in certain industries.
Here are a few common rules of thumb used to estimate the value of startups:
Revenue Multiple:
This rule suggests valuing a startup based on a multiple of its annual revenue. The multiple can vary by industry, but a common range might be 1 to 5 times annual revenue, depending on factors such as growth prospects, market conditions, and the startup's unique characteristics.
User or Customer Acquisition Cost (CAC) Ratio:
For startups heavily focused on user or customer acquisition, the CAC Ratio can be used. The valuation is based on the ratio of the Customer Acquisition Cost to the Lifetime Value of a Customer (CAC/LTV). A lower ratio may suggest a more attractive valuation.
Runway Multiple:
This rule considers the startup's runway, which is the length of time it can operate with its current cash reserves. Valuation may be estimated as a multiple of the runway, with factors like growth rate and market potential influencing the multiple.
Engagement Metrics:
Some startups, especially in technology or social media, may be valued based on user engagement metrics. For example, a valuation rule might be based on the number of active users, daily or monthly engagement, or other relevant user behavior metrics.
Technology or Intellectual Property (IP) Value:
Startups with valuable technology or intellectual property might be valued based on the perceived worth of their innovations. This could involve assessing the uniqueness of the technology and its potential market impact.
Pre-money Valuation Multiplier:
This rule involves applying a multiplier to the pre-money valuation of the startup, often based on factors like the industry, growth potential, and the team's expertise. The multiplier could range from 1 to 5 or more, depending on the perceived risk and upside.
Dave Berkus Valuation Method
The Dave Berkus Method is an approach to valuing early-stage startups developed by angel investor Dave Berkus. This method provides a structured framework for assessing the value of a startup by considering various qualitative factors.
The key elements of the Berkus Method include assigning subjective valuations to these factors, culminating in a maximum valuation cap of $5 million. It is particularly suitable for early-stage companies where traditional financial metrics may be less applicable. However, it is often used in conjunction with other valuation approaches for a more comprehensive assessment.
How it works:
Start with a pre-money valuation of zero, and then add the valuation ($) by the quality of the target company in light of the following valuation factor:
Concept Stage: Value for the startup's concept or idea: $20,000 - $50,000
Prototype Stage: Value for a developed prototype or working model: $50,000 - $500,000
Quality of the Management Team: Value based on the strength and experience of the management team: $50,000 - $500,000
Strategic Relationships: Value for established partnerships or collaborations: $50,000 - $500,000
Product Rollout or Sales: Value based on initial sales or agreements to purchase: $100,000 - $1 million
Market Opportunity: Value based on the size and attractiveness of the target market: $500,000 - $5 million
Competitive Environment: Value based on the startup's positioning and competitive advantage: $100,000 - $1 million
Berkus Maximum Valuation: Maximum valuation, even if the sum exceeds this value: $5 million (maximum)
Cayenne Valuation Calculator
Developed by Cayenne Consulting, it uses 25 questions to assess the progress of the new venture and calculate a pre-money valuation for investment purposes. www.caycon.com/valuation.php
Bottom Line
It's crucial to note that while these rules of thumb provide a quick estimate, they have limitations. The unique characteristics of each startup, the stage of development, and the industry context should be carefully considered. For more accurate and nuanced valuations, startups often engage with professionals or use more comprehensive methods like the Discounted Cash Flow (DCF) or Comparable Company Analysis (CCA) when appropriate.
Factors Affecting Valuation
Founder’s valuation and the investor's valuation will usually contradict each other. This difference in agreement is where negotiation of terms takes place. In the end, the agreed-upon valuation of your business will depend on the following factors:
The type of investor (angel, VC, family and friends, etc.)
Your prior success as an entrepreneur.
The “going rate” for similar companies (comparables).
The growth rate of related sectors / marketplaces.
Your revenue / user growth rate.
How likely or how soon you can be break-even / achieve profitability.
The team that you have around you.
IP or strategic partnership protection.
Your goal as a business founder is to create shareholders value fast, which will grow the company valuation.