What is a Valuation and Why is It So Critical To Know?

Unfortunately, 90% of the entrepreneurs that I meet don’t really know what a valuation is. I totally empathize with all these entrepreneurs’ ignorance because I didn’t know this stuff either when I started raising capital for my first company.  Fortunately for me, I had a few brilliant mentors who taught me what I needed to know. Unfortunately, traditional educational institutions don’t teach these must-know practical skills to entrepreneurs.

Your company’s Valuation is the worth (or value) of your company right NOW.

Unfortunately, your company’s valuation is a very ambiguous number when you’re a privately held company. There’s no private company “blue book” where you can look up its estimated value. In hard-core reality, your company is really worth whatever the last or highest buyer offered you (given that there’s even a market for it).

Calculating private company valuations is an ART, not a science!  It’s a value based upon what can you realistically justify and defend in a negotiation. There’s no one real way to do it, particularly if you’re a start-up.

However, with that said, your company’s valuation determines the ownership that you have to relinquish to investors for the capital that you seek (in an equity deal).

Therefore, it’s very important that you arrive at a justifiable formula and number to pitch and to sell your investors to close your funding. What you determine your company’s valuation to be prior to seeking funding will be initial “sticker price” of your equity.  More likely than not, this could just be the starting point of your negotiations with investors – or if you’ve made the argument well, you could get your asking price.

What Are Pre- and Post-Money Valuations?

Your Pre-money Valuation is the value of your company prior to having money invested in it. Post-money Valuation is the value of your company after the investment (the equation is shown in the diagram). The mistake that most entrepreneurs (and many investors) make is they think the equity price (or share price) is based upon the “Post-Money Valuation.”

It’s NOT!  It’s based upon the Pre-Money Valuation – what your company is worth right now!

Here’s a simple analogy:  Imagine you want to sell your house.  You price your house at $1M based upon your market research for similar homes to yours.  Now, someone wants to buy your house and then put in $4M worth of improvements and refurbishments into it.  Just because they’re going to put money into your house after your deal is done, doesn’t allow you to charge a higher selling price – it’s still only worth $1M – right now!  

You can’t say to the buyer, “Hey – but it’s potentially going to be worth $5M after you put $4M into it so I want to charge you $5M instead of $1M.”  That would be a ridiculous request – right? See how this works? It’s the same with companies – you can’t value your company based upon what the company will be worth after there is money put into it – you must value it based upon what it’s worth before the investment is put into it.  This is a critical mistake 90% of all entrepreneurs make and its why many deals don’t get done – the entrepreneur has over-inflated their company’s current value.  

How Do You do Your Company’s Valuation – A Two Step Process

If You Want to Maintain More Than 50% Ownership,
Then Your Pre-Money Valuation Must Be MORE than the Amount of Capital You’re Raising!

First, keep in mind that there are experts in this field that charge anywhere from $5K – $100K to do a valuation for a company.  It’s considered a skilled art.  However, it’s not difficult to learn.  At this stage of development, your company’s valuation is likely simple enough to do it yourself (or at least get a round-about value) and I suspect you can’t afford a high-paid consultant.

No one knows your company better than you do and when in a pinch – entrepreneurs must learn these new skills to lead their company.

Additionally, this exercise will teach you how to defend your valuation in your negotiations with investors.  This is critical as you’ll never be able to close a deal if you can’t defend what it’s worth (unless you find a highly novice investor that doesn’t want to negotiate).

Also, you should carefully evaluative any matrix you use.  I’ve read the advice of a few of these online funding platforms that describe how to do valuations and the matrixes they offer are very weak (if not wrong).  I say this because many of the matrixes I’ve seen proposed base the valuation too much on the “future value” (post-money valuation) rather than the “current value” of the company (pre-money valuation).  

Now, most entrepreneurs would prefer to use one of these flawed or weak formulas because their valuation looks much higher.  But once again, go back to analogy above of the milk and cereal – unless you’re one of the rare few entrepreneurs that happens find an uneducated, novice investors that will fall for your over-inflated price (value), you’ll likely never raise the capital you seek and likely your company will die.  

It’s much better to be realistic now and create more value if necessary prior to seeking funding (e.g., by staging funding, creating value using one of the “4-P’s” (see below)) if you need to, rather than to fail altogether.

Step #1 – Your Valuation Matrix

As stated above, valuations in privately held companies are determined by market demand, which is a very ambiguous number.  Therefore, a valuation matrix is a formula that makes-up a justifiable argument to demonstrate the company’s value.

Below are three matrixes often used in the industry.  Ideally, if you can use two matrixes and average their findings – it makes for a much stronger argument when negotiating with investors.  However, not all of the matrixes can be used by all companies depending on the stage of development (if you have revenue or not).  Below is an overview of each matrix:

Asset Matrix: (Great for all Companies especially Start-Ups and Early Stage). The Asset Valuation Matrix consists of adding up all of the assets in your company.  Maverick calls these the “4 P’s”: Perception, Proof, Partnerships and Intellectual Property.  The Asset Matrix lists a justifiable assumption for each category and establishes a value, then adds up all the values to arrive at a pre-money valuation.  The categories are: (1) physical assets; (2) management team sweat equity and capital contributions; (3) intellectual property; (4) customer contracts; (5) strategic partnerships and JV’s (joint ventures); (6) goodwill; (7) cash on hand; and (8) other miscellaneous assets.  

Strategic Partnership Matrix: (great matrix for companies with Strategic Equity Partners):  The Strategic Partnership Valuation Matrix involves projecting the company’s valuation based upon the terms of a strategic partnership (e.g., equity for services).  If by definition your company’s worth (valuation) is what the last or greatest purchaser paid for it, then logic states that if you cut an equity deal with a partner for services/products or some value, then you can value your company based upon the value of this strategic partnership.  For example:  If you cut a deal for equity for technology services, you could bid-out these same services to a few tech development companies and then average these bids to determine a value for the equity that you traded for services.  This is a very strong argument and can increase a company’s valuation tremendously.  Because these services are considered “soft-dollar” investments versus “hard-dollars” you should account for this in your discounting factor.  See explanation below.

Enterprise Valuation: (only for companies with revenue).  The Enterprise Valuation is the most widely used valuation matrix.  It is determined by taking your company’s EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) times a “multiple”.  This valuation matrix is really saying “we know for sure that the company is at least worth X based upon its profit before taxes – so, if we bought the company now, we know it would be worth at least X… times a multiple of Y.”  Now, the question is what is the multiple (Y)?  

To determine your valuation multiple, you can research publicly traded companies in your industry and determine their current valuation multiple.  However, please keep in mind that publically traded companies’ multiple are almost ALWAYS higher due to the liquidity of their shares than privately held companies.  Traditionally, multiples used by most investors for privately held companies are conservative (ranging between 3 and 7), with the majority of investors and investment banks using “3” as their default multiple.  I often get the argument from my tech entrepreneurs that think their multiple should be in the teens – well, don’t count on that! Remember: investors are always going to take a more pessimistic viewpoint.  

Step #2 – Applying your Discounting Factor and Subtracting out Debt

Regardless of what you determine your pre-money valuation to be, investors will almost always apply what’s called a “discounting factor”. It’s a percentage that is applied to the valuation to discount it based upon risk.  (e.g., 20%, 30% or more).  This discounting percentage is based upon many factors (e.g., how strong is the management team, how long to profitability, competition, level of experience, etc.).  It’s a series of weighted questions to determine the level of risk in your deal.  Just keep in mind you’ll need to apply some percentage to your valuation (because investors will if you don’t).  Also, you will need to subtract out any debt the company owes from the final pre-money valuation.

Transforming Your Valuation Into an Equity Offer

Using your pre-money valuation that you just determined, you need to calculate approximately how much of the company you’re willing to sell to get the money you need. Think of this in terms of percentages even though what you’re really selling is stock which is represented in the form of a percentage of ownership. Imagine a scale, and on one side is your company BEFORE you raise capital (now) counterbalanced by the value of the money the investor is investing.

One of the things you’ll notice about most investors is that they are math wizards! They seem to calculate everything quickly in their heads (of course, this is their area of expertise and they do this every day). You have to become as quick as them at these mental calculations to negotiate with any strength.  Therefore, you need to learn a few pre/post valuation mental-calculating short-cuts. At first, it may seem intimidating to a novice.

However, once you see how it’s calculated, you’ll see it’s really not difficult to do. Expect from the moment investors hear your pitch that they are calculating your pre- and post-valuations in their heads to determine what equity percentage they want for the money you’re requesting.  Here’s the math short-cut that starts with the equation:

Pre-Money Valuation + Money Invested = Post Money Valuation

HOW TO CALCULATE PRE/POST VALUATIONS QUICKLY IN YOUR HEAD

Example #1: You want to sell 20% equity for $1 million. What are you saying to the investor is your pre-money valuation? Here’s the math:

20% Equity = $1M Investment, therefore,
If 20% x 5=100%, then
$1M x 5 = $5M (Your Post-Money Valuation is $5M).

Remember the equation for Pre/Post Valuations is: (Pre-Money + Investment = Post-Money)
Therefore, Pre-Money + $1M = $5M
Pre-Money = $5M – $1M (the Investment)
Pre-Money Valuation = $4M

You are telling the investor when you ask for $1 million for only 20% equity in your company, that your pre-money valuation (current valuation) is $4 million. Can you justify that?

Note:  A critical mistake that both entrepreneurs and investors make is they forget to subtract out the money invested (part II above).  Remember: you’re seeking the pre-money valuation, NOT the post-money valuation!

Example #2: Let’s try to do it one more time, but now try to do it quickly in your head. You want to sell only 33.3% equity of your company’s to the investor, but you still want $1 million. What are you telling the investor is your current pre-money valuation?
33.3% x 3 = 100%
$1M x 3 = $3M (Post-Money Valuation)
$3M (post money) – $1M (investment) = $2M Pre-Money Valuation

So, you’re saying your company is currently worth $2M.  Can you justify that?

Hopefully, you’re seeing how easily this can be done. With this knowledge, you know now that you must be able to JUSTIFY a pre-money valuation of $2 million if you only want to give up 33% for $1 million. Got it? This is very important in negotiations.