The is the ninth article in a series of posts focused on deconstructing the essential elements of creating a Business Plan.
Business Planning Articles:
Valuation & Ask Deconstructed
The ninth section of a business plan centers upon determining the value of your business and of then formulating the ask, or offer, you aim to present to investors or capital partners.
This section of your business plan should be between 1-2 pages in length.
The purpose of the Valuation & Ask section is to share with the reader your perspective on the present economic value of your business.
Because the value of your business will likely change overtime, it is important to make sure this section logically complements the rest of your business plan and is up to date.
The ask represents what your business needs, typically in the form of capital, to progress to it's next stage, and what you are prepared to offer for access to that capital or resource.
Understanding how to value your company can be a real challenge for early stage business leaders.
For many entrepreneurs the exercise can become a highly emotional and personally difficult, but startup leaders should work to maintain a productive level of objectivity and practice emotional discipline.
Demonstrating a high level of passion for your enterprise is no doubt a virtue that can often excite and convince an audience, but the process of raising venture capital is often emotionally straining. Investors will doubt your valuation, question your methodology, and test your ability to remain level-headed and/or openminded during the entire process.
Entrepreneurs should consider meditation, practice self-control to conceal their innermost emotions, and always be open minded because the capital raising process is a form of negotiation that often takes significant time and energy to navigate successfully.
Practically speaking, the exercise of determining your company's valuation and then sharing the methodology with your reader can be achieved using a variety of different methods.
Here, we will cover a variety of methodologies that can meaningfully help how you determine your startups valuation.
On a basic level, valuing a startup can be compared to choosing a fantasy sports team.
The more athletes you add to the group the higher the value of the team becomes. Moreover, the value of the team can be further affected by adding athletes with greater or lesser experience and ability.
Lastly, the performance of the team in a competitive environment will be greater than any individual’s single contribution. Teamwork and cohesion, therefore also affects the value of the team.
Similarly, startup entrepreneurs should seek to accumulate different forms of assets including people, resources and technologies to increase the value of their business and reduce the probability of failure.
The more assets a startup accumulates the higher it's valuation can objectively be determined.
But, entrepreneurs should also keep in mind that determining valuation, particularly for early-stage businesses, is more art than science and typically has little to do with the current value of the company.
Most venture capital deals in early stage businesses are done as convertible preferred stock investments.
This means that the money investors provide to the business is functionally similar to a debt instrument in the event that the business does not work out as anticipated. Investors adopt this approach to protect their money should the business go bankrupt by ensuring that they will get their money back before the entrepreneurs and other stakeholders do.
Entrepreneurs should accept that this approach is widely adopted by investors because only a small portion, a minority, of the businesses they invest in will work out as anticipated.
This perceived negative attitude of investors should not be taken personally. Nor is it truly a negative attitude. Investors are simply trying to make educated decisions on the best investment opportunities that present the least amount of risk.
For early stage businesses, there are 8 common approaches to determining the value of a company.
Some of these methodologies are practically more appropriate for investors than entrepreneurs, but small business leaders should review all of the approaches to understand how investors can approach the valuation exercise.
Moreover, understanding the different methodologies to value a business is the best way to defend any valuation you calculate with evidence and confidence.
1. The Berkus Method
The Berkus Method is a very simple technique to estimate the value of your company.
First, compare your business to a similar company that has been recently valued in the startup ecosystem and that has achieved some measure of success.
Then, assess how your company compares to the other businesses across 5 different criteria; sound idea, prototype, quality management, strategic relationships, product rollout or sales.
In the eyes of the investor, each criteria represents the following:
A. Sound Idea
Represents the basic value and risk of the concept.
Represents the technology and the risk associated with it.
C. Quality Management
Represents the execution risk of the leadership building the company.
D. Strategic Relationships.
Represent the market risk of developing an marketing the solution.
E. Product Rollout or Sales
Represents the production risk of the solution, and the evidence of market traction.
For each criteria set a $ value and the total of the values should equal your estimated startup valuation.
Should your business operate in a unique industry, assume a maximum value of $500,000 per category.
Practice objectivity when estimating of how well you business fulfills each criteria. Applying the full $500k for each of the criteria will raise a red flag and indicate that you approach lacks an objective perspective.
By applying this method, the maximum valuation of your business is $2.5 million, $2 million for pre-revenue business, and $2.5 million for post-rollout or revenue generating early stage businesses.
Berkus Method Example
The Berkus methodology best serves entrepreneurs of pre-revenue and pre-money startups, meaning companies that have not generated income or raised significant venture capital.
The methodology is also an effective tool to gain perspective on what your business needs to work on to maximize its potential and value in the marketplace.
For more information on the Berkus Method, click here.
2. Risk Factor Summation Method
The risk factor summation method is a slightly more complex version of the Berkus Method. With this methodology, 12 criteria are used determine a startup’s valuation, and the criteria are judged based on the level of risk each factor represents for your business.
The common twelve criteria include:
2. Stage of Business
3. Legislation/Political Risk
4. Manufacturing Risk
5. Sales and Marketing Risk
6. Funding/Capital Risk
7. Competition Risk
8. Technology Risk
9. Litigation Risk
10. International Risk
11. Reputation Risk
12. Potential Lucrative Exit
The first step is to assign a value to your startup business.
Then, entrepreneurs must adjust their valuation based on 12 risk factors.
Assign an initial $ value to each risk factor based on the average value of a similar company within your industry. This is the most difficult part of the methodology because finding actionable data on other businesses can be a challenge.
Risk Factor Summation Method Example
For each risk factor use a multiple of $ 250,000 to value to risk of your business compared to your determined industry standard. A maximum of +$500,000 represents very low risk, while -$500,000 represents a very high risk.
Some use a point system of +2 for very low risk, +1 for low risk, 0 for neutral, -1 for high risk, and -2 for very high risk. And, then assign the +/- $250,000 for each point.
The risk factor summation valuation method is more appropriate for investors when judging pre-revenue and pre-money startups than entrepreneurs.
For more information on the Risk Factor Summation Method, click here.
3. Scorecard Valuation Method
The Scorecard Valuation Method is similar to the Risk Factor Summation Method in so far as specific criteria are identified and then weighted. However, instead of judging the value of a businesses based on risk, this methodology determines value based on the venture’s likelihood of success.
First, determine the average pre-money valuation of pre-revenue companies in your region and sector. Pre-money represents startups who have not received a significant round of capital investment.
Second, establish a number of criteria, and assign percentages to each criteria based on how impactful the factor is to the company’s success. Together the percentages should total 100%.
A typical list of criteria and impact percentages includes the following elements:
Strength of Entrepreneur & Team 30%
Size of Opportunity 25%
Competitive Environment 10%
Need for Additional investment 5%
Customer Feedback 5%
Next, determine how your company compares to each criteria.
For example if you consider your strength as an entrepreneur & team is above the industry average, assign a value of 125% to the criteria.
Then, multiply the value you assigned to each criteria, i.e 125%, to the criteria’s standard impact percentage, i.e 30%, to calculate the factor, which in this case should equal 0.375.
Lastly, the sum of all your factor results equals the multiple to apply to the standard valuation of start-ups in your region and industry.
Scorecard Method Example
Similar to the David Berkus and Risk Factor Summation Method, this methodology is best suited for investors to value pre-money and pre-revenue startups.
To read more about the Scorecard Valuation Method, click here.
4. Comparable Transactions Method
Should your business operate in a popular industry with extensive ties to the venture capital community, the Comparable Transactions Method is an effective way to determine your company’s valuation.
The methodology is sometimes called the M&A Comps or Deal Comps and is the chosen method to determine the enterprise values for mergers and acquisitions deals of similar companies.
With this methodology the first step is to identify a common indicator between your company and others in your industry that effectively represents the value of both businesses.
Examples of common indicators include; sales, revenue, monthly recurring revenue, number of retail outlets or locations, patents, intellectual property, headcount, users, weekly active users, gross margin, EBITDA, etc…
After identifying the common indicator then simply compare the performance of the other company or companies against your own.
Comparable Transactions Method Example
The table above illustrates the methodology using both Earrings Value/Sales and Weekly Average users to determine the value of a company.
The results reveal that the value of your business can be either $332 or $3,520. The stark difference between the values demonstrate that the industry and common indicator can significantly impact the calculation of your company's value.
When using financial data as a common indicator, it is good practice to identify relevant multiples for instance Enterprise Value/Sales, or Enterprise Value/EBITDA and apply the multiple or weighted average of the multiples to your company.
The Comparable Transactions Method is an effective valuation tool for both entrepreneurs and investors of both pre-money and post-money startups, as well as pre-revenue and revenue generating companies.
For more information on the Comparable Transactions Method, click here.
5. Book Value Method
The Book Value Method centers upon tabulating the value of all your company’s tangible and intangible assets.
Tangible assets include; property, equipment, furniture, technology, etc… They include goods of a material nature and can be easily reflected in accounting.
Intangible assets include; brand, intellectual property, databases or customer records, etc… They are of an immaterial nature, and are not easily monitored or valued.
In some cases, intangible resources can be called intellectual capital that can be further divided into 3 categories:
A. Human capital
Represented by the skills sets of the stakeholders.
Represented by the relationships between stakeholders.
C. Structural capital
Represented by legally protects resources like intellectual property, as well as operating processes, policies, information, content, leadership traits and culture.
After calculating the sum of your business’s tangible and intangible assets, then subtract any liabilities your business may have, for instance; debts, loans, lawsuits, accounts payable, and in some cases preferred stock.
The result will represent the economic value of your company.
Book Value Method Example
The Book Value Method can be utilized by entrepreneurs and investors, however, because of it’s focus on tangible assets the methodology it is not well suited for startups. Most startups focus their valuation on intangible assets such as intellectual property and users.
The Book Value Method is therefore best applied to established companies who are actively generating revenue. Whether the business has or has not raised venture capital is irrelevant for the Book Value technique.
The technique is equally valid for entrepreneurs and investors.
For more information on the Book Value Method, click here.
6. Discounted Cash Flow Method
The Discounted Cash Flow Method utilizes future cash flows of your business to determine the present or current value of your company.
For this methodology, the business must generate a certain amount of cash as income, revenue, or profit each year.
Under this method, the present value of a business rests on it's ability to generate cash in the near future, typically over a 2-5 year period.
Applying the Discounted Cash Flow Method requires adopting the following formula to calculate the value of your business future cash flows.
Discounted Cash Flow = CFn / (1+r)n
CF = Cash Flow
r = Interest or Discount Rate
n = Period/Year
First, take your company’s end of year cash flow, and then divide it by 1 + the annual interest rate, which should equal your assumed growth rate for the following year. So if your company grew by 5% this year, then you can apply the 5% as your interest or discount rate.
If you believe your company will grow by 10% in the next year, than apply that percentage as the interest or discount rate.
Then, repeat the process for however many years you are attempting to project your company’s value on. Each year’s cash flow should be added together.
Your formula for a 3 year period should look like this:
DCFn + DCFn + DCFn
DCF = Discounted Cash Flow
n = Period/Year
If you believe that your company’s growth will change year to year, apply a weighted average percentage to each year you apply the discounted cash flow formula.
The final component to calculate is your company’s Terminal Value. Terminal value can be thought of in two ways:
A. First, as a representation for the indefinite continuation of your business, in which cash you should apply the following formula.
TV = DCFn(1+Lr) / (r-Lr)
DCFn = The cash flow of the last year of your analysis.
Lr = Long Term Growth Rate
r = Interest or Discount Rate
n = Period/Year
Therefore, the terminal value of your company is calculated by multiplying your company’s final projected cash flow by 1 + the long term growth rate. The long term growth rate is typically less than the year to year growth rate or discount rate applied to each year’s calculated Discounted Cash Flow.
The result should then be divided by the discount rate you applied to the final year’s cash flow minus the long term growth rate.
B. Second, Terminal Value can serve as a representation of an exit after a defined period of time, in which case you should apply the following formula.
TV = Exit Value / (1+Lr)n
Exit Value = future value of your startup when it is sold (apply the Comparable Transactions Method or other suited Valuation Methodology)
Lr = Long Term Growth Rate
n = Period/Year
Finally, placing all the formulas together, calculating the value of your business using a 3 year Discounted Cash Flow Model looks like this:
PV = DCFn + DCFn + DCFn + TV
PV = Present Value, which in this case would be the Enterprise Value.
DCF = Discounted Cash Flow
n = Period/Year
TV = Terminal Value
Discounted Cash Flow Method Example
The Discount Cash Flow method can be utilized by entrepreneurs and investors to determine a business's valuation.
The methodology’s focus on cash makes it better suited for revenue generating business, and preferably cash positive ones.
For more information on the Discounted Cash Flow Method, click here.
7. Chicago Method
The Chicago Method is a valuable methodology to apply for your company's valuation when your business or startup has unlimited potential.
This perspective is typically limited to internet, software or service businesses among a few other exceptions.
The Chicago methodology specifically addresses the challenge of valuing infinite potential by assigning three valuations to your business.
A worse case scenario (a low valuation), a normal case scenario (an industry standard valuation), and a best case scenario (a high valuation).
The low, normal and high valuations can be calculated with the Discounted Cash Flow, another appropriate valuation methodology, the internal rate of return formula, or other relevant and industry standard multiples.
Then, for each valuation, assign a percentage that reflects the probability with which each scenario is likely to happen.
Chicago Method Example
Lastly calculate the weighted average of the 3 valuations to determine your businesses valuation using the Chicago Method.
Underlying this valuation method is an assumption about the potential upside of the business in the near to longterm future and not an analysis about the tangible or evidence based value of your business.
The Chicago Method is appropriate for entrepreneurs and investors. However, the methodology is best suited for revenue generating startups because specific evidence (sales, revenue, users, etc..) is often required to demonstrate the potential of the business.
For more information on the Chicago Method click here.
8. Venture Capital Method
A common valuation method used by individual investors and venture capital groups is the Venture Capital Method.
With this method, investors determine the return on investment they would like to reap from their investment into your business. The desired return on investment investors expect can vary significantly depending on the industry, so it is always valuable for entrepreneurs to examine the venture deals happening within their sector to build the right perspective.
Generally, investors seek to reap a return on investment of anywhere between 10 times to 30 times their initial investment.
For technology and internet companies desired ROI is often higher.
The traditional formula for Return on Investment (ROI) is:
ROI = Terminal Value / Post-Money Valuation
Terminal Value = The value of your company at the event of exit or sale.
Post-Money Valuation = The value of your company after an investment is made.
Typically calculating your company's Post-Money Valuation involves adding your company’s pre-money valuation + the new investment made into your business. However, for the Venture Capital Method post-money valuation can also be calculated with the following formula:
Post-Money Valuation = Terminal Value / Anticipated ROI
Terminal value is determined by establishing a reasonable expectation for a company’s revenue in the year of it’s sale or exit by the investor. With a future revenue expectation, investors can then estimate the company’s earnings in the year of the sale or exit by comparing the expected earnings with other similar companies in your industry.
Now, with a Post-Money valuation, a pre-money valuation can be easily calculated by subtracting the investment “to be made” into your business from the post-money value calculation.
Pre-Money Valuation = Post Money Valuation - Investment
As an example, let us assume that an investor desires a 20X return on their investment on $2 million dollars into your startup for a 30% equity stake.
A 20X return, means that for every $1 dollar the investor puts into your company today they expect to receive $20 at a future date, for instance after a period of 5 years.
At the end of 5 years, the investor believes your startup could be sold for $150 million dollars.
With these data points; the investment, the expected multiple on investment return, and the perceived future valuation of your startup, investors can determine your company's present value by applying the follow methodology.
Venture Capital Method Example
In this example the enterprise value is the pre-money valuation attributed to your business before any investment is made.
The Venture Capital Method is best suited for investors evaluation pre-money and post-money startups.
For more information on the Venture Capital Method, click here.
When composing your Valuation & Ask section of your business plan, it is good practice to share with the reader the methodology you adopted for your valuation, and briefly explain why it was chosen.
Simply sharing a nominal figure is not enough.
Especially for pre-money and pre-revenue startups, entrepreneurs should provide some justification to the reader for the valuation they determine for their business.
Depending on the methodology you adopt, the best way to provide justification is to offer between 3-7 reasons or factors that contributed to determining your valuation.
Reasons can include among the following factors:
1. Founding Team
2. Potential of Idea
3. Market Size
5. Intellectual Property
9. Status of Business
10. Evidence to base Current Achievements
For revenue generating start-ups a great reason would be sales. For internet start-ups a good justification can be the number of subscribed users.
Lastly, for each reason or factor within your valuation, always assign a $ value, which together should add up to your startup’s total valuation.
Adopting this approach is a great way to offer insight to the reader of your thought process, and of the factors you believe contribute more or less significantly to your valuation.
When calculating your company's valuation, and conducting subsequent negotiations with investors, it is important to understand many of the venture capital terms
Among the confusing elements of determining your startup’s valuation when negotiating with investors are the terms pre-money valuation and post-money valuation.
Pre-money valuation represents the valuation of your company before any investment has been made into the business by the current round of investors.
Post-money valuation represents the valuation of your company after an investment has been made into the business by the current round of investors.
Pre-money valuation + Investment = Post-Money Valuation
So, if your company has a pre-money valuation of $1 million, and then receives an investment of $500k, the post-money valuation would be $1.5 million for which the investor would take a 33.3% stake in your company’s equity.
Looking into the future, investors are always keen to recuperate their investment in the event of an exit or initial public offering.
The exit value of your business represents the price that the business will be sold for, if it is eventually sold. Exit values are typically determined by calculating the past exits of comparable companies.
Return on Investment
When deciding whether or not to invest in your business, investors will establish an assumption about the expected return on investment they would like to recuperate at the exit event.
Using exit value and expected return on investment, we can also calculate post-money valuation with the following formula.
Post-Money Valuation = Exit Value / Expected Return on Investment
Expected return on investment is typically a multiple of the investment made into a business, investors typically seek between a 10X to 30X return on their investment over a 5-10 year period.
So if investors determine the pre-money valuation of your business is $1.5 million, and decide to make a $500K investment into the company, making your post-money valuation $2.0 million and their equity stake 33.3%, then a 25X expected return on investment over a 5 year period would make the desired exit be $50 million.
Working backwards and assuming a desired exit of $50 million, we can make the following calculations.
Post-Money Valuation = $50 M / 25X = $2 M
Pre-Money Valuation = $2 M - $500K = $1.5 M
Entrepreneurs should be confident when negotiating with investors and display a willingness to learn how the investors approach their investments.
Always ask for clarification about the meaning of the terms being used in a deal and how investors make their calculations. Doing so will ensure that all stakeholders are on the same page, which can minimize the chances of disagreement and a relationship breakdown.
The last component of the Valuation & Ask section of your business plan is to declare what you as asking for in dollar terms as investment for your business, and what you are willing to offer (equity or debt) to the investor(s) for their investment.
The best way to approach this section is to state in very clear terms what you capital need is for this round of investment and the equity your company is willing to offer for the investment, or the debt and terms of interest your business is willing to take on for the investment.
Expressing this can either be done in a stand alone paragraph or in bullet points;
Capital Requirement : $1.5 Million
Equity Exchange: 30%
Following your ask, it is important to offer several detailed reasons to explain why your company needs the capital investment and for how long the investment will sustain or grow your operations.
Typically a period, called a runway, of 6 - 24 months depending on the round and level investment is common for startups and early-stage businesses.
Several common reasons startups needs capital investment include:
Establishing an executive team to fill necessary roles
Hiring necessary staff to grow operations
Purchasing technology and/or raw materials
Funding inventory for purchase orders
Obtaining proper legal protections
Moving to a location or expanding workspace
Developing a prototype of the solution
Testing a product/service in the market
Initiating/expanding marketing efforts
Running a trial program
For each reason, provide a few details in list form to provide greater context for the reader about the short term and long terms needs of your business.
Clearly establishing your company’s capital needs, and probable uses of the investment will convince the reader that you have a solid perspective of where your company needs to go in the short term, the costs associated with your strategy, and of how that strategy builds into your long term vision.
Finally, state how much capital you will probably seek in the next round of funding should your business require it at the end of the runway provided by this round of investment.
Rather than providing a dollar amount, simply state the multiple, for instance 3X or 5X, of the current round as your target for the next round of capital investment.
The valuation & ask section of your business plan should follow a pragmatic series of assumptions based on subjective areas that broadly relate to every aspect of your company.
Investors know this, so being adequately prepared and presenting a logical argument for your valuation is ultimately the most important part of the task.
The process is more art than science, but the valuation should be based on sound financial data that you will provide in the following section of your business plan, the Financial Plan.
The more evidence you can provide for your valuation, and the more you can demonstrate an understanding of the complexities involved in valuation techniques from the persecutive of the entrepreneur and the investor, the more credible your calculation and position will be.
The valuation exercise is not necessarily a task of precision.
Claiming your business is worth $347,645.21will raise some eyebrows, and no investor wants to argue about the dollars and cents of your valuation. So round any valuation you calculate to the nearest $50,000.
Flexibility is also an important message to convey to investors. No valuation is set in stone, and entrepreneurs should not hold too firmly to any valuation they attribute to their company. The reality is that the valuation of a company should constantly change and reflect the progress being made by the business.
It is also the case that investors will rarely agree with your proposed valuation from the onset. They want to see how you will react to their perspective, how you will defend your valuation, and how you handle their negotiating tactics.
Ideally, both parties will exit the negotiations believing that the valuation and the deal struck is fair, yet fully aware that either side would have liked to receive more for what they provided. This feeling is normal, and should not discourage entrepreneurs.
Ultimately, investors want to know that your primary focus is launching or growing the business you are so passionate about.
Too much focus and energy on the valuation will not be welcomed by investors and it will distract entrepreneurs from doing the hard work of growing their business, which is and should be their #1 priority.
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