Establishing a valuation for a startup business is not only a challenge, but it is (on a positive note) an opportunity to be endlessly creative depending upon projections and other variables. Having said this, valuation is the primary issue, aside from survivability of the underlying business, that concerns both the promoters and the prospective investors in the startup.
Sadly, most entrepreneurs are clueless about the issue of company valuation and the need to have some underlying theory to support it when a prospective investor inquires. The valuation model must be established by the company’s owners or promoters immediately, before solicitation or recruitment of investors begins — and, admittedly the process is somewhat arbitrary at its very starting point, but a model constructed on logic needs to be created.
Established companies value themselves (assuming that they are not publicly-traded) based upon several approaches, or upon an average of the of the results yielded by several approaches. These include 1) values of comparable companies in the same industry and of approximately the same revenue size or point of revenue growth; 2) net present value of several consecutive years of either historical cash flows or projected cash flows, with the latter used far less frequently than the former, in the the interest of conservatism; 3) the cost to replace the business at its current operating level; and d) the liquidation value of the business, where the fair market value of all the assets are reduced by the amount of all liabilities and either a fairly negotiated value or a distressed value (i.e., the fire sale) in an immediate cash sale at auction.
None of these approaches lends itself to valuing a brand new enterprise, so alternative, creative approaches have to be designed. The only solid variables to work with are 1) an initial starting point valuation for the first investor who comes in; 2) the timing of an investor’s capital contribution, which is the order (i.e., first-in versus last-in) of that contribution — the later the investment, the higher the company’s dynamic valuation, because the perception is that later adopters are more risk-averse and not as critical to the new entity’s very survival; and 3) the amount of the investment, on the assumption that a larger investment is more valuable to the company than a smaller one, so that it should be “appreciated more” in terms of a bargained-down valuation.
I would propose that a combination, or multivariate formula comprised of these three variables be applied to solving the valuation issue. This could either be done with a degree of arbitrariness and instinct, or it could be done with a multivariate type of formula.
By way of example, if each factor could be assigned a weight (represented as the inverse of a decimal fraction), perhaps a dynamic valuation formula for a new enterprise could look like this:
Dynamic Valuation = Preliminary Valuation x f(order, amount).
In terms of result, the earliest and largest investors would be buying at a lower Dynamic Valuation than the later and smaller investors. Intuitively as well as practically, this makes a great deal of sense.
Douglas E. Castle
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