"It's an art and a science" is a descriptor not often used in the financial world. Numbers, by definition, are qualitative. The exception to the norm is valuing startups, which may be neither art nor science, and instead something approaching voodoo. In this episode, Dave acts as startup shaman and explains the various ways to roll the bones to come up with a number.
Thanks Joe. Good to be here.
I have to admit, all this talking about startups has got me interested in starting a startup, but before I do that I just need to know, how much is a startup worth in Florida?
I think you know the answer to that is, it depends. As really there is no real answer. There are only guidelines. There are quite a few valuation methods that I can talk about. But before we get into that, it’s important to back up and talk about what we really do consider to be a startup. There are dozens of definitions. If you look online, everybody has a definition of a startup. Like Investopedia, they define a startup as a young company founded by one or more entrepreneurs to develop a unique product or service and bring it to market. Now, a lot of the other definitions are quite similar, but there’s never been a real consensus on how you really define a startup.
You know, I don’t trust the internet Dave. I only trust you. So, how do you define a startup?
Thanks, Joe. First of all, as in all these podcasts, we’re talking about technology. Not starting a restaurant or a consulting business. We’re talking about technology startups. So, within technology, I define a startup by the phase that they’re in particularly, as where they are in raising capital because that’s the most accurate indicator – I think – of the progress of the company. I talked previously, about the sequence of funding; their friends and family, angel investing, venture capital, and private equity. Typically, angel investors come in at what we call the seed stage or even pre-seed. Then venture capitalists will fund in at Series A. Some angels may also be involved in Series A. Then there’s a Series B and a Series C etcetera.
All right, so where in there does a baby grow up and start being a startup?
Talk about the first funding. The first funding is pre-seed or seed level. These companies have no revenue. Maybe some early revenue, but pretty much no revenue or early revenue. That’s definitely a startup. When you get to a Series A, company typically then has a proof of concept. They have some revenue, some contracts. They’re probably not profitable. So, I would consider them they’re still a startup if there in a Series A – have funded with a Series A. When you get to Series B however, these are later stage. These companies might be profitable. They’re looking for growth funding. That’s why I consider a startup basically as, a company has left the startup stage. It’s now in the growth stage, in Series B. For our discussion today, I would define a startup as a company that’s in the seed up to Series B or through a Series A stage of funding. That’s what I would consider to be a startup.
When you’re talking about these companies at Series A or before, you’re saying they potentially have no revenue or they’re losing money. So, what are they worth if they’re in that situation?
That’s the first question I always get asked when sitting on a panel or doing an interview is, “How do you determine the value of a company that has no revenue and certainly, no profit?” the actual answer is that startup like anything else is worth what someone’s willing to pay for it. I know that’s not much help, but there are other factors to consider. There are lot of factors to consider. For example, there’s a site called Seedcamp and they say, “The biggest determinant of your startup value are the market forces in the industry and the sector in which it plays which include: the balance or imbalance between demand and supply of money, the recent and size of exits, the willingness for an investor to pay premium to get into a deal, and the level of desperation of the entrepreneur looking for money.”
I don’t really feel clarity on that. That’s not much help.
I agree. Fortunately, as I said previously, there are a number of models and methods that can be used to quantify the value of a startup, these include the Berkus method, the scorecard method, the venture capital method, the risk-factor, combo platter, book value, valuation by stage, market multiple, discounted cash flow, cost-to-duplicate. And there are others.
Dave, that’s a really long list. I hope we’re not going to go through all of those.
Fortunately, I personally think most of them are bogus. And they don’t really give you realistic results. There are two, however, that I think are applicable and can result in reasonable valuations for pre-revenue and pre-profitable companies. The rest rely on too many assumptions. They try to quantify factors that are actually more qualitative. Like assigning a value to, from one to five or zero to 10 on the strength of the management team or the competitive environment or the political risk or the manufacturing risk. Those are all based on opinions. Not really likely are going to give you any meaningful results on the real value of a company.
All right. So, what are the two methods you prefer?
That would be the venture capital method and the valuation by stage. I’ll start with the venture capital method. It’s based on the expected return to the investor. I think this is best illustrated by using an example. So, say investors at this stage like the SeedFunders typically, want to expect the potential 10x return on their investment. That’s because – as we said before – most of these investments will fail or produce little. Half of them are going to fail. Another three or four out of 10 are going to produce little return.
So, you need to see a 10x potential in all of the investments. So, when you do get a 10x, it basically balances out the failures and produces the overall return that the investor is looking for. If an investor is convinced that a company can be worth $50 million at the exit. So, it’s worth $50 million at the exit, and the investor needs to see a 10x return. The value to that investor today is $5 million because they want to see a 10x return on the $5 million to $50 million in the future. But it’s not as simple as that even, because dilution has to be considered.
So, additional investments in the future in this company before the exit will dilute the original investor. So, if the original investor thinks that they’re going to be diluted by 50% throughout the life of this company before there’s an exit, then today’s value isn’t really $5 million. It’s $2.5 million because that dilution needs to be taken into account. This way, if everything goes right and the company is successful, and all the assumptions are right, and the company exits at $50 million in the future, the investor meets their 10x goal. All has to go right in the company. The investor has to be sure, pretty sure that the $50 million is going to be reasonable to get their 10x return.
That makes a lot of sense. And the other one you mentioned was the valuation stage. What’s that?
Yes, just like it sounds. It puts a valuation on a startup, depending on what stage the company is in. Typically, in a valuation stage, a company could be worth up to $500,000 if it has a good business plan, an exciting idea, a growing industry. That could be worth up to $500,000. Up to $1 million, a company could be worth up to $1 million then, if it has a strong management team that’s going to execute that plan. So, again you could be pre-revenue, pre-profit. You have the team. You have the plan. You’re in a growing industry, exciting idea. It could be worth up to $1 million. Higher valuations then take place from one to $2 million if the product is developed or what we call an MVP – a Minimum Viable Product or a prototype.
Again, one to $2 million if you have the plan, it’s a good idea, you have a strong management team, and you’ve developed an MVP or a Minimum Viable Product. Higher valuations then take place; two to $5 million if the company is launched, has some revenue, has some partners, has strategic alliances. That’s the companies in the two to the five-million-dollar range. Then $5 million and up typically, coming up to Series A if they have revenue, they have grown, a path to profitability, proof of concept, and those kinds of things. I know those are large ranges, but it does give a guideline that is reasonable to start negotiations when an investor wants to invest in a company.
I joke a lot. I think someone has started a seminar series for startups saying, “If you have a good idea, you’re worth $3 million,” because we see a lot of submittals with no MVP, with just an idea, and a three-million-dollar valuation on that. That’s not reasonable particularly, in Florida, $3 million for an idea. You really need to have some product, develop an MVP, and be launched in some revenue to get in the three-million-dollar valuation range. Outside of Florida, you might see those kinds of valuations, but we’re talking about valuations in Florida. Really, $3 million for a good idea with a management team is not feasible.
Sounds like this is as much art as it is science. It definitely makes me grateful I’m part of an angel group like SeedFunders. Any closing thoughts.
Yeah, I’ve been doing some research. I recently came across a website that actually has a calculator that says you can determine the value of your startup. It’s called a startup valuation calculator. I scoffed at it. I said, “Yeah really, you can answer a bunch of questions and come up with a valuation of a startup.” They’re 25 questions, and you put in things about your product, your industry, your revenue projections, market conditions in IP kind of things. Some of the things, you can’t really forge them like, “Do you have revenue or not?” or, “Is your product developed?” or, “Is the market growing?”
I tried it with companies that we have invested in or have even reviewed or submitted. Actually, the results were quite accurate. I was pretty surprised. It was kind of fun to simulate because you can change the data. You can answer all the questions. And you could go back and say, “Wait a minute. The market is bigger than I thought,” and you change that data. It recalculates and gives you a different value. It was fun to go through, and determine what valuation companies can be just by answering these 25 questions. Like I said, the valuations really seem to be in line with the valuations by stage that I just talked about – the method I just discussed particularly, in Florida.
The model doesn’t have any factor for the area, but it seemed to me to be pretty accurate for the valuation of companies in Florida. If anybody is interested, the company that produced the model is Cayenne Consulting. And you could check it out at www.caycon.com that’s W-W-W C-A-Y-C-O-N.com/valuation. You can go in there and put your answer to the 25 questions. And play around and have some fun, figuring out how much is my startup worth in Florida.
I just put SeedFunders podcast in there, and it says we’re worth hundreds of dollars, Dave.
And, we are over valued then.