How a business is valued is the source of much discussion and controversy in the startup community. Eager entrepreneurs are burning away developing their businesses when they start to find success, and then hit their growth cap due to limited funding. Their company desperately needs additional capital to continue to grow, but how do they go about getting that funding, and under what terms?
Let’s take a look at a company’s valuation from a practical standpoint. If you have a business that is generative $1,000 of revenue each month with no intellectual property (whether tangible or non-tangible), how much is such a company worth? It would be easy to argue that the company would be worth approximately $12,000 based upon its annual revenue, or even arguably $24,000 if there was a 2x multiple given. There also may be some additional goodwill thrown into the valuation due to the team that is in place, the market penetration, or the intellectual barrier to entry. However, as a whole, the valuation will float around this number.
To explain it in another way, we can look at it similarly to the valuation of a house….
How valuable is the lot it sits on? How big is the market?
How much money would it take to build this house? How much capital would it require to ramp up a business of this type?
How much are the appliances and extras in the house worth? How much is the team worth?
Does it have a pool? Are there any patents or intellectual property such as a unique process or secret sauce?
Are there features that are unique to this house? Does the company have a competitive advantage?
When a business is broken down in such a way, this may begin to help you understand where valuations come from. Does a business that generates $1,000 per month with no intellectual property or barrier to entry warrant a $5 million valuation? As a general rule of thumb, definitely not…
The second half of this equation is the amount of funds needed for the startup. This should have quite a bit more research that justifies “the ask”. A company should do a thorough market analysis to determine what activities will be needed in the future to grow the business.
Some areas that should be heavily considered are areas such as:
Marketing and Sales: How will this money be spent? What is expected conversion rate? Expected cost per customer acquisition? Will a sales staff need to be hired?
Inventory: How much inventory should be on hand? What is the cost for various levels of production? Are there components that should be purchased in advance due to timeline to acquisition?
Hiring: What key positions will be needed to grow the business? How much is typical salary for each of the positions?
Infrastructure: What additional software will be needed? Office space? Development for additional features for the website or software?
Runway: How long will capital be needed to operate the business until it becomes self sustaining, or the next round of funding is needed?
Once all these pieces are figured out, a budding entrepreneur should have a good estimation of the funding needed. Don’t forget to pad the request a little, because there is always an unforeseen moment where costs run high. You never want to have to return to an investor and ask for more funding because you didn’t think far enough ahead to predict some bumps in the road.
Last, but definitely not least, be realistic in your valuation! I added extra emphasis because I cannot state how important this is. If you are not realistic, then the potential investors will walk away and not take you seriously in the future. You never want to ruin a relationship that could be prosperous for both parties.
If you have any questions and would like some help with your company, don’t hesitate to reach out to the Ark Applications team at info@arkapps.com!