Money Matters: Know Your Valuation

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Welcome to Money Matters, conversations about financial matters for startups with Roseann Heavey, a partner at Noone Casey.

From an accountant’s perspective, at what point does a company need to start thinking about its valuation?
Entrepreneurs need to put a value on their startups in order to raise money, and investors need to put a value on their investments to generate a return. Valuation matters when a startup is looking for investment because it determines the share of the company the founder has to give away to an investor in exchange for money. Let’s take an example – based on a projection for the next 18 months, I need to raise €500,000. I am prepared to give away a total of 5% of my company for that money, which means I need to have a valuation of €10 million. The question though is – do I have the backup for such a number? The valuation could be based on recurring revenue projected for years ahead. It could be looking at the users on the website, and the traction, which works well for subscription businesses. You can look at the users on a weekly basis, monitor how they fluctuate through time and start making projections from there. The valuation could also be based on the assets of the company, including the IP.

How do you determine the value of IP?
There are three approaches to this. The cost approach, market approach, and income approach. The income approach is probably most popular. It’s based on the assumption that the value of a piece of IP today results from the financial benefits that it can generate in the future. IP can have very different values depending on who owns it and how they intend to use it.

What other metrics can founders use for projections?
At the early stages, traction, reputation, revenues, and distribution channels are all ways of coming up with the backup of the valuation of the company. There are also several distinct approaches to base the valuation – on the asset, sales, dividend, earnings or cash flow.

What would be the typical valuations you see at the early pre-revenue stages?
I’ve seen valuations anywhere between half a million to two million for pre-sales companies, even with a half-built product. A lot of it is based on the belief in the software and the tech gone into it, and the potential of the market. You have to show very clearly how you are going to spend the money in order to convince investors that your valuation is accurate.

How do you put a number on belief and potential, though?
Valuation at the early stages is a lot about the growth potential, as opposed to the present value. It’s up to the founder to develop a process for valuing the company based on comparable companies and financial projections. Find out how much similar companies in your industry and geography are worth. Add to that financial forecasts to defend the valuation. Most importantly, work out how much money you need. It’s estimation of costs versus revenue and growth. Sometimes you can’t compare yourself to anyone, and those calculations are your best bet. Determine how many years it will take to be profitable, and look at how much comparable companies were valued at when they reached profitability.

How does the valuation change over time?
Before you can determine what the value is now, you have to go back to the initial valuation and put down everything that has changed since then. You will use this information to determine whether the company is worth less, or more, and why. It could be any mix of reasons: changed pricing; new or different employees; improved product; better market fit, etc. All these aspects modify the value. You will have to input them to alter the projections. One thing to be clear of is the pre-money valuation and post-money valuation. Pre-money valuation refers to the value of a company not including external funding or the latest round of funding. Post-money valuation includes outside financing or the latest injection. These two concepts are critical to ownership percentages.

If a company is loss-making, how does that affect valuations?
If you do not grow as you had projected, you may have to do a “down round,” to not run out of cash. A down round is an investment at a lower share price than previous valuations. This could be the case if you didn’t meet the benchmarks. Valuation is based on the potential for growth, which sometimes takes longer to achieve. You have a concept and a product, as well as the time, effort and costs put into a piece of innovation unlike any other in the world. That’s what you’re pitching against at each point.

What are realistic projections in terms of time frame?
We typically make projections for three years and revisit them all the time. For a more substantial sum, you will be accountable for the first 18 months, and investors will look carefully at the projections against reality. They will look to see you are following through with what you said you would do.

Should you aim for lower or higher valuation?
It depends on the approach to growth you want to take. You generally have two strategies – 1) Go big from the outset or 2) Raise steady as you go. Going big is about quick growth – raise as much as possible and spend it to grow as fast as possible. That requires a higher valuation. If you start with a high valuation, you will need an even higher valuation for the second round which means you have to grow a lot between rounds. Raising as you go along is about steady growth – take money only for what you need to operate and spend as little as possible. You do not need as high a valuation here to get the money you need without giving out too much of your company. When you are trying to answer that question, just be realistic with yourself.

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