Wednesday 28 October 2009

"Ten tips for start-up valuation"

Intellectual Property Marketing Advisor has just circulated this feature entitled "Ten tips for start-up valuation", penned by Martin Zwilling (CEO & founder of Startup Professionals, Inc., and Managing Partner of Southwest Software Ventures & and Consulting). The theme is that, when selling a start-up to potential investors, it's important to get them excited about your team, your product, and your company. Once they're hooked, they cut to the chase and ask the key question: “What is your company’s valuation?” That's when the tips come into play. As a sucker for lists, I found myself drawn almost magnetically towards them. According to Martin:

"* Place a fair market value on all physical assets (asset approach). ... New businesses normally have fewer assets, but it pays to look hard and count everything you have. Be sure to include computer equipment, office equipment, furniture, tools, and the value of inventory or prototype products [So far, so good ...], including development costs [... but I'm not convinced that 'development costs' lie comfortably within 'fair market value', particularly for prototypes that do not fit within the R&D template of a well-established technology].

* Assign real value to intellectual property. The value of patents and trademarks is not certifiable, especially if you are only at the provisional stage. A “rule of thumb” often used by investors is that each patent filed can justify a $1M increase in valuation [I hope that a 'Ten tips for investors in a start-up valuation' will caution against such an arbitrary and extravagant rule of thumb. The patent may be useful or useless, valid or invalid; the existence of a market, and the projection of a product or process (whether patented or not) into that market, may prove more useful guidance].

* All principals and employees add value. [How true, particularly if they're (i) nailed down by decent contract terms, (ii) happy to stay put and (iii) not claiming the IP rights for themselves] Assign value to all paid professionals, as their skills, training, and knowledge of your business technology is very valuable. Back in the “heyday of the startups,” it was not uncommon to see a valuation upped by $1M for every paid full-time professional programmer, engineer, or designer [But look what happened to most people who invested in start-ups and gave up their day jobs ...].

* Early customers and contracts in progress add value. [Another good point] Every customer contract and relationship needs to be monetized, even ones still in negotiation. Assign probabilities to active customer sales efforts, just as sales managers do in quantifying a salesman’s forecast. Particularly valuable are recurring revenues, like subscription amounts, that don’t have to be resold every period. [The formal accounts and public trading statements of customers can enhance the start-up's value: if your early customers are the Procter & Gambles or the GEs of this world, it might by worth leveraging this]

* Discounted Cash Flow (DCF) on projections (income approach). In finance, the income approach describes a method of valuing a company using the concepts of the time value of money. The discount rate typically applied to start-ups may vary anywhere from 30% to 60%, depending on maturity and the level of credibility you can garner for the financial estimates. [This is the point at which the tips allude to factors that make a business look less valuable -- but it's important to be realistic and to appreciate that investors are buying a risk as well as an opportunity]

* Discretionary earnings multiple (earnings multiple approach). If you are still losing money, skip ahead to the cost approach. Otherwise, multiply earnings before interest, taxes, depreciation and amortization (EBITDA) by some multiple. A target multiple can be taken from industry average tables, or derived from scoring key factors of the business. If you have no better info, use 5x as the multiple. [the investor will probably have his own guidelines for selecting a multiple and, particularly if familiar with the sector, may be hard to shift]

* Calculate replacement cost for key assets (cost approach). The cost approach attempts to measure the net value of the business today by calculating how much it could cost for a new effort to replace key assets. [This is a tricky one: a key patent may be irreplaceable if the start-up is built around it. But that doesn't mean that the start-up is worthless]

* Find “comparables” who have received financing (market approach). Another popular method to establish valuation for any company is to search for similar companies that have recently received funding. This is often called the market approach, and is similar to the common real estate appraisal concept that values your house for sale by comparing it to similar homes recently sold in your area. [I'm not enthusiastic about this. Unlike real estate, where comparators are relatively easy to find and the criteria for their evaluation are stable and predictable, IP-based start-ups rarely have such good comparators, except for low-risk brand- or design-based start-ups like a new burger franchise or teen-driven fashion house]

* Look at the size of the market, and the growth projections for your sector. [As indicated above, I think this is really important] The bigger the market and the higher the growth projections are from analysts, the more your start-up is worth. For this to be a premium factor for you, your target market should be at least $500 million in potential sales if the company is asset-light, and $1 billion if it requires plenty of property, plants and equipment [No comment, but many readers will not find it hard to read my mind ...].

* Assess the number of direct competitors and barriers to entry. Competitive market forces also can have a large impact on what valuation your company will garner from investors. If you can show a big lead on competitors, you should claim the “first mover” advantage. In the investment community, this premium factor is called “goodwill” (also applied for a premium management team, few competitors, high barriers to entry, etc.). Goodwill can easily account for a couple of million dollars in valuation". [Being second on to the market is also useful in a sales pitch. The innovator has had to educate the market as to the desirability, functionality etc of a new product or process at its own expense, but second-timers have no such inconvenience].

I'm sure that readers of this weblog will have some comments of their own, so I hereby throw this feature open for debate. Please feel free to post your responses below.


Unknown said...

This is a great list, and I am going to hold onto it, as well as pass it around. While some of this might seem obvious, it is surprising how many start-up folks don't think about how to ascribe value to the various aspects of their business. As a result, much of the value then gets put in the nebulous "goodwill" bucket. This list allows the start-up entrepreneur to put dimension around the various aspects of her business so she can better articulate the value.

One thing I would add is that the entrepreneur must routinely perform the valuation process. In this way the results then become part of the current, recurring and potential revenue and valuation calculations. These ongoing valuations can then go into the balance sheet to better demonstrate the value of the company.

Raymond Hegarty, FDI CEO, IP evangelist said...

I think this list - with your comments - is a great starting point for discussion.

I particularly like point 4 - "Early customers and contracts in progress add value".

Actually, that one could replace all the others. In the current climate, there are no investors with pots of money to sponsor projected earnings.

Now the entrepreneur must dig into internal assets to generate working capital. If they can show this ability, then they can attract investment.

But if they get good at that, maybe they don't even need the investment....

Raymond Hegarty, CEO, intellectual property evangelist