Before you start thinking about what your startup is worth, there are three terms you need to understand. These are:
- Pre-money valuation
- Post-money valuation
- Exit valuation
Each of these are important and give you an idea of what dollar value you can place on your business.
Pre-money and post-money valuations are determined by what your investors are offering you (or what you are offering your investors). The terms simply describe the size of the pie based on what portion slice your investors are getting.
So for example, if your investors are offering you $1 million for 25% ownership of your business, then the value of the entire business is $4 million. Simple, right? This is a post-money valuation, since it assumes the size of the pie after including the $1 million injection from the investors.
Pre-money valuation is the value of your business before including the cash injection from your investors. In the above example, the pre-money valuation is $3 million, since your investors have not yet invested the $1 million that they are supposed to give you.
Now, the exit valuation is where things really get interesting. This is the dollar amount that your business will sell for when your business is ready to be snapped up by Google or Facebook or whoever else wants to buy you out, or what your business will be worth when it’s ready for an IPO.
We know that startups at any stage of their life are being bought by big companies that can afford to purchase them. Frequently these businesses are purchased for huge amounts of money, sometimes more than $1 billion.
So what will your business be worth when you make your exit? There are many approaches to calculating an exit valuation, which we will just discuss in a minute. But first, let’s understand the relationship between your exit valuation and your pre-/ post-money valuation.
Let’s go back to the example in which your investors are giving you $1 million in exchange for 25% ownership of your business. Your investors will want to make healthy returns on their investment when it’s time to exit. Some investors are happy receiving 10 times what they invested, while others need 30 times or more since it’s such a risky investment.
Supposing your investors want 20x returns. This means they should get $20 million as their share of the exit prize money. If you remember, they own 25% of your business, so that means the total exit valuation of your business should be $80 million in order for them to show interest.
Back to the interesting part now. How do you figure out what your exit valuation will be?
The best thing you could do is obviously to gaze into a crystal ball and see yourself in an expensive suit negotiating across the table with your future parent company about the exact dollar amount of the exit prize.
But since nobody can see the future with such clarity, MBA Finance guys are the next best bet. These amazing super-humans are armed with cryptic formulas (sorry, ‘formulae’) that can put an exact dollar value on all your future earnings, right down to the penny.
Mostly, they discount your future cash flows based on the principle that a dollar earned in the future is worth less than a dollar earned today, so future earnings should be discounted using an appropriate discount rate. This is known as a DCF analysis (Discounted Cash Flow analysis).
So if you’re likely to make $250 million in profit in five years from now, then this will be discounted back to the present day to arrive at a net present value that could be $30 or $40 million.
However, Finance guys are usually quite a shady lot who are pretty unhappy with life and eventually realize they are living a lie so don’t depend on them too much. (Just kidding!). (Not).
An even more accurate way of understanding your exit valuation is by looking at similar companies who have made an exit recently. Of course, you need to come up with a pretty detailed analysis to prove the similarity. A good business analyst, consultant or MBA Finance guy can help you with that.
At the end of the day, understanding your exit valuation is very much like gazing into a crystal ball, so you need to rely on good sense to come up with a realistic valuation. It all comes back to how much money you’re trying to raise and the share of equity you’re willing to give, because then you can at least have an idea of the exit valuation you should be having.
Preparing a business plan that discusses your business idea, the market and all the internal and external factors to arrive at an appropriate ball park figure is the key to a credible valuation.
After all is said and done, probably the best advice you can ever get is that you shouldn’t waste too much time dwelling on your business valuation. You should be focusing on having a business to value.
If your business idea will sell, you’ll get a good valuation from the market. Make sure the idea is well presented and makes rock-solid sense to investors.