One of the big lures of startups for many, I think, is the sort of American-dream, rags-to-riches stories of the many startups that minted billionaires through sheer grit and “hustle”. I think this lure has become particularly big in the last few years, given that the number of unicorn companies has seen incredibly growth over the past decade.

Having been through startup funding and valuation negotation myself, I thought I’d share my learnings on how to figure out what price tag to put on your company.

You’re Selling A Business

Whether it’s bank loans, seed rounds, growth funding or an IPO, when you’re raising funding you’re selling a part of your business. There is no single “right” price for a company at any stage, because it all depends on who your target customer is and how good you are at selling to them.

Coming from an economics background, I used to think that valuing a company was just a matter of finding the right financial model and plugging in the values and you have yourself a deal. But experience has shown me that story-telling, trust-building and good old salesmanship is about 90% of it. It’s mainly about convincing the financier that the value they are buying is higher than the price they are paying.

Since all buyers want to, at a minimum, receive the fair value compared to the price they are paying, valuation models are essentially methods at estimating what the fair value price of a company is. Investors and M&A departments usually conducts a good amount of due diligence to confirm the value they are buying, so you can count on them using financial valuation models as guidelines. As such, it only makes sense that you also do the due diligence on what your company is actually worth. Otherwise, you might be leaving money on the table.

So in this post I’ve listed 3 typical valuation models that can be used to understand how your company might be valued. This will give you at least an idea of a price point, should you need it. But this area is indeed one where your mileage may vary.

The Scorecard method

The Scorecard method is a valuation method best applied to early-stage, usually pre-revenue startups. It was originally conceived by the angel investor Bill Payne, as a way of determining an estimate for the value of a company that has no business data, such as revenue, to evaluate.

The general idea of the valuation method is to compare the target company to a set of industry peers with known valuations (from e.g. financing rounds), and then adjust the valuation according to how the target company scores on a number of factors that are assumed to correlate to future success (and hence valuation).

The method works by obtaining a representative sample of early-stage companies with known valuations, and then finding the factors for the median company of that sample. The valuation method is then simply to compare how the target company scores in relation to the median company, and then adjust the valuation up or down. The factors influence the valuation different y (they are weighed) to account for the hypothesis that certain factors are more important than others. But the general idea is: If the median valuation was $1 million and your company scores 110% compared to this, then your company’s valuation is 110% * $1 million = $1.1 million.

The factors that are used in the original used in the method along with their weights, are:

Strength of the team (30%)
Size of the opportunity (25%)
Strength and protection of the product/service (15%)
Competitive environment (10%)
Marketing, sales channels and strategic partnerships (10%)
Need for additional investment (5%)
Other (5/%)

Pros & Cons

The Scorecard method is useful for companies that are very early-stage (i.e. prototype or MVP phase) and do not yet have sufficient data points about their business. I consider it a fair valuation model, in the sense that it is based on peer-comparison and thus gives a sense of how the market might value such a company. However, it does have a few shortcomings:

Scoring a company is subjective, since many of the factors cannot be fully quantified. This means that differences in opinion will have an impact on the final result.
The model is heavily skewed towards the company’s initial conditions, e.g. team and market opportunity. This means that it quickly becomes less useful as the company starts getting traction, since it cannot accurately account for this growth.
It only really makes sense for companies that are similar to the group of peers on which the initial survey is based, otherwise it’s like comparing apples to oranges.

DCF Model

The Discounted Cash Flow (DCF) model, is one of the most widely used valuation models in finance. It is a general financial valuation model and comes in many different colors, but the underlying premise is the same: The price of an asset is equal to the Net Present Value (NPV) of its present and future cash flow.

Let’s break this down:

Net Present Value means the net value today of some series of cash flows in the future. It is an adjustment made to future value events to account for the “time value of money”.

Present Value is the answer to the question: How much money would you need to put in a bank account that pays a guaranteed 3% interest per year, in order to have $100 in one year? The answer is $100/1.03 = $97.09, since $97.09 + 3% * $97.09 = $100. So the Present Value of $100 with a discount rate of 3% is $97.09.

Net Present Value just means that you sum up the present values of all cash flow events (both positive and negative). E.g. an investment might have an initial cost but yield positive cash flow in the future.

The reason why the value of the asset is equal to the NPV of its present and future cash flow follows a principle that states that if an asset is priced correctly, there will be no arbitrage (risk-free profits):

If the price P of an asset is less than the NPV (P < NPV), you can borrow P amounts of money at the discount rate R and buy the asset. You then receive the cash flow from the asset, pay off the loan and are left with a profit. Continuing on our example from above, let’s say you have the opportunity to buy a bond that guarantees you $100 in 1 year for $95. If the bank charges you 3% to loan money, you can make a risk-free profit by simply borrowing $95 at 3%, using that $95 to buy the bond, and then one year from now receive $100 from the bond and pay $95 + 3%*$95 = $97.85 to the bank. You are then left with $100 - $97.85 = $2.15 profit.

On the other hand, if the price P is higher than the NPV, you could just invest an amount of money equal to NPV at the discount rate and end up with a cash flow that is the same as the asset, but cost less. E.g. if the price of the bond from above was $99, instead of buying the bond you could take your $99 and put them in a bank account and earn 3% interest. After 1 year, your bank balance would be $99 + 3%*$99 = $101.97, which is $1.97 more than you would have gotten from the bond.

The Model

The general principle in the DCF model is to forecast, as accurately as possible, the future cash flow of a company and then calculate the NPV of all present and future cash flows. This means that the main source of errors in a DCF model come from the users ability to forecast. In turn, this means that companies with business models that are easier to forecast (such as subscription businesses), usually have lower uncertainty about their value and should have an easier time getting financing.

As I mentioned above, DCF models come in lots of variations, typically because predicting the future is a very open task. But generally, you base your financial forecasts on your historical performance and make some assumptions about future growth and macroeconomic factors such as the interest rate and price levels.

As a simplified example, let’s say that you own a niche online newsletter with 10,000 subscribers, 1,000 of them paying $60 per year each for premium content. You’ve had your newsletter for a number of years, and hit 1,000 premium users about 5 years ago, but never seemed to be able to grow it any further. On the plus side, there hasn’t been anyone cancelling, so you’ve been pretty steady at 1,000 paying users.

Your costs of running the business is pretty cheap: you use some online services to distribute the newsletter easily, costing about $600 per year, and you pay yourself a salary of $12,000 per year for producing the content (it doesn’t take you very long to write). Adding in some administrative costs, your annual fixed costs are $15,000 and have been pretty steady. So each year, you generate 1,000 * $60 = $60,000 in revenue, and pay $15,000 in costs, netting you a profit before tax of $45,000. Assume for simplicity that you live in a tax-haven with 0% corporate tax.

The value of your company is therefore your current assets (say $100,000 in the company bank account) and the NPV of all future $45,000/year profits. If the discount rate is 3%, your NPV will be:

NPV = $100,000 + $45,000/1.03 + $45,000/1,03^2 + $45,000/1,03^3 + … = $100,000 + $45,000/0.03 = $1,600,000

So the DCF value of your company is $1,600,000. Of course this assumes many things: The interest rate will stay at 3%, you’ll have net change in paying subscribers, your price is always $60 per year, you will forever get a salary of $15,000, taxes are always 0%, etc. That second equality sign is a mathematical “trick”, by the way, that allows you to calculate an infinite sum of discounted values as a perpetuity.

This is a very simple model, that has very few moving parts and is therefore too simplified, but I think it illustrates the model well. In practice, there are usually tons of factors affecting your operating costs and revenue (maybe you have good reason to believe that the company is about to experience 1000% growth!), as well as external factors like which discount rate to use. This is the reason why Wall Street analysts can spend thousands of hours trying to make their model more realistic, tweaking small assumptions about their expectations towards the future. In practice though, the model is only as reliable as its input and it will likely just be a piece of supporting material in justifying a price tag.

Pros & Cons

The DCF model is useful insofar as it provides a rational economic valuation, that theoretically reflects a “true” value as long as your forecasting abilities are accurate. If you have lots of financial data, stable growth and your assumptions are accurate, the model can provide an accurate measure of your company’s value.

But the model is heavily biased towards future earnings, so the accuracy of projections will carry a lot of weight. If projections are not accurate, the model is not very useful for measuring anything other than dreams. As a model, it’s therefore much more relevant when you have sufficient data to base your projections on, which requires a certain level of company maturity.

This bias towards future earnings also helps explain why there were so many “unicorn” companies born during the 2010s: With global interest rates at historical lows and the natural propensity of startups to dream big and stretch the truth, it’s easy to see how the DCF model can be twisted to produce extremely high valuations.

VC Method

The Venture Capital method, coined by William Sahlman in 1987, is a valuation model similar to the DCF model, in that the valuation is derived by discounting some future cash flow. In this model, the cash flow is a liquidity event (e.g. selling the company or an IPO). It is a kind of “back of the envelope” method of determining a valuation, and like the DCF model can be made more or less detailed depending on the needs.

The VC method basically solves the following question:

Given a required Return On Investment (ROI), what is the value today of a company worth X in a liquidity event Y years from now?

As a more concrete example, the VC method seeks to answer the following question:

As an investor, given that I expect my investment to return 20% per year, and I expect this company to be worth $30 mio. in 7 years, how much should the company be valued at today for my investment to be successful?

The general approach to the VC method is to compare companies to their industry peers, and look at what valuations and metrics the exitted peers exhibit. E.g., for a given group of mature companies that are considered your peers/competitors, what was the valuation at the time of sale, and what did their financials and business model look like compared to yours?

Acquisition data is usually hard to get by, so say we survey public 10 companies selling to the same customer base as you and with a similar business model. During the survey we record their revenue, gross profit, EBITDA and free cash-flow. From these, we can generate averages for the relationship between the financial KPI’s and the valuations, such as “revenue multiple” (valuation / revenue), “EBITDA multiple” (EBITDA / revenue), and so on.

Based on these multiples, with a forecast of our companies financials up to a liquidity event, you can guesstimate what the valuation of your company should be at the time of the liquidity event. Call this number your company’s Expected Valuation at the liquidity event.

To calculate the value today, you calculate the NPV of the Expected Valuation using the VC’s required annual ROI as the discount rate. This should theoretically give you the value of your company today, for it to be a deal worth considering for a VC firm.

In simpler form:

Valuation today = NPV of Expected Valuation in year T

Expected Valuation in year T = Financial forecast in year T * multiple

Discount rate = required ROI

Your Mileage May Vary

These are models and therefore simplications of reality.
They are just estimates and should give you indications of what a company could be worth.
As with all models, changing the underlying assumptions can produce drastically different results.

If you’ve read this and still have no idea what to do from here, I can recommend the tool Equidam. It’s a web service where you basically fill in details about your company, and it runs the data through several valuation models to give you an estimate of your company’s value. The models and parameters are maintained by Equidam, which means that you don’t have to do tons of research on what the current industry multiples and discount rates are. It might save you quite some time, especially if you are not a finance-y person. Just remember that they’re only models of reality, and the only real price for something is what a buyer is willing to pay.