I recently had a conversation which seems to repeat itself time and again — an entrepreneur wants to start a business, calls me for some basic advice, and then we get into some of the details. Invariably, we get around to the subject of valuation.
Since this is a blog where you can feel comfortable asking “stupid” questions, I’ll make it safe for you. So, here’s the reality: Your high-tech business is worth as much as you can get for it.
There’s no formula. There’s no cash flow model which can justify a startup’s valuation. There’s just what you can get.
Jim Clark, after successfully starting Silicon Graphics, went on to start his next venture, Netscape. He arbitrarily set a valuation in the mid-teens (I recall it being around $15 million, but my memory is a bit vague). Of course, this is a ridiculously large valuation, but he could get it. He did the same thing again with WebMD. He got the most he could get from the market.
Others may not be so lucky.
How it all happens is the art of raising capital, and for better or worse, a major job of the entrepreneur.
Pre- and post-money
As you probably know, key terms are pre-money and post-money (often referred to as the “pre” and “post”). Pre-money is the valuation before you raise money. Post-money is the valuation after you raise money.
It’s dead simple: Your dilution (how much of the company you give away) is simply determined by dividing the amount raised by the post-money valuation. Let’s say you value your business at $4 million (the “pre-money”). You raise $1 million (the “raise”). You now have a $5 million post-money. Divide $1 million by the post-money ($5 million) and you see that you gave away 20%.
Often, for pre-revenue startups, founders raise angel money first, which then converts at the valuation of the Series A. The Series A is the first real round of funding, and startups hope that it is an institutional round. In my opinion, it is more favorable for the entrepreneur to raise angel money to convert at the Series A valuation. However, angels sometimes would rather go straight into a valuation discussion.
Valuing a tech business that has revenue
After your business is running a while, you will likely want to look for an exit. If you’re like most entrepreneurs, you’ll tell your investors that you want to go public, but really, most tech companies get bought rather than go through the cumbersome IPO process.
What valuation you get is, again, a subject of some considerable subjectivity.
The acquirer (and the bankers), will typically go with a combination of models that justify the valuation.
There are three primary models used in valuing companies:
– Discounted-cash flow
– Comparable public company valuations
– Precedent transactions
Discounted-cash flow (DCF) — if you don’t know what this is, let the banker worry about it. In tech company valuations, it’s not a vital model, but it’s heavily used in non-tech industries, where the business is predictable and well-established (or, similarly, in tech companies where there is an established and predictable business). The DCF simply presumes a set of cash flows occurring annually over a future period of time, assigns a terminal (end) value of the business, and then discounts the cash flows to the present (because cash in the future is worth less than cash today). How it discounts is based on old mathematical models dating back literally 150 years, but is now automated in any spreadsheet program. Again, it’s not worth worrying about too much.
Comparable public company valuations — A more important metric, this method uses the valuation of public companies in your space to determine how the broad market is valuing the business. In technology, there are a number of multiples that are used, but often, a multiple of revenue is employed. You can get an idea yourself of comparable public company valuations by assembling a list of public companies in your space, and looking up the multiples on any major finance website (Yahoo has a nice section that shows the key multiples for any company, under “key statistics” on any public company quote page).
What companies you choose for your valuation has an impact, but be careful not to BS too much by only selecting the hot companies in your space, as any reasonably intelligent acquirer knows very well what companies are comparable to yours.
So, for example, if you’re in the security space selling an advanced firewall product, you might choose Symantec, Palo Alto Networks, Fortinet and FireEye (not the best examples, but I’m just giving examples here). Take the core valuation metrics (multiples of cash flow or EBITDA, multiples of revenue, etc.) and then calculate the average and the median, and apply it to your own numbers.
Key multiples typically used are multiples of revenue and multiples of EBITDA.
EBITDA is a very important metric for some buyers, in particular private equity and growth equity investors. [As a side note, I will add that Cash Flow is not the same thing as EBITDA, and this is important to remember for working through your financials and your strategy. I got caught in a trap years ago between Cash Flow and EBITDA. I was heavily Cash Flow focused (specifically, Cash Flow From Operations — CFFO). For technical reasons not worth getting into here, my EBITDA was poor, but my CFFO was wonderful. I thought I could explain it away to investors. I couldn’t: they simply cared about the EBITDA. It was shortsighted on their part, but in the end, it was my fault for not realizing just how important EBITDA was to these institutional buyers. I’ll never make that mistake again.]
Plenty of bankers publish information on financial metrics for prospective clients; Pacific Crest Securities has one of the better models, published every few weeks. I’m sure if you contacted them, they’d be delighted to put you on their mailing list.
Precedent transactions — this is the most important valuation metric, as it is what other companies in your space are being acquired for today. Any banker has access to services which provide this vital data, but you’ll likely have your own list of companies that have been acquired, what they got acquired for, and what the multiples were. Again, you’ll apply this to your own numbers. Keep track of deals in your space.
After looking at precedent transactions and comp public multiples, you’ll have an idea of what your company should get valued at. A good banker is very, very useful in this process.
Now, different buyers have different metrics. Financial buyers typically pay on a multiple of cash flow (perhaps 3–6x cash flow for a highly leverage acquisition, perhaps 7x-10x cash flow for a non-leveraged situation, sometimes more for something that’s important to them). Strategic buyers (in other words, non-financial buyers) are all over the map. If they believe it’s strategic, the sky, literally, is the limit. I’ve seen numbers that are stratospheric. I’ve also seen numbers that are surprisingly low.
In the end, get what you can get. This is where the art of negotiation really, really matters.
Of course, never lie and fudge your numbers. You can get in awful trouble post-acquisition, and besides, do you really want to make all that money in a sleazy way?
So good luck and feel free to contact me if you want any advice in this process.