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Company Valuation: Is There a Formula?
Today at the 5th Annual MIT Enterprise Forum Entrepreneurship Workshop, Professor Tarek Kattaneh of the Olayan Business School at AUB presented on company valuation. While his talk offers an overview of techniques using price/earnings ratio and discounted terminal value, it was a touch out of place when speaking to startups, who often are not valued using these techniques.
As Wamda CEO Habib Haddad pointed out, "While this approach works for established companies, it's almost never how valuation is computed for an early stage. For startups, especially at a pre-revenue stage, valuation is more often a combination of team, size of target market, position compared to similar products and companies and to some extent the exit opportunties."
"Good investors will want to fund the startup with enough cash for them to reach the next milestone (profitability or a new product launch etc...) on a valuation that will not overdilute the founders, because at the end of the day, investors are mostly investing in the team in early stages, and it's only fair for founders to retain enough ownership and stay motivated for the long run," he says. "An investment deal more than any other type of deals need to be executed as a win-win mainly because it's a long term relationship where investors and founders will work together to grow the company and take it to the next stage."
Yet if you'd like to understand this method for valuing later stage companies, here is a summary of Kattaneh's description of this technique.
An investor is looking to invest around $500,000 in a software startup and is trying to determine how much equity to request for his investment.
The company is projecting that it can generate a net income (net profit after tax) of $2 million after 7 years. It currently has 100,000 shares outstanding.
To determine an appropriate valuation, the investor begins with comparing the company to similar companies on the local stock exchange, looking at their price-earnings (P/E) ratio.
If most of the companies on the local stock exchange have a price-earnings ratio of 20, consider that your company at some point in the future, say 7 years, should resemble these companies, which means the value of your total stock divided by your projected earnings should approach that P/E ratio of 20. So if you think your revenues will be $2 million in 7 years, the predicted terminal value of your company would be $40 million in 7 years ($2 million x 20).
The company and the investor have to come to an agreement about the value of the company. Calculating the discounted terminal value is one method that can be used.
The discounted terminal value is current value of a company based upon its predicted terminal value and future projected cash flow. For the company, the discounted terminal value will be based upon projected revenues. For the investor, the relevant numbers will be based on her minimum required return.
For example, if an investor wants a 50% annual return rate, she can determine the value of the company to her today, by taking the Predicted Terminal Value / (1+Target Return)^(Number of years). Here, this would be $40 million / (1+50%)^7 = $2.34 million. This is the value of the company to the investor today.
Once an investor decides how much she wants to invest, she can then use this value to determine her required percent ownership based upon the discounted terminal value.
Required percent ownership can then be calculated by taking the investor's Intended Investment/ Discounted Terminal Value. Here, that would be $500,000/ $5.27 million = 9.48%.
Once the required percent ownership is determined, the number of new shares should then be determined by the (Original Share *Required percent ownership) / (1- Required percent ownership). Here that would be 100,000 * 9.48%/ (1-.0948) = 10,472.
The price per new share can now be determined by Current Investment/ Number of New Shares: $500,000/(10,472) = $47.75.
So with this value for the new shares, the implied pre-money valuation would be the total number of existing shares * price per share. Here that is 100,000 * 47.75 = $4,774,000.
The implied post-money valuation includes the total number of shares, including the new shares: 110,472 * $47.75 = $5,275,038.
Again, here are the formulas:
- Discounted Terminal Value = Terminal Value/(1+Target Return)
- Required Percent Ownership = Investment/ Discounted Terminal Value
- Number of New Shares = Investment/(1-Required Percent Ownership) - Investment
- Price per New Share = Investment / Number of New Shares
- Implied Pre-Money Valuation = Number of Outstanding Shares * Price of New Shares
- Implied Post-Money Valuation = Total Number of Shares * Price of New Shares
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