August 22, 2016 by Fred Haney
Creating and Measuring Value For High Tech Startups
“The chief executive officer of a high tech startup company needs to know how the value of a company is measured and how to create value.”
One of the purposes of a high tech startup company is too create value for the founders, shareholders, and investors. How is value created in the startup phase, and how can it be measured?
Let’s begin with how you value a high tech startup company. There actually are “scientific” methods for estimating the value of a company. I’ve put “scientific” in quotes, because only a portion of the approach is really “scientific.”
From an economic point of view, the intrinsic value of a business is the value of the net cash that can be extracted from it over the lifetime of the business. The method for calculating the “time value” of this cash is called a “net present value” calculation. The basic idea is that cash flows into the business in the form of investment and out of the business for distributions or when the company is liquidated or sold. If you have an estimate for cash flowing into and out of the business, and the cash available at the time of liquidation, you can use a spreadsheet function called “net present value” to calculate the worth of the business today, assuming a particular desired percentage return on investment, or “discount factor.”
I know this is a mouthful, but it’s fairly straightforward once you understand the math. To value your business, you need at least a five-year projection of cash required by and produced by the business, along with an estimated “terminal value” for the business.
Another way to think about that present value is, “If you invested today’s ‘value’ at the specified ‘discount rate,’ then you could produce the cash outflows and inflows prescribed by your forecast.
Angel and venture capital investors usually require a 60-100% internal rate of return (discount rate). They don’t actually make this kind of return on average, but they want to see this kind of potential return as a “hurdle rate” for each investment. You can apply the NPV function to your company’s cash flow projection to estimate today’s value for purposes of investment.
It’s a little more complicated for early stage investors because they need to make some assumptions about the additional capital will that will be required and the amount of dilution that will result.
Whether you use the spreadsheet function or not, the important point here is that there is a reliable method for calculating the value of your start up, assuming that you and your investors agree on the assumptions in your business plan forecast.
Too many chief executive officers of high tech startups make the mistake placing an arbitrary value on their company. They try to get a larger number than their friend. Or they guess what the valuation should be. Or they come up with a valuation that will allow them to retain a large percentage of ownership in the company. Unfortunately, investors, at least venture capital investors, are probably using a NPV method to value their business, and it will usually produce a lower valuation than the founder might like.
In some of my talks on this subject, I have said, “You build your five or ten-year cash flow projection and your spreadsheet and if your business produces the kind of revenues profits most investors will want to see, the answer will be around $2-3 Million.” This is said tongue-in-cheek, but it’s not far off. You can do the math yourself if you project $50 Million in revenue, 10 to 15% after-tax profits, and a reasonable “terminal value,” then reasonable assumptions will probably lead you to a valuation in that range. This may seem low, but it is fairly realistic.
In the startup phase of company, the business consumes cash rather than producing it, so the value depends almost entirely on the “exit value” and the risk of success. Here’s one way to think about: You might be able to increase your “NPV” valuation by reducing risk, which might justify a lower “discount rate.” You do this by achieve key milestones. By definition, this is a “bootstrap” or “lean startup” strategy where you move the company as far forward as possible little or no capital. If you can develop the product, for example, you have eliminated much of the product risk. If you can get a customer for your product, you have eliminated some of the “will anyone buy it?” risk. If you can manufacture your product for the predicted cost, you have taken some of the manufacturing cost risk away. If you can attract a seasoned and successful chief executive officer, you have reduced the “management risk.” If you can reduce all of these risks, it will help increase your value and your likelihood of attracting capital.