Learn Before You Earn: How to Figure a Startup's Pre-Money Valuation…

Q: Why is a company’s pre-money valuation important to investors? How is it determined, and what other factors should investors consider? Are there online tools that would assist in calculating my venture’s valuation?

-anonymous

A: I find settling on a valuation to be one of the top challenges young entrepreneurs face today. Before I tackle the question, let’s examine what valuation is and how it works.

A company’s pre-money valuation, or PMV, is its estimated value immediately prior to accepting funding. Every time entrepreneurs seek to sell ownership in their company in exchange for financing, they must figure out PMV. It determines how much ownership existing shareholders or members will give investors in exchange for financing.

Here’s an example: Say you want to raise $1 million in financing. If you place a PMV of $1 million on your startup, then investors would receive 50 percent ownership and the company would forgo 50 percent. If the PMV was instead $3 million but you still only needed to raise $1 million, investors would only receive 25 percent ownership in the company and existing shareholders would give up only 25 percent.

In determining the PMV, I often see entrepreneurs spend a lot of time developing financial projections to which they apply the discounted cash-flow method. This approach is meaningless for early-stage companies because the projections are usually inaccurate and unreliable.

Instead, an entrepreneur should turn to the angel community, as they have developed methods that are respected and commonly used. You can find some of these methods in the valuation section of angel investor Bill Payne’s blog. Most angel investors will recommend using a blend of methods rather than relying on one method. Also, if possible, find out what companies with PMVs similar to yours have successfully raised funds.

Related: How to Raise Real Cash for Your Startup

Keep in mind that, when deciding PMV, entrepreneurs and investors tend to have opposite estimates. Existing owners are motivated to have a high PMV, because they will suffer less dilution. Investors are motivated to have a low PMV, because they want to maximize the amount of ownership they receive in exchange for their funding.

Interestingly, many entrepreneurs choose to forgo the entire research process and place a PMV on their company simply by deciding how much of the company they are willing to give up in exchange for the funding they seek. This approach can lead to an unrealistic PMV, which sends a message to investors that you are unprepared.

As for online tools, some free or inexpensive spreadsheets exist, but they generally are too simplistic and employ a single-valuation method. There are some high-priced consultants, but they tend to charge more than entrepreneurs can afford.

Related: 8 Keys to Sizing Your Startup Funding Requirement

My partner and I are developing a web-based tool that will collect an entrepreneur’s answers to more than 70 questions and apply to them a blend of the valuation methods angel investors most commonly use plus factor in valuation comparables. This will help entrepreneurs create a defensible PMV, intended to withstand scrutiny by angel investors. Feel free to visit www.worthworm.com to register for the public beta if you’d like to test it out.

While PMV is important to investors, they also look at other factors like the quality and completeness of the management team, the size of the market you are targeting, whether you would have a sustainable advantage over competitors, scalability and customer-acquisition costs. This is not an exhaustive list, but it will give you a flavor for some of the key issues investors would explore.

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