One of the more common themes I run across on a daily basis is how to value a company. The ultimate answer of how much a company is worth is not what I think, but rather what one person would pay! Valuation is both art and science. It can also be driven by market dynamics (i.e. with peak economy, valuations are now at higher levels than in years past). Another interesting angle is what purpose are the valuations serving … is it for a sale, is it to raise a round, is it just for paper accounting? A few thoughts below on how to think about valuations.
Build a Great Product/Business First
Before you even worry about valuations, make sure you build a great product and business that customers love. Do the customer discovery, get paying customers, achieve product/market fit, create a repeatable sales process, have high net retention, etc. If you build a strong team and business with loyal customers, you have a much better chance of growing and sustaining your business through the different whims of market valuations and fundraising. There are companies that raise large rounds at high valuations that are based more on ideas than actual substance. In the long run, great businesses are built through hard work and not just inflated valuations.
How to Value a Company
Valuation is both art and science. At a pure and simple level, a company’s value is based on the projected stream of future cash flows discounted back to today’s dollars. For a given industry, there are often accepted multiples (usually revenue, EBITDA, or net income) to project what a business is worth based on current financials. For example, if an industry is trading at 8x revenue, a $5 Million revenue company would simply be worth $40 Million. There are also comparables from recent transactions that can inform a relative multiple. Beyond multiples, there are other numerous factors that can tweak a valuation: team, growth rate, net retention, gross margin, market size, etc. While all of that science is helpful, there is still the art part of the equation: how strongly is their strategic fit to an acquirer? Is there competitive pressure? Are synergies available? How strong is the team? In the end, both art and science are used to assess the valuation and if you ask 10 people to value a company, you will likely get 10 different answers.
I think the biggest watchout relates to making sure you are focused on building a great business vs. just raising money at a high valuation. While raising money at a high valuation may be an option (and even a good option), be careful that your focus is on the ultimate goal of a strong and sustainable business that can ultimately be sold vs. just moving on to the next raise. Each subsequent raise at a higher valuation also amplifies the pressure on growth and raising the next round. Another thing to consider is raising at a significantly higher valuation also can increase the risk to your next valuation if something goes wrong or delays. Often a company raises a round at a valuation with enough runway to make it 18 more months and raise again at a higher valuation. If that happens and something stalls in the business, you could be left with running out of money sooner and/or at a flat/down round that could limit your business prospects as well as potential investors. Beware of market whims. Just because you raise at a certain higher valuation in a peak economy, know that valuation could drop just from changing market conditions and vice versa. Lastly, be prepared to articulate why you value your company a certain way beyond just “somebody told me so” or “a friend of mine raised at $X million.”
Valuations are an ever changing number, often for reasons out of your control. Be sure to build a solid business first and let valuations take care of themselves.