It’s an interesting area.

I think it’s one of those processes where you need to have a model behind your views. Or even better, a number of models all pointing to a similar figure. The best reference is comparable sites.

But at the end of the day, valuation is a function of how much money you need, how much equity your investor/s want, and how much they are prepared to pay.

So it’s both a left to right (model driven), and right to left (demand driven) process.

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Steve Sherlock Reply:
November 26th, 2009 at 4:53 pm

@zac – i agree about model drive, given the model requires a certain injection to be properly executed. anything less would compromise the whole project. how well this matches then with demand is another question.

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One thing to be aware of is that there essentially 4 types of investors out there each with a different focus: Venture Capitalists, Private Equity, Angels and Strategic Investors. The main driver in valuations for VCs and PEs in particular is the projected Internal Rate of Return (IRR) and then the Net Present Value (NPV). It may be a useful exercise to run 3 sets of projections, Optimistic, Pessimistic and ‘Medium’. Look for an IRR of between 25 and 35% (Excel can do all this) on the desired capital investment. The NPV calculation can then be used as your guide to a valuation in 3 versions – the lowest may be your ‘bottom line’ deal. A Strategic Investor will only value the business based on what positive financial impact acquiring or investing in yours will have on their own products and bottom line.

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Steve Sherlock Reply:
November 26th, 2009 at 5:02 pm

@Jerry – thanks Jerry i think that’s pretty good advice around 3 sets of projections. will do some work on IRR and NPV, should be interesting to see the outcome.

with regards the four investor types, i agree with this. I’ve found first hand that strategic investors are not really interested in investing per say, they want to buy it. this is possibly the path of least resistance though not ideal given there is a lot of unrealised value. (though i would say that

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Testing out your valuation and its methodology in real “live” investors is a mistake almost all entrepreneurs make when trying to raise capital. This is 100% the wrong approach.

Its like testing out your unproven shark proof suit on great whites! If it doesnt work, you are dead.

Same goes with real investors. If they dont find your valuation palatable, then they wont invest. Its now very unlikely that they would consider your investment if you go back to them in the future. You have just blown the opportunity which might have cost you tens of thousands of dollars.

What you do is find 5 or 6 friends or associates who are skilled in capital raising, valuations and corporate transactions. They are relatively easy to find. Jerry Bloom (above) would be one such person.

You run your valuation, price, model and methodology past them and get their feedback. They will tell you honestly if you are in the ballpark. You make adjustments based on their expert advice.

Then once you have something that is more valid, based on their feedback, you then start to approach investors – and lots of them for an early stage business such as this. In my recent experience (and i have raised many millions for many companies), you would need to approach 30 to 50 potential investors to get one who will actually invest. So if you are seeking to raise say $500k in 10x $50k parcels, youd need to be able to show your deal to around 300 to 500 would-be investors. You might get lucky and get one investor who takes the whole lot. In which case you need to approach 30 to 50 wealthy investors.

To solve all this, simply put someone onto your board or advisory board who has raised significant capital before. Or engage a corporate advisor who specialises in capital raising’s in your size/sector. There are tried and tested ways to raise capital – its not rocket science. Why would you try to re-invent the wheel?

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Steve Sherlock Reply:
November 26th, 2009 at 5:16 pm

@Reuben thanks for the input. I agree with you about running valuations past some independant experts. have done that to some extent and taken that feedback into account.

so point taken – to talk to the right people and adjust accordingly.

however I’d say even after the best advice, its still a test to some extent, just with narrower range of getting it wrong. i.e. i dont believe in getting something perfect or 100% right, always some room to move i reckon Reuben

actually was talking to someone today about your service, and they gave WI a good rap to be used as “part of” the overall raising strategy. im giving it some thought.

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Steve, what I omitted to say was that we have just raised a Series A fund of $2M from a strategic investor (essentially a customer) in a deal that still leaves plenty of upside over the next 2-3 years and with the founders still in the majority position. It took something like 6 months to negotiate but the deal means we treat them is a preferred customer – which is not a bad thing at all… Incidentally we raised about $300K in our first 2 years from Angels, Family and Friends.

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We generally try pretty hard to move the discussion away from the valuation method and back onto the real performance issues, which is where the real uncertainty is.

To do that, we generally start with a fairly detailed and consistent forward forecast (sales revenue & costs to sell, COS, expenses, EBIT – hopefully you’re past the heavy product development work at this point), which must be based on implementing the detailed stratgies and tactics in your original business plan and extrapolating out 3 or 5 years – but based on not having any additional investment and funding everything out of cash flow. I know that’s fantasyland, but this is all about lines in the sand, not rocket surgery. Apply a risk factor, and bring that back to a net present value (excel: NPV()) to get your DCF valuation on a standalone basis.

Then spend some time with your plans for how you’re going to use the new investment, and rebuild your forecast on the basis of having the new money (or other resources, if this is a strategic deal rather than a capital raising – our specialty, I might add, in shameless self-promotion). Do the same NPV/DCF to get a line-in-the-sand valuation with the investment.

This gives you the real tools to look at the old “1 + 1 = 3″ chestnut, and put some real numbers in there. The important element to target is ‘DCF2 – DCF1 – Cash,’ which is in effect the value created by doing the deal. If everyone understands these numbers and agrees on them, then the discussion is really about how to share out this created value, rather than arguing about the existing crumbs.

One interesting thing this points out is the value of a strategic partner with complimentary resources over a straight cash investor. The strategic partner will potentially realise the same returns and the financial partner, but will also get beneficial impact on their own business (which you can model), which improves the outcome – and potentially the valuation they will recognise.

No one is actually going to go in there and understand your numbers enough to debate this sort of a model, but it gives you a pretty strong platform with which to justify your numbers – as strong as your forecasting, anyway – and doing your homework will at least show them that you’re someone who does their homework.

Cheers,
Paul.Hauck@ICTStrategicServices.com.au
Principal

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Your closing point about supply and demand is indeed the final word on any valuation, but to get to that point you need to present an offer, of course. Or you can present your relatively conservative view of future earnings prospects and let the potential investors make up their own mind (they will anyway). IP, sunk investment, time spent, comparative analysis and the like means little in the end. The only thing that really matters to an investor is the prospect of an exit based on future profit (or expectations of future profit) and the relative risk associated with that. The risk assesment is largely based on how the investors view you (the founder) and your key team members, and your apparent likelihood of success.

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see what i mean:

• “1 + 1 = 3″
• ‘DCF2 – DCF1 – Cash,’
• (IRR)
• (NPV)
• COS, EBIT
• 100%
• $2M
• (excel: NPV())
• $50k parcels
• 25 and 35%
• DCF
• IP, sunk

now put all the above into the cauldron, stir it all about and you’ve got a bamboozled entrepreneurs, jobs for consultant to help unravel the confusion, and investors with the upper hand against wood duck entrepreneurs (like me)

why can we simplify it and just use some plain language?

how about this, let’s say i was a big travel company (like wotif.com) and i was looking to acquire a business like Oodles. I’d just ask myself this:

1. how much money will it cost me to develop the software?
2. how much will it cost to put a global branding package together?
3. how much time will it take before we are ready?
4. and what’s the opportunity cost of this delay?

and not one acronym or scientific formula in sight!

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Paul D Hauck Reply:
November 27th, 2009 at 10:55 pm

I take your point, and on one level I agree with you – if it were simple and easy, things would be miles more accessable for many, many more people and it would not require experts to do the work. That would be great, and the same could be said for doctoring, lawyering, rocket science, auto mechanics and trout fly tying.

But the problem is that this stuff is not simple. And when you’re asking for significant money which is someone’s retirement fund, they’re going to want to know that a) the right analysis has been done and the deal stacks up; and b) that you’re a guy who can do the sums or get advice from someone who can, because that’s going to be important in running your business, too.

Realistically, Steve, would you hire a CEO who was stumped by “100%” or what “EBIT” is? Investment decisions are about “IRR”s and “NPV”s, and it will be very had to convince investors to trust you with their hard-earned money without understanding them.

Your 4 simple points are a great example – they sound very simple, but how on earth would those 4 questions tell you whether your company is worth $2.4M or $3.7M or nothing? Nobody in business can reliably put a simple number on 1, 3 or 4, and without understanding the risks and probabilities and how to analyse them, you won’t make any sense of them at all. And those are not analyses you can do in crayon.

There is a fundamental problem with doing valuations, in that you’re taking very rubbery, shaky guesses, plans and assumptions and trying to translate them down into real quantifiable numbers – and that is always going either be very complicated, or to be very simple and inexplicable – an art. And neither is going to be simple and satisfying for a 1-page article.

But I would say that, wouldn’t I?

Cheers,
Paul.Hauck@ICTStrategicServices.com.au
Principal

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Wotif is owned by investors. Investors (largely investment funds) are largely driven by these acronyms and ‘scientific’ formulas. It would be nice to think things can be thought about simply, but its just not the case. Money has a time value, value needs to be adjusted to risk, etc etc. DCF may not be enough if your planning on changing your leverage in the coming years (you may then need to use APV).
TRUE, the number may be way off in the end, and you may have wasted all this time coming up with a number that was wrong, but if everyone ignored the important (and complex) parts of valuation, valuations across business would be overall a less reliable piece of information, more bad companies would be funded, and the economy would be less efficient.
This, of course, does not even touch on the fact that when attempting to raise funding, complex valuations tick more boxes.
If I was wotif, asking myself 4 ‘simple’ questions in regards to a multi $m investment just doesn’t cut it.

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Hi Steve,

Keep going and keep learning. You are correct that numbers and formulas are the way to value a business along with knowing how valuable it could be if funded and grown in the right way. It’s a mix of left and right brain that makes the best story and if you can take the investor on a journey it’ll help reinforce the figures.

Good luck, it sounds like you’ve come a long way from your first attempts. If you can continue to do this you’ll save yourself a lot of effort and need less consultants, accountants and lawyers. If only every entrepreneur took this approach we’d be getting far better, more accurate valuations along with keeping investors interests protected.

Simon

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A pretty robust model for valuation is NPV. My team (in Group strategy for a company operating in 40 countries) used this for evaluation of capex (including new products, projects, and new ventures into new countries). It would have given the right answers through the dotCom boom (but, if you read Mary Meeker’s dilemma in Blood on the Street by Charles Gasparino, there are times when the right answer is not marketable.

The smart approach is detailed cashflow estimation for the first 3 years, then less detailed projections beyond that (because you can’t justify any estimates out there, and inaccuracy is discounted anyway).

From watching the experience of people who have had their companies taken away from them by venture capitalists, you need to be mindful of the consequences of getting your estimates wrong. The VCs are not just interested in the value of the company, for the purpose of valuation of their investment, they may also hold you to certain targets. If you fail to meet those targets, then the investor’s ownership percentage of the company increases at your expense.

Given all of that, a cashflow model (with assumptions documented and jointly subscribed to) that you can maintain and discuss with your investors before and after investment is a way of arriving at a justifiable valuation, and one that will tell you where you’re going during the tenure of VCs in your company.

It’s a shame to see people who dazzled themselves and others by big valuations and big money, winding up with heavily diluted equity (by term sheet ratchets), sacked from their own company and ending up running a one-person consultancy for startups.

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I’d add that if you are getting serious about an investment with someone, then as part of the due diligence process, it could be a good idea to share your model with your investor and let them run their own scenarios (e.g. on cash flow drivers and investment hurdles). They can then understand the risks and can’t bleat if things go wrong.

Taking the example of Tony Abbott’s swimwear photographs, sooner or later truth will out, and we’ll know whether he’s smuggling a budgie or a cockatoo!

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Steve said: “After all my agonising over the correct formula to apply, it was pointed out to me that ultimately the value I put on the company is irrelevant because all that matters is what the market is willing to pay.”
The AFR 18 Jan 2010 (p22) has a relevant discussion on UBS view of Carsales.com (disclosure: I’m a shareholder, but not increasing my shareholding for the reasons below). UBS Jeremy Bendeich says that at 30 times forward earnings the price of CRZ is just too expensive. P/E is a rule of thumb equivalent of DCF and can be applied and compared simply.
Right now, debt-free dot coms (WTF and WEB) are on high P/Es and record prices. Looks like “what the market is willing to pay” is below a P/E of 30.

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Steve Sherlock Reply:
January 19th, 2010 at 1:10 am

as one knows when they reply to one of my blogs, i don’t reply to ‘anonymous” bloggers.

to me the anonymous bloggers hide behind to the veil of anonymity which means you can’t check their the background of their comments or their ulterior motive. i.e.they can’t be trusted unless they are prepare to be open (you know who you are mr and mrs anony-mouses)

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