The ultimate dark art, and probably the most controversial piece of work for a pre-commercial enterprise. Putting a value on a business is a critical requirement of exchanging investment capital for equity as it determines how much equity that investment is worth.

It is likely that the investment amount required is dictated by how much is required to be spent to achieve the next milestone, so the valuation will directly relate to how much of the business is exchanged and will then be owned by the investor. Too much equity traded too early leads to founder dilution which can be a red flag for later investors.

There are a number of ways to value a company. One that is trading will commonly use a multiple of the pre-tax EBITDA profit, with the multiple determined by the industry. Here’s a list derived from a 2019 survey of public companies. If they are significant, then existing assets will be added to that value.

The most common method for VC’s is to calculate the exit value (based on financial forecasts) using the EBITDA multiple and then work backwards by dividing their required return on investment (ROI) for each year to exit. VC’s will apply a higher ROI to earlier stage companies to offset the risk of a zero return.

For example a company that is expected to make a $5m EBITDA at the time of exit in year 5, in an industry with a multiple of 10, will have an exit valuation of $50m. The VC is expecting a 100% year on year ROI (to double the value of their equity each year), so the valuations are $25m in year 4, $12.5m in year 3, $6.25m in Year 2, $3.125m in Year 1, and $1.5625m now. So if the company needs a $300k investment to start that growth, then the pre-money valuation is $1,2625 and the equity required to secure it will be 19.2%.

Other methods that can be used include:

  • Scorecard (how does the business stack up relative to other comparable companies)
  • Checklist (evaluates key metrics of the company and assigns $ values to them),
  • Discounted cash flow (weighs cashflow against equity, and likelihood for survival)

Each are likely to give different results, and Founders are inclined to pick the one with the largest result. The investor may disagree with your methodology or may have a preference for one method over another, so be prepared to justify your choice and that you may have to negotiate.

Getting a third party evaluated report adds credibility to the valuation being presented. Some reports will use a variety of methods and then weight them to produce a consolidated figure. All of these methods are only as good as the data used to construct them, so be prepared to talk through the evidence when commissioning the valuation and also when explaining it to an investor.