Financing How to value your startup – understanding the common startup valuation methods
Maybe you are fund raising or considering selling a portion of your startup to an investor. Either way you need to value your startup to figure out a fair price for the equity being sold and money being added to the business or being taken out by you.
There are a few approaches to valuation and taking on an investment in your startup.
Valuation based on EBITDA
EBITDA (pronounced eee-bit-dah) is earnings before interest, tax, depreciation and amortization. You can roughly think of EBITDA as annual net profit for now. So if your startup is further along and generated $1M ($1 million) in profit in the most recent year then a multiple might be used such as 4 and your startup could be valued at $1M x 4 = $4M. If you wanted to sell 25% of your company then the investor would pay you $1M as the owner of the company and they would receive 25% of the stock. The multiple could vary based on the stability of the business in recent years, growth opportunities and many other factors. EBITDA-based valuation is seldom used in the startup software world and is more common with a traditional business like a physical store or a services business. The valuation is being determined based on the efficiency of the business to generate revenue while keeping costs low.
Valuation based on revenue and growth
It is more common in the software startup world to calculate valuation based on revenue and growth. This is because these startups typically grow very fast and use all their cash to grow even faster meaning that there is seldom much if any profit. To calculate valuation using this method, you take the revenue of your startup and multiply it by a multiple. The multiple is negotiated between the parties based on the growth rate of the startup. A startup growing at 40% per year may receive a multiple of 6 to 10 whereas a company with 10% growth may only receive a multiple of 1 or 2. High growth can really drive up the value of your startup in these calculations!
An example might be that your startup did $3M in revenue last year and did $2M the year before so your growth rate is 50%. This could allow you to negotiate a multiple of perhaps 12 so your startup is valued at $3M x 12 = $36M. Selling 50% of this startup and receiving $18M from an investor would definitely be life changing. 🙂
There can also be many variations to valuation since some companies may want to value the company on revenue for the last 12 months, or projected revenue for the forward 12 months or even a mix (6 trailing months and 6 projected months). Lots of options and complexity.
Valuation is a fairly complex topic and I am giving it a very cursory overview. There are companies who will charge you thousands of dollars to analyze your business to produce a report on the value of the business. For some transactions, this may be necessary especially if you need to substantiate valuation for tax purposes or other compliance reasons.
What about pre-revenue or early revenue startups?
Calculating value is even harder if there is no revenue or if it is very early days and the startup doesn’t have much revenue yet. In these situations, a convertible note is often used. A convertible note is effectively a loan that converts into equity for the loaner at some point in the future. It allows valuation to be put off until a Series A round of financing occurs which will be an easier time to determine valuation. Convertible notes are simpler, faster and typically cheaper (in terms of legal fees) than an equity purchase for early stage startups. There are also possible advantages in terms of taxes and not giving away any control in the startup but I won’t dig into this as convertible notes are a big topic all on their own. Just know that a convertible note has an interest rate and typically also a valuation cap and often a conversion discount.
Example of a convertible note
Investor puts in $500k and receives a convertible note with a conversion discount of 20% (fairly typical) and a valuation cap of $5M and an annual interest rate of 5%. When the Series A round happens after 1 year, let’s say the valuation is determined to be $10M. Assuming shares are being sold at $1 per share in the Series A round, the investor would buy their shares at 0.50 per share due to the valuation cap so they would receive 1 million shares. The conversion discount wouldn’t apply since the valuation cap yields a lower share price than the discount. The investor would also receive additional shares based on 5% interest for 1 year on $500k (25,000 shares). The early investor is rewarded with 1,025,000 shares for their $500k early investment whereas the Series A investor only receives 500,000 shares for $500k.
SAFE (simple agreement for future equity)
A popular alternative to convertible notes in recent years is the SAFE agreement which was created by Y Combinator (you can download a template online). They are very similar to convertible notes but they are not a loan and do not accrue interest. They are simpler and easier to implement than a convertible note.
Hopefully this has given you a basic understanding of valuation so you know some of the terms and where to start digging further. Good luck!
Also remember that the most attractive thing to an investor will be revenue and growth – so build a great startup that is growing and you won’t have trouble finding investors.