The Art of Valuation II
Continuing “The Art of Valuation” series, we give a brief review of the valuation methods that the entrepreneurs can use to value their companies before engaging any investors.
With the experience of company valuations, investors (usually former investment bankers) can make a good estimate of how much a company is worth and the amount of equity they seek from the startup company with their investment. They enter into a negotiation process with a clear idea what they want. For the entrepreneur, you need to do the same. Most entrepreneurs, regardless of their age groups, don’t seem to have a good idea on how much their business is worth, and how much investment they need from the investors and worst, most of the time, they gave away too much for too little. Here are some common ideas to give you a brief idea on how to do the estimates for valuation of your company:
- 1. Price/earnings ratio: The price/earnings (p/e) ratio is a common method of valuation used for established companies with a reasonable track record. The method adopts a multiple to the after-tax profits of the company. The simplest rule of thumb is that the multiple will increase as the company’s growth expectations increase. One uses a multiple between 8 and 12 for a mature company, and a multiple of 20 or even 30 for high growth companies (particularly high tech companies).
- 2. Sales Multiples: One can estimate the value of a business by the aid of comparable values using known and existing businesses as a benchmark. Examples of good metrics are the price/earnings ratio (PER) and the market to sales ratio.
- 3 . Return ratios: All investors view profit maximization as their primary self-interests. To do so, they look to maximize the return on investments (IRR). The IRR is the compound rate of return of the cash flows associated with a particular investment. It is the method used by venture capitalists to determine the relative attractiveness of an investment opportunity.
[1] New Venture, “Starting Up: Achieving success with professional business plan”, McKinsey & Company.
[2] Koller, Goldheart and Wessels, “Valuation”, 4th Edition, McKinsey & Company.
[3] Bygrave, Hay and Peters, “The Venture Capital handbook”, Prentice Hall.
No related posts.
Loading ...
One Comment, Comment or Ping
James Seng
Those number you cite are often for listed companies. Mature stable companies get 8-12 P/E and high growth company gets 20-30 P/E and even above 100 if you have a “sexy story” like China play or if you are Google.
However, in a startup, you are nowhere near the stability of a listed companies and therefore you have to take a discount on P/E.
In fact, the further you are from IPO, the more discount in P/E or P/S you have to give. If you expect to go IPO in Round D at P/E of 10, you can expect Round C to do at P/E at 6, Round B at 4 and Round A P/E at 2 or even 1.
As crazy as it sound to do P/E of 1, there are significant risks in early stage. P/E are forward figures (ie, up to your imagination) so if you are very early stage, you might not even survive after 6 months, not to mention 12 months or maybe you wont even hit your target.
The earlier the investors, the more they expect.
So if you are a startup raising 100k, 1M or 10M, be reasonable in your valuations.
Most of the deals I done fall apart because of unrealistic expectations from the founders.
May 9th, 2007
Reply to “The Art of Valuation II”