No negotiating item between entrepreneur and investor creates a wider gulf than this one. The two parties may agree on every other point but will have diametrically opposing views on what the startup is worth and how much equity the investor should receive in exchange for his capital.
To put it bluntly, placing a credible valuation on a startup is impossible. Privately held companies on the sales block are typically valued at a multiple of their historical ODCF (Owner’s Discretionary Cash Flow). ODCF is the cash that can go into the owner’s pocket after all operating costs are covered for the year. Obviously, since a startup lacks historical ODCF which is the basis for an objective valuation, any opinions expressed on valuation will be entirely subjective.
As a rule of thumb, this is what invariably happens when a startup is seeking seed capital. The entrepreneurs convince themselves based on discounting future cash flows that the company is worth today, say, $5 million. So, since they are looking to raise only $500,000 the investor providing that sum should be happy with 10% of the equity. Then when they start talking with a serious investor they discover that he expects 50 or 51% of the equity for his money. That’s the magic number for most angel investors these days.
You need to know these two terms.
Pre-money valuation: venture capital terminology for the valuation given to a company by a venture capital firm before it puts money into it. For example, a start-up is valued on a pre-money basis at $4 million. After $1 million is invested the company has a post-money valuation of $5 million with the venture capital firm owning 20%.
Post-money valuation: valuation placed on a firm immediately after receiving a round of funding.
Business Valuation Issues Related to Startup
Article discusses issues to be considered when formulating a valuation for a startup.
This is strictly for entertainment purposes.
Academic paper on the subject.
Calculating the Real Value of High-Tech Companies
Dramatic fluctuations in the stock prices of Internet companies have been common. As a result, it’s often very difficult to determine the real value of those companies. This article explains some of the problematic accounting practices and other issues behind valuing high-tech companies.
So, you need some money to get your tech start-up moving. How much of your company should you give up to get the money? This article explains how to value your company for venture capitalists.
This model explains a simple way to value a start-up company when working with investors. It is provided courtesy of Joe Ollivier of First Capital Development, a private investment and hard money lending firm based in Provo, Utah.