Chapter 6: Raising Capital
Simply put, your valuation should be inclusive of existing value (earnings, assets, intellectual property), and projected value (financial pro-forma’s, IRR for investors, future valuations & off ramps).
If your company has sales or even profit, establishing a valuation is much simpler, since you can base it off of your earnings. If you’re privy to the capital raising world you may have heard of the phrase “EBITDA”. EBITDA stands for: Earnings Before Interest, Taxes, Depreciation and Amortization. Wikipedia describes EBITDA as “a measure of a company's profitability of the operating business only”. There is some controversy as to whether this metric is necessarily the best for evaluating a given company. However, a lot of investing professionals will use this metric to compare different investment opportunities within the same industry, and it’s often used in discussions of valuation as well. If you’re looking for a deeper understanding of EBITDA and what it actually means, Investopedia has a good article you can check out HERE.
EBITDA is a good starting point to get an idea for a valuation for your business, as there’s a lot of public data to see how other companies in your industry compare. By taking the value of a company and dividing it by the EBITDA, you are left with the EBITDA Multiple. This value can vary wildly from industry to industry. However, it should give you a rough idea of what your company may be worth. Check out this list of EBITDA multiples by industry to see where your company valuation might fall: https://www.equidam.com/ebitda-multiples-trbc-industries/
It’s important to note, even if your company has no revenue yet, you can still calculate (and investors will likely want to see) EBITDA, EBITDA multiple and valuation based entirely off of pro-forma financials. Pro-forma financials are essentially a prediction on what you think your company’s financials will look like in the future, particularly if certain things were to come to pass. For example, if you’re raising a pre-revenue Series A round, you might have pro-forma financials that show how you intend to spend the investment money, and what you expect revenues and expenses to look like as you launch your product. Later in this section we’ll cover how to create your own pro-forma’s, but for now, just know that you absolutely can (and should) utilize pro-forma financials to establish your company’s valuation.
Another thing to take into account when choosing a valuation is your investors’ perspective on the deal. You can set your valuation to be whatever you want, but if investors don’t think it’s a good deal, you won’t get any funding. One of the key metrics venture capital investors look at to compare different deals is Internal Rate of Return (IRR). The calculations for IRR can be a bit complicated, but the general idea is that IRR represents the profitability of an investment while taking into account the time value of money. Check out this article on Investopedia for a more detailed look into IRR calculations: https://www.investopedia.com/terms/i/irr
These days, most VC’s will look for an IRR of around or above 20%. So when thinking about valuation (and your financial pro-forma’s), it’s important to mak e sure that the numbers work out to a 20%+ IRR for the investor. If not, then you might struggle to secure any financing.
This process can get complicated, so a good place to start is with how much money you actually need for your business. Once you have that number, you can ask yourself how much of your company that money is worth. Maybe it’s 5%, maybe it’s 25% - this will give you an “ideal” valuation. Then you can run the numbers on your existing sales or pro-forma’s, and somewhere in the middle you should be able to arrive at a valuation that works.
Overall, establishing a valuation can be a mess of math and voodoo. What it really comes down to is can you tell a convincing story. At the end of the day, if you can convince investors that the investment is a good deal, then the valuation can be whatever you want as long as it’s defensible.