Valuing a Startup

The problem arises when using the comparable transaction valuation method on startups. In many cases, the startup in question has little to no revenue. Therefore, using the comparable transaction method is not ideal in these circumstances. The majority of investors use a Discounted Cash Flow (DCF) method valuing with startups. While this method can work well, it does not follow the traditional framework of a valuation based on the company’s assets, liabilities or past profits. Instead, the startup’s valuation is based on their potential for success using metrics such as growth, active user base and possible profits. In essence, the DCF valuation model uses the concept of time value of money. Typically, future cash flows are factored to the company’s projections of at least three years. These cash flows are then discounted by using cost of capital to give the factoring party a present valuation of the company.

Adding Potential

The largest take away from the typically DCF valuation method for a startup is the need to prove potential. Without potential, the valuation of the venture in question will be quite low. Though having revenue may increase the valuation and the likelihood of receiving investment, the growth potential for future profits is what will drive the investment. A few key growth factors which may be considered by startups to show their potential growth could be:

• Active User Base
• Lifetime Value of Client
• Total Addressable Market
• Organic Traffic

Currently, there are over 50 valuation methods used by investors globally. Although the majority of investors use a DCF method, all of the methods used focus on potential. Therefore defining your venture’s potential in a myriad of areas will give a clearer picture to future investors; no matter what valuation method is used.

The post Investing in Potential first appeared on Five23.

Confidence

noun | con·fi·dence \ˈkän-fə-dən(t)s, -ˌden(t)s\
“The feeling or belief that one can have faith in or rely on someone or something.”

Creating financial projections can be a difficult task if an entrepreneur does not take into consideration all the contributing factors. Besides historical financial data, an entrepreneur must be account for:

Direct Market Size: The market the company can capture in ‘x’ amount of years.
Marketing Materials: An estimate of the cost marketing the product and company will cost.
Taxes: An assumption of the cost of taxes in the jurisdiction of the company.
Amortization: Payments on a debt overtime. In many cases this is in relation to a loan at initial stages of the company.
Employee Cost: The cost of hiring workers, not forgetting insurance and pension cost if applicable.
Administrative Cost: Operation overhead; office space, insurance, internet, etc.
Attorney Fees: An attorney to act on behalf of the company in an event of litigation.
Growth Rate of Competitors: Considering this rate will allow the company to make predictions based on realistic data.

When all of these items are accounted for in the financial projections, an entrepreneur should be able to enter a pitch meeting with confidence, having a better understanding of the market and over cost; allowing more accurate and realistic financials projections. This realism of financials speaks to investors; it shows the entrepreneur understands what they are worth and to invest in them.

The post The Most Important Thing in a Pitch Meeting first appeared on Five23.

Can you name a company that has gone out of business? There is a plethora of failed companies to choose from and we’re sure you will have no problem finding one. Companies like Blockbuster, Radio Shack and Pan Am have all closed their doors for good. Five23 investigated the top three reasons why companies big and small fail, and you might be surprised as to why.

Market Knowledge

All companies start to fill a gap in the market. Whether it be a boat repair shop or an accounting office, they are finding needs in their communities and fulfilling them. This sense of market knowledge is strong when an entrepreneur starts their business, although, overtime it may wear off. Analyzing the micro and macro levels of the direct and indirect market is important to understand trends and the needs of your customers. The data you can extract from this type of analysis can help your team develop strong products that your customers want. This will also allow you to track trends in the market.
Imagine if Blockbuster had the foresight to acquire Netflix when they started noticing their market share shrinking. Or what if they started their own dvd home delivery and online streaming service just weeks after Netflix did. Maybe we would be saying “Blockbuster and Chill”.

Financing

It may come as no surprise that one of the top reasons startups fail is due to lack of financing. Only 20% of all companies raising money actually receive the funding they are looking for. This means the other 80% never acquire the capital required to get off of the ground or continue developing their idea. Many hopes and dreams of companies are stopped short for this reason, and they don’t have to be.

There are two options to obtain the necessary financing for the company to advance: Investment and Profitability. Investment can be hard to obtain but possible (Five23 covers it heavily in our blog post “here” & “here”). The second option, to become profitable, is generally difficult for young companies, but is the easiest way to establish stability. Being profitable is the goal for all companies and the quicker entrepreneurs discover how to become profitable the better. Bringing in solid revenue is the best way to ensure a strong future for the company.

Stubbornness

A common weakness in entrepreneurs is stubbornness. In some cases it may help, but in most, it is an Achilles heel that will cause even the best businesses to fail. All companies need to adapt to the ever changing market (as we discussed before), and while some don’t always see change coming, the ones that do have to acclimate.

There comes a time when an entrepreneur sees a change that he / she doesn’t want to make. Although there are valid reasons for not completely changing a product or service, making small pivots is essential. The majority of the time, the reasons business changing decisions are not made, is because of an entrepreneur’s emotions and unwillingness to change the business they spent so much time growing. However, in many cases, if the change never occurs, the business may be passed up for a product or service that is more accurate to what is wanted by the market.

To summarize, paying attention to the ever changing market is one of the best ways to stay ahead of the competition. It may allow you to have a strong and profitable product that will lead to many years as a successful company, so long as you are willing to change to stay up to date with the needs and wants of your customers. Failing to do either of these items greatly increases the chances of the business going under.

The post Top 3 Reasons Companies Fail first appeared on Five23.

Have you had to raise money for your startup before?

If you are like 99% of entrepreneurs the answer is ‘Yes’. In order to realize a young entrepreneur’s dream of scaling to profitability, funds are needed ─ luckily there are several sources of capital to help fulfill those funding needs. 

Typically, raising money from friends and family is the first step when starting a new business. While they can give you that initial needed boost, it’s more than likely that it will not allow you to see the product to fruition, and then find yourself in the position of raising more funding. Upon reaching this stage, more traditional Angel Investors or Venture Capitalist funding is normally the best option for startups in this position, however, for many the capital is never raised and their dream may stop there. 

Five23 started to look at why so many entrepreneurs never receive funding. There are a few reasons emerging as to why this is happening. In some cases, the idea itself could be the reason why the investors don’t see any opportunity for the startup to advance. Another unseen aspect is the human factor. Many investments are made based on the team behind the company and their ability to deliver goals and handle responsibilities. If investors feel the team can not meet those expectations, the investment will not be made. Finally, the most important of all reasons, which is consistently overlooked, is an incorrect valuation. More often than not, the entrepreneurs overvalue their company by at least 50%. This reason alone is why four out of five startups never realize their dreams. 

When angel investors and venture capitalist look at a company, the first thing they analyze is how much the company is worth. They do this primarily focusing on how the market is growing, what is the future value of the company, possible mergers and acquisitions, etc. When all of these items are weighed, a value is calculated. If this number is more than 20% different from what the startup says they are worth, the investor closes the door. 20% is too great of a difference to overcome in negotiation, and the due diligence process stops before it even starts. 

So how can startups keep the due diligence process moving? The simple answer is by having a correct valuation. If the entrepreneur values their company within a margin of 10% to what the investor thinks the company is worth, they are much more likely to close a deal. 10% in either direction can be justified and agreed to easily. But how can founders do this, how can they standardize their valuation to match that of an investor? 

The solution is a third party. By having an unbiased outsider look over your business plan, financials and team, you obtain a very accurate and realistic picture of what the company is worth. Valuing a company in this manner is very similar, if not the same, to what an Angel Investor or Venture Capitalist would do. This allows you to be in that margin of 10%, giving you the opportunity to see your company reach its goals.

The post The Importance of a Correct Valuation first appeared on Five23.

Hockey Stick Projections

If you have a startup or been involved with one in anyway, you have definitely seen these charts. Hockey Stick Charts as they are known in the investment world are simply exponential curves based on projected earnings or revenue of the company. These charts start at a very low and flat point. As time moves down the chart, the price starts to increase. Typically after a few months or years in the chart’s history the price starts to triple or quadruple. Quickly going from $1.5mm in revenue to $5mm, then to $20mm the following year. Once you reach the end of the chart a mere 7 years from where you started, the company’s revenue has reached a whopping $400mm.
While this is the dream and goal of every startup up entrepreneur, it is rarely realized by pre and post revenue companies. A more accurate chart is one that increases at a much more linear rate of a 161% per year. This means that if your startup is bringing in $1mm of revenue today, in all likelihood, you will bring in $2.6mm the following year. This rate of growth has been tried and tested by Five23 and seems to be the most accurate when creating realistic projections. Mind you, for post revenue companies it is vitally important to calculate using your actual growth numbers. Start your calculation using those numbers, then use a weighted value of 161% in your business valuation calculator to find an projected growth rate.
When White-Listing and valuing companies, Five23 only looks at realistic projections based on hard numbers and market data. This ensures a strong business valuation while concreting realistic and obtainable goals for the startup.

Bias Market Data

Market data is key when calculating a business’s valuation. It provides vital information and shows the path the startup will most likely follow throughout its life. These indicators can be quite powerful when used with realistic projections. The problem arises when only a section of the market data is viewed.
We’ve seen it time and time again, whether it be in startup decks, business plans or even pitch panels; entrepreneurs are plagued by bias data. It is great when you see 20% of businesses in your field see an average growth of 300% per year. However what happened to that other 80%? In most cases they go the other way. 50% saw a down year with negative growth and the remaining 30% closed their doors for good. This is the type of data that is essential, yet new companies owners seem to be blind to it. Viewing only a portion of the picture.
It has been said, “Don’t raise your voice, improve your argument”. When entrepreneurs use bias data they are raising their voice. When they show and prove how they are a part of that 20% which saw an increase, they are improving their argument. This should be the goal of every new business, show how you are better than the market and why you will beat it. This will increase your valuation calculation much more than bias market data.

Five23 | Standardizing Valuation Calculations

Human Impact

It has been said that 80% of all investments are made on the team, not the company. We at Five23 have seen this time and time again. Great companies with poor leaders seldom move past a ‘Seed Round’. Yet a new company with spectacular leaders can have a lacking business model and easily see a ‘Series B’ raise and even an acquisition. This happens because the team is bought, not the company.
While being a great and eloquent leader is not an easy thing to learn, it can be done. However we at Five23 feel the most important element in this equation is the ability to see your team’s flaws and how to improve them. Investors want to see roadmaps. This includes a roadmap on how to improve your team. Being triumphant on a personal level when times get tough is a must, although showing how you were triumphant is even more important. Having the ability to handle large amounts of stress effectively and with confidence is key. In many cases new companies over-value their true ability in these matters.
When Five23 calculates a valuation using our business calculator, this human factor plays a part. It can raise or lower your company’s valuation based on a few key factors. Mind you, the value is weighted to ensure a high amount of accuracy.

Unicornism

One of the most detrimental things that can happen to a startup is having a bloated vision of self-worth. While having great self-esteem is a must, having it too high can cause a negative effect. Especially when calculating a valuation. We’ve seen it time and time again. An entrepreneur walks into a meeting stating that the coming is worth ‘X’. The problem is there are no solid figures to back it. They see what other entrepreneurs have been able to do and think they can do the same. We hear it all the time, “We will be the next Google”. And maybe you will be, but odds are the startup will not.
We at Five23 call this Unicornism: the blind belief a startup will become a unicorn. This can happen even to the most realistic entrepreneurs. However the problem arises when this belief is factored into the valuation. This is why having a third party do your valuation is so important. It takes all the emotion out of the equation and focuses on the hard data.

End Goal

All companies raise money for a reason. Either they want to hire more talent or maybe set up a production line. While there are necessary funds required for such ventures. The number should not drive the valuation. Basically, don’t set your valuation at $20mm because you need to raise $5mm and don’t want to give away more than 25% of the company. Startups rarely receive funding this way, sadly it is quite common to do the business valuation calculation in this manner.
By far this is the biggest mistake a company can make when raising capital. That’s why Five23 takes it so seriously. We take into consideration the funding needs of the company to reach its next goal. However never at a cost to the valuation and the ability to raise funds.

The post 5 Reasons for Startup Over Valuations first appeared on Five23.