finance, venture-capital, entrepreneurship, valuationI would like to learn more about the statistics, formulas, and financial concepts behind venture capital deals. I’ve seen several books that are more of an overview of the venture capital process from both the side of the entrepreneur and investor, however these focus on the entire process and what to expect rather than the methods of valuation.
You don’t need an entire book… :)
There are 9 generally recognized ways to value a startup (assuming it’s on software/saas/hardware business):
1. Sales Multiple A quick and easy way to estimate the value of a software company is by applying a multiple to your annual revenue. For companies with significant direct costs of sale such as purchased hardware, applying the multiple to gross profit is more appropriate. There is some latitude in valuations based upon the growth of the company, using trailing (last 12 months), actual (fiscal year projections) and forecasted (next twelve months or fiscal year) revenue. The sales multiple method is not often used when revenues are highly volatile or declining. Sales of software companies typically occur in the 1 to 2 times revenue range, although sales at higher and lower multiples do occur.
2. Price Earnings Ratio This traditional method of valuation has been applied to companies in all industries, and is the most often quoted method of valuation for public companies. P/E multiples ranging from 5 to 50 are common in the software industry, with growth of company and growth of industry directing the selection of the multiple. A reasonable valuation is generally around 10 times net income.
3. Internal Rate of Return Method Internal rate of return is a classic financial methodology used in valuations, where projected profits are discounted back to the current period. The problem with software companies is that most of them do not have a stable enough history to rely upon the numbers. In other industries, the calculation might use up to ten years of projected cash flow, discounted back to present value and discounted a further fifteen percent. Software companies would never use more than five years, and would employ a higher discount factor of twenty percent or more.
4. Free Cash Flow Model This method is often used to value privately held software companies, with a range of five to eight times the cash available to spend after operating expenses being the usual method of calculation. Free cash flow is important when the buyer intends to finance the purchase using the revenue from the purchased company itself. Free cash flow is net income plus interest expense, income taxes, depreciation and amortization, minus software development costs capitalized in the current year and current year fixed asset purchases.
5. Replacement Value This is one of the best ways to create some minimum value, especially for young software companies, or where the investment in technology has been heavy and the life span of the technology is long. Replacement value goes up where there is a high barrier to entry due to proprietary tools or patents or new technologies. The replacement value assigned to the software is determined by calculating the amount of time and cost which would be saved in the rewrite of the company’s products. The value of the installed base may generally be figured at around four times the recurring revenue.
6. Book Value Method Book value is the amount of assets on the books in excess of the liabilities on the books. While an important accounting concept and important in managing the business, it is generally not very relevant in determining the true value of most software companies, since the value of the user base, recurring revenue stream, and cost to recreate the technology are largely ignored using this method. Also, book value for a software company may be influenced heavily by the company’s policy with respect to capitalizing software development costs. Book value is often multiplied by a multiple of 2 or 3, then used as a sanity check against other methods.
7. Liquidation/Salvage Value This value, in software businesses especially, is only used as a minimum floor below which no offer should ever fall. Software companies have very little in the way of hard assets, and the most valuable assets are intangible.
8. Similar Company Transactions A very logical way to examine the value of a company is to base the value upon what someone else is willing to pay for a like company. Unfortunately, information on private company transactions is rarely available, except when public companies purchase privately held firms and must reveal the amount paid in their 10-Q and 10-K forms for public scrutiny.
9. Recent Internal Transaction Price This value often sets the basic minimum if there has been such a transaction within a relevant time period. Qualifying transactions would include actual share sales prices, qualified stock options granted, valuations by independent appraisers if used for Employee Stock Option Plans under ERISA rules, or internal buy-sell transactions between partners. There is flexibility here, as in any valuation, based on the negotiation as to how the payment is to be made and over what time period, etc.
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