Valuation

2003: “The subscription model of buying music is bankrupt. I think you could make available the Second Coming in a subscription model, and it might not be successful.” 
— Steve Jobs, in Rolling Stone


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Calculating Your Business Value.

After coming to terms with exchanging ownership for cash investment, the main challenge is establishing and agreeing the valuation of the entity. Let’s say you want to borrow $100,000 and you are willing to give up 20% ownership of the company. That means you already value your business at $500,000. What is that valuation based on? Do you have customers lined up? Have you contracts in hand? What pre-orders can you guarantee?

These are questions going through the minds of the potential investors. Of course, you think your company is great, but investors need a degree of confidence that their money is going to bring a return. The less you can guarantee or predict, the more ownership they will want in order to mitigate their risk. In reality, if you have little more than a great idea, some seed capital, and a strong business plan, most investors will want more than 50% of your company from the start.

The process of valuation, however, is a negotiation between you as the person with the brilliant idea and the investors who see potential in it. Valuation gets calculated in two terms called pre-money and post-money. Pre-money refers to a company’s value before it receives outside financing, or the latest round of financing, while post-money refers to its value after it gets outside funds, or its latest capital injection.

Suppose that an investor is looking to fund a hi-tech startup with a check for $250,000. Based on its potential and the amount of money the entrepreneur has already put in, they agree that the company is worth $500,000. The ownership percentages will depend on whether this is a pre-money or post-money valuation. If the valuation is pre-money, the addition of $250,000 bumps up the company value to $750,000 post-money. The investor would own 250/750= one third of the equity. If the valuation takes into consideration the $250,000 investment, it is referred to as post-money, meaning the company was really only valued at $250K when it stood alone. Now valued at $500,000 the founder and investor are equal (250/500) owners.

This means that as an entrepreneur you must fight hard for the best pre-money valuation possible, which adds even more weight to the need to perform the business-plan process with real stakeholder feedback.