Startup valuation for geeks

Valuation is the process of coming up with the market value of a company. This means that any investor who is on the right side of sane will see the valuation of the company before he even sneezes in your direction. Yet to most techies and geeks ‘valuation of a company’ looks like ‘?%&*#$@!?%&*#$@!?%&*#$@!'(martian symbols). Me being the philanthropist(ego maniac) I am, could not let those ‘money types’ blabber away about stuff like valuations, return on investments and discounted cash flow. Instead i decided to put my ‘amature quack’ status to good use by preaching my own brand of geek friendly finance. Anyway im all set to venture into the deepest darkest corners of the universe where few geeks have ever been before for your benifit. In case i fail miserably be kind and point my mistakes(Then you can be rutheless and point and laugh(comeon where is the fun when not kicking somedboy who is down) ).Anyway let me start by telling you why geeks(startup geeks) should understand valuations.

Reason 1: Stop kidding yourself(Know Thyself)

Most startup founders tend to believe that their brilliant idea is worth millions. As it turns out most of the time a brilliant idea is just that an idea. One of the best things to do for a startup is to stay grounded in reality instead of fantasy. Dont get me wrong, dreams should and do drive you but what you should be worried about are illusions. Valuation of your company forces you to deal with the reality of what your value is based on for the most part solid data and for some part conservative estimates. Hence a valuation of your startup can give you a clear picture of how “valuble” your company is which is much more relevant to you as you are investing your precious time in it. If you feel that your not getting good return on your investment then its time to reasses your companies goals and policies. Hence valuation can serve as a good tool of introspection for your company.

Reason 2: Bullshit Filter

Know that the value of your company can act as a filter against all the bullshit figures others(investors) will come up with. It is always the investor’s imperative to undervalue your company, i’ll explain why. Suppose your scouring the market for a company to buy and come across the company ‘SuckersAreUs’. Well as it tutns out the founders of the company are all suckers and dont really know how much their company is worth. What do you do? well you say “Aaaah! your company isnt so gr8(even though you know it is) no one is going to pay 5 million for it.” The suckers not knowing their own value agree to be bought out at 3million dollars. What you have just bought a 5 million dollar company for 3 million dollars. Im not suggesting that all investors try to take you for a ride, but its good to know the approximate value of your company so that you will be protected against people trying to hussle you out of what is rightfully yours. On the flipside you must also take your valuation of the company with a pinch of salt as some of your assumptions might be off. Look at the friendster story. Its living proof of how wrong valuation assumptions by the company can spell doom. As they say valuation is more art than science and sometime ur art can really suck.

Reason 3: Makes you look cool

nuff said.

And now presenting to the world, “suman’s framework for startup valuations”(trumpets in the background playing pompous tunes). Before we start with the framework though let me explain what my reasoning behind this kind of a framework is so that you could point out some obvious blunder i committed and i could correct it.

Value of a company

How can one quantify the value of a company? Well in financial terms there are many ways to do this but let us try to approach this from the logical point of view. Let us begin by asking ourselves the simple question…

Q) What does a company do?

A) A company or business in general acquires resources or materials at price ‘x’ produces product ‘A’ and sells it at a price ‘y’. The company makes a profit when ‘y’>’x’. Where the price of both ‘y’ and ‘x’ are decided by their supply and demand in a normal market environment.

Value Addition

From the above we see that ‘x’ is the value of the resources which are input into the company and ‘y’ is the value of the product which is the output of the company. The value discrepancy(Y>X) can be taken as the quantification of the value added by the company. Hence value addition of the company and consequently the value of the company can be determined using this approach. Here one has to take note that the value or the price of the input resources are taken individually for each resource. This is done because any possible integration of the resources can add value or make the resources more costly. For example google’s 1600 strong research team is worth more than the same 1600 researchers existing independently out in the market. Here the value of sum of all parts is definitely higher than the value of the parts. So you might be thinking how can one quantify something like “myspace”. Well you just assign a value(price) to each user, page hit or content unit and the cumulative value of all these units is the value of the products produced. And if your company is a startup without any customers yet, then look at your competition and make a conservative estimate looking at their sales and projecting what your sale might be. worse still if you are a high ip startup with zero customers and zero competition then you have to find some way to gauge the latent demand for your product in the market, without which you might as well be randomly picking a number as the value of your company at this point.
In the above diagram and paragraph we were able to quantify the value of the company only in one product they produced. In order to determine the value of the company let us extrapolate the above to say the following. The value of the company is

Value of products over a period ‘T'(VOP) – Value of resources over period ‘T'(VOR) = Value of the company over a period ‘T’

here ‘T’ is usually one year. Yeeeeeeeeeeeeey we have the value of the company finally! Not so fast skippy, we still have a lot to go through. You see the value of an investment is slightly more complicated than that. The purpose of investing money is to make more money. Which means it doesnt just matter what the value of your company is today, of more importance is what the projected value of what the company is a few years down the line. Let me explain this in detail.

There are 2 companies, company ‘GoGetters’ Company ‘Slackers’

Company ‘slackers’ is a multi million dollar company with huge assets

Today’s net assets 12 million dollars………………………………Projected net assets in 5 years 15million

Company ‘GoGetters’ is a small company

Today’s net assets is 1 million dollars……………………………..Projected net assets in 5 years 5 million

Now given 500,000$ to invest, which company would you invest in? If you said the ‘slackers’ u are one and if you said ‘GoGetters’ u are correcto. As you can see the second company gives higher returns on my investment than the first one. Hence if i was an investor i would also asses the value of the company not just with today’s cash flow but also the cash flow that is expected in the future.
So now the formula morphs into

value = (VOP1 – VOR1) + (VOP2 – VOR2) + (VOP3 – VOR3) ……

here 1,2,3 .. represent the years where 1 is now and 2 is over the next year so on and so forth.

But there is another problem here, you see 1$ today is more than 1$ tomorrow. Similarly 100$ today is more than 100$ 5 years from now. This is called inflation where the money today is worth more than money tomorrow. There is also a certain risk here because except the first year all the other years are projections of what the value might be. Hence if it is a high risk industry where either demand or supply of both product and resources can fluctuate then this risk needs to be taken into account. Another thing that also needs to be discounted for is the value of no risk investment, which means if you put your money in a bank instead of in the company you’ll be getting 5% or 6% return on your investment every year and this needs to be taken into accound when discounting projected future values.

So we need to discount

i = inflation

r = risk

n = rate of returns for no risk investment

Now the formula morphs into……..

value = (VOP1 – VOR1) + (VOP2 – VOR2)/(1+(i+r+n)) + (VOP3 – VOR3)/(1+(i+r+n))*(1+(i+r+n)) ……

Note here that we did not discount for the present year this is because our investment is at the current inflation, with no risk and no interest. Now let us see how this works with an example.

First and foremost we need to assign values to the variables

i = 2% rate of inflation.

r = 3% risk.

n = 5% rate of no risk return.

vop1 = 200, vor1 = 100

vop2 = 300, vor2 = 200

vop3 = 250, vor2 = 200

when we substitute in the above formula we get ( i left the calculation to you, check wether im right)
value = 232.22

So if you float 100 shares of your company each is worth 2.3222 after the valuation. One must make conservative estimates of all the above variables and that too only projected to 4 to 5 years in the future. Beyond which such assumptions are not meaningfully possible. The above framework can also be viewed as a different take on discounted cash flow method check it out for more info. And another thing since this is for startups im taking year 1 as the first year of operation. If this is not the case with you then you have to add Net Present Value to the above equations.

Net Present Value = value of the company before the earnings of this year(VOP1 – VOR1), Which could mean the earnings of the previous years of operation. So the entire formulat will be……

value = NPV + (VOP1 – VOR1) + (VOP2 – VOR2)/(1+(i+r+n)) + (VOP3 – VOR3)/(1+(i+r+n))*(1+(i+r+n)) ……

And that’s that for today boys and girls. I’ve been sleeping on the keyboard for the past hour so all the above could be random key strokes. Bye

-Suman

3 Thoughts to “Startup valuation for geeks

  1. Thank you. It’s a very easy to understand explanation.
    I started to involve in the risk management of the energy trading industry. Do you know where I can find simple articles like this about risk management, financial related, valuation, pricing models, simulation, etc. This would help me out a lot. Thank you.

  2. Hey christine,

    Sorry i can’t guide you the appropriate material but, google should be a good starting place. Search for stuff like “Risk modeling” and analysis models. Hope this helped.

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