Basic financial topics for startups

02/28/13 23:51:00    

By Michael Mealling

I work out of a co-working space so I see a lot of startups and entrepreneurs in various stages of formation. One of the more concerning things I've seen lately is how statements coming out of Silicon Valley and Y-Combinator are suggesting companies can get multi-million dollar pre-money valuations with no revenue and no customer validation. I would like to think that in Atlanta we have a bit more financial sanity.

There are two general methods used to value a company. Which one you use depends on whether or not the company has revenue and earnings. If the company is pre-revenue then something like the Venture Capital Method is used. The general idea is to figure out the terminal value at harvest time (i.e. how much the company is worth when you want you liquidity event) and then discount that back to the present. The key is understanding how you get to that terminal value. I personally prefer Perpetuity Growth Model since that includes both a discount rate and a growth rate. Others use a comparable company metrics to proxy for those but, IMHO, that hides to much information and includes assumptions about future markets that may not hold.

The other method is to look at liquidity events for similar companies and simply figure out a multiple of EBITDA. I.e. if I'm building a consulting company I can generally assume a multiple of 2x or maybe 3x if I have something strategic. So if my EBITDA is $2 million/year I can value the company at $4 to $6 million. That's a large range and it becomes a negotiation about where along that range you should be. Knowing WHY those comparable companies got those values means you go into that negotiation as an equal.

I would really like to help entrepreneurs to better understand this. ATDC has a series of workshops that includes a workshop on Financial Literacy for Startups. I will find out when the next one is scheduled for and update this article.

Are there other tutorials out there that can help an entrepreneur understand the hows and whys of valuations and finances?