Every seed investor has the following experience (or one like it) in valuation. An entrepreneur delivers a professionally developed, spiral-bound, four-color, business plan accompanied by a snappy Power Point presentation. After a twenty minute discussion, the presenter states the investment opportunity is valued at $30 million. The entrepreneur believes in five years company sales will rise to dizzying heights, despite there being no sales to date! AND for only a $5 million investment today, the investor can get 15 percent of the action. This scenario happens much too often, and unfortunately, both investor and entrepreneur have wasted their time.

This is why investors typically get to key questions early on: "How much money do you need? What equity percentage are you offering? What are you proposing to do with the money? How and when will the liquidity event occur? What market pain does this venture cure? And, why is your product the dominant solution?"

Yet another (and more frequent) valuation scenario is like the following: the investor and entrepreneur have spent weeks in discussions only to discover that the investor's analysis yields a $5 million enterprise valuation and while the entrepreneur's estimate is $8 million. They are only $3 million apart, but they might as well be $30 million apart. Here the investor's logic is much like that used in buying real estate. The buyer compares the property value to sales of similar properties in the neighborhood and sees that the purchase price is above the highest range of properties sold in the last six months. If it is commercial real estate property, the buyer might (a) calculate that it will not generate sufficient rent levels to reach a positive cash flow or (b) not appreciate in value over time to offer an expected rate of return. The disciplined, sophisticated investor, who never becomes infatuated with an opportunity, remembers there are always more investment opportunities than there are investors and moves on.

Determining a realistic valuation for a given venture is a fundamental requirement for seeking equity financing. In a sense the investor is "buying" into the future value of the business after its potential has fully optimized and then is "for sale" to the public or an acquiring company. Investors take no interest in ventures without a realistic liquidity event in its future. Liquidity events are what equity investing is all about.

Valuations of ventures are part art and part science, based upon mathematical formulas, knowledge, experience, and negotiating skills. The more knowledge entrepreneurs have about various valuation approaches, the more effective they can be in developing realistic valuations, defending their logic and negotiating terms.

Investors set valuations based upon rates of return they hope to achieve. The rate depends upon the company's development stage and the expected time to a liquidity event such as an acquisition or an initial public offering (IPO). Earlier stage ventures and longer time to liquidity implies both greater risks and higher expected rates of return. For example, an investor might expect to earn a 10-times return (10X target multiple) on investment in a startup venture projecting an IPO in five years. In contrast, a later stage company with sales and three years from an IPO presents less risk and justifies a 3-times (3X) return.

One Approach: using target multiples to first estimate the company's value at the time of liquidity is one way to derive present valuation. Multiply projected earnings in the year of the expected liquidity event times the historical industry price-earnings (P/E) ratio. Make additional adjustments and calculations for such factors as the expected IPO market, the risk factors, and the expected rate of return. Example: assume that a startup company is seeking $1 million from an investor who expects a 10X return on investment (ROI) with an IPO. The company projects to have $5 million in earnings in an industry with an average historical P/E ratio of 20. This calculates to a post-IPO valuation of $100 million. The company also plans to raise $40 million in its IPO, so the company's pre-funding valuation would have a present value of $5 million (Calculation: {$100 million -$40 million / Expected ROI} - $1 million).

Startups are always difficult to value because they have no performance history. Many investors apply rules of thumb for their investment criteria based upon assessment of risk involved and the opportunity offered: Is the founder a beginner or a seasoned entrepreneur with experience in the specific market? Does the market opportunity offer sales above or below $50 million in the fifth year? Depending upon a combination of factors, investors may use a range of $500,000 to $3 million as the pre-funding value of the company.

These are but a few considerations in arriving at a valuation. Unless you are valuation savvy and aware of the variables including market conditions, don't try this at home! Find an expert.