When you decide to sell a house, there is a fairly straight forward way of determining a fair market value. You find “comps.” Comps are slang for comparable sales. This method involves finding homes sold within a recent period of time that compare in size, type of construction, age, amenities and neighborhood. The values are reduced to price per square foot in order to compare apples to apples.

A “comp” approach is often used by investors to determine the value of a startup business. If three startup biotech companies received first round funding for new drug introductions, an investor could consider the average of the three levels of funding as a comp for a similar investment. The weakness of this approach is much like pricing housing – sometimes it is a buyers’ market and sometimes sellers’.

First time entrepreneurs typically have no idea how to value their new venture, and of course it is a required condition to secure an investment. Say for instance, an entrepreneur knows she needs $300,000 of capital to get her business off the ground and is seeking equity funding from investors. The investors will want to know how much ownership they will get in exchange for their $300,000.

The answer is not a guess or an estimate. With exception of the comp approach, it is a mathematical formula derived in a variety of ways. The variables included in the calculation include the average price earnings ratio (P/E) for the industry of the company in consideration, the projected net earnings of the company in the last year before the investment is paid back (usually 5 to 7 years), and the amount of investment.

Some investors use a “back-in method.” This approach uses the following logic. Each investor has different expected rates of return on their investments depending of the riskiness of the investment. Money market and certificates of deposit have low risk and low rates of return in the range of 2% to 5%. Expectation of return for mutual funds and stocks might be in the 12% to 15% range since they are more risky than savings. New venture investment rates of return will fall in the 25% to 50% range depending on the progress and performance of the company.

In the case of a back-in valuation, assume the investor’s pre-determined expected rate of return for high risk deals is, say, 40% per year. Assuming a deal with the following variables: P/E of 15; projected payback in year 5 after investment; net earnings in year five of $2,000,000; and a $300,000 investment, the calculations would look something like this:

Expected total return on investment (1 + .40)5 x $300,000 = $2,258,860.
Market valuation at time of sale: P/E 15 x $2,000,000 net = $30,000,000.
Percentage of investor’s equity: $2,258,860/$30,000,000 = 7.5%

In this case the investor's percentage of ownership is based upon an anticipated future valuation of $30,000,000 and an anticipated future return of $2,258,860. While this is a legitimate valuation approach, investors are well aware that much can happen between the date of investment and the intervening time before liquidation and the future valuation is not a realistic reflection of the value today.

Most investors prefer a more temporal approach using a discount method to allow for the fact that the company today does not meet the performance criteria of a mature company. Discounts are assigned based on the stage of a company’s development. If the deal is an idea without a business plan, the discount might be as high as 80% to 90%. A deal with a business plan and a prototype but no product or sales could garner a 60% to 80% discount while companies with product and sales will range from 25% to 60% depending on their profitability. These discounts are applied against current comparable sales in the market using a multiple of sales or earnings. Companies with the potential for continued high growth will sell for higher multiples than ordinary companies with steady or declining growth prospects. For example, a medical company with a strong pipeline of new products might sell for 4 times sales or 8 times earnings where an old manufacturing companies might sell for less than 1 times sales. Looking at this method to value a pre product, pre revenue startup medical company seeking a $1,000,000 investment, the investor would compare the startup to a comparable sale and discount the valuation. For illustration, say similar medical companies are selling for 4 times sales (e.g. 4 x $10,000,000 = $40,000,000). The discount for still being a small pre product, pre revenue company is, say, 80%. The discounted value would be $8,000,000 ($40,000,000 x (1.0-.8) = $8,000,000). The total valuation after the investment would be $9,000,000 ($8,000,000 + $1,000,000 = $9,000,000). The investor’s equity would be 11% ($1,000,000/$9,000,000=.11).

My preferred method for a startup is a risk approach to valuation. My preference is based upon the fact that it is difficult to project realistic revenues of a company that is still an idea, future P/E values, and the market environment for mergers and acquisitions five years in the future. My approach takes the national high-average for funding for startup stage deals which today is about $3 million and discounts that amount by analyzing the amount of risk in the deal. The risk profile considers the five primary risk factors investors use in assessing a deal: product, market, finance, management, and execution. Each of these risk factors is assigned a weighted share of the $3,000,000 with each having a maximum value of $600,000. Each factor is then discounted based upon a variety of measures to derive a value for each risk factor. The risk factors are then summed to generate a total valuation. For example, assume risk values of: product, $500,000; market, $400,000; finance, $300,000; management, $500,000; and execution, $300,000. The total valuation of this startup deal would add up to $2,000,000. The total valuation after an investment of $300,000 would be $2,300,000 giving the investors an ownership percentage of 13%.

As you can tell, valuation is as much art as math. At the end of the day, it comes down to a negotiated agreement. But, it is important to realize that failure to understand the valuation process puts the entrepreneur at a distinct disadvantage. If the valuation is too low, the entrepreneur is giving more equity than necessary. If the valuation is too high, the investor usually assumes the entrepreneur is too financially unsophisticated or unrealistic to justify an investment. In either case, it is critical that entrepreneurs seeking private equity investment be just as knowledgeable as investors in arriving at a valuation.