Valuation methods

You need to know the value of your business to be able to attract outside capital

Valuation is an important skill when you need to attract outside investors, share shares with partners or sell your company. Valuation of a company can be based on three basic principles:
  • How much time and money did it take to get as far as you have come (cost based valuation)
  • What is the nett worth of your assets when you have paid all your bills and repaid your debts (asset based valuation)
  • What is the present value of your future cash flow when you discount that cash-flow for risk over time (discounted cash-flow or DCF valuation)
    • A variation of the DCF method is the valuation based on multiples, a quick and dirty method to do a 5 sec. valuation or reality check.
When you want to prepare an investment proposal you need to know the value or your business. You can use one of four valuation methods. Tim Bennett saved me the trouble of making online lectures to explain the above methods. He explains the methods very well. Pay close attention because he covers what takes one hour of lecturing in just ten minutes.

Three ways to valuate your company

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Discounted Cash Flow Valuation

The present value of a business is basically determined by three aspects:
  1. the value of its assets minus its debts
  2. its ability to create a positive cash flow
  3. its future value against a discount rate
We discount future value according to the following principle:
  • when I offer you a debt certificate for 100 dollars that is payable in one day, you might be willing to pay me 99 dollars for it.
  • when I offer you a debt certificate for 100 dollars that is payable in one year, you might be willing to pay 90 dollars for it (I am good for it).
  • when I offer you a debt certificate for 100 dollars that is payable in one year and I tell you I need the money because I just lost my job, you might be willing to pay 70 dollars for it.
  • same situation as before, I am out of a job and I promise to pay you back in two years, how much would you pay me for my dept certificate of 100 dollars?
    • answer A: 70 dollars
    • answer b: 49 dollars
    • answer c: 40 dollars
The answer is ... because when you offer me 70 dollars for my debt certificate, the discount rate you offer me is 30%. The next year the discount rate is still 30%, but the debt certificate is only worth 70 dollars, so its is discounted by 30% of 70 dollars = 21 dollars. I.e. answer b is correct.

Investors see you as a person who needs the money because you just lost your job. Discount rates for start-ups vary from 30% to 80% depending on the strength of the business model and the experience of the entrepreneurs.

In the spreadsheet below you can enter your nett cash flows and the discount rate to calculate the present value of your business and the internal rate of return (ROI). The following should be taken into account:
  • make a copy of the spreadsheet for your own use
  • enter your entire investment budget in Year 0
  • you need to establish the end value of your business after year 7. We multiply the nett cash flow in year 7 with the "end value multiplier" (usually 5) and discount that value to the present.
  • Normally for start-ups the value of its assets minus its debts is zero
  • The present value of your company is under "present value"
When your present value is 500.000 dollar and an investor has invested 200.000 dollar they would be entitled to 40% of the shares in that company

Net Present Value in 3 minutes

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