One of the most important issues when raising money from investors is the valuation of the company. This will drive all of the other financial terms of the deal: how many shares will be sold, at what price per share, and how much equity the investor will own in the company after the transaction.

In essence, for early stage (pre-revenue) startups, the company’s valuation is whatever the market deems it to be.  I’m not being glib, that’s actually how it works.  For example, say that I have a flat screen TV that I want to sell, if someone offers me $800, and then someone else offers me $900.  I’m selling it for the $900 and that’s the TV’s market value.  If an investor values you at $1M, then that’s your market value.  Now he could be undervaluing you, but probably not by a large amount, and if the investment goes forward at that valuation then it’s the de facto market price.  Now that doesn’t mean that there is no room to negotiate.  That’s why it’s always said that early stage company valuation is an art and not a science.

When there are no financials to base a valuation on, other factors become all important.  What is the idea; who are the founders and what is their experience; what is the potential market for the idea/product, and does it have any traction; and a host of other factors.  Typically, an investor will assign a valuation that they believe accurately projects what the company might be worth.  Usually the founders will state that this is low, and try to renegotiate it up.  This is all part of the process, and taking a step back, you can see where both sides are coming from.  The investor has a somewhat limited amount of funds that can be invested (at the current time or for the current fund) and needs to maximize returns, so its better to get a larger piece of a company for a lower price on day one.  The startup is usually very optimistic that its product has the ability to be “the” idea/product/site that will change everything.  As with most things, the number usually ends up somewhere in the middle.

To arrive at a valuation for a more seasoned company, there are metrics that can be evaluated.  These are generally multiples and comparables.  There are things like monthly website visitors, active users, etc. that can be helpful.  These are dependent however on the company’s revenue model, as if the company offers a Freemium product, then only a smaller percentage of the overall user base is paying for it.  Likewise when using comparables, either similar companies offered or actually sold, the differences in the companies needs to be taken into account, which is not always easy to do.

The traditional way to value a company is through its revenue numbers.  Software companies on average are looked at as being valued at roughly ten times (10x) their annual revenue.  Companies in other industries have other multipliers that are generally used.  These are a good rule of thumb, but don’t give the whole picture.

Probably the most widely used ratio to show a company’s value is the Price to Earnings Ratio (“P/E Ratio”).   The P/E Ratio is the market value of each share of the company’s stock divided by the earnings of the company per share of stock (usually the earnings for the last twelve months).  It shows how much a company is valued at based on the company’s cash coming in.   It can be useful to show the perceived value of a company, especially when compared to others in the same industry.  You can see that different companies may have similar earnings, but the prices of their stocks are varied.  The ones that are currently trading at a higher price are seen as having more value, but sometimes this can show that a company is being overvalued in the market.  The ratio is much less useful when comparing companies in different industries.

The PE ratio is more of a snapshot of what a company is worth at a current time.  If you want to account for the growth of the company, you need to add another item to the equation. The Price/Earnings to Growth ratio (“PEG”) does this.  This is found by taking the P/E ratio and dividing it by the company’s annual growth in earnings.  The higher the PEG, the higher the growth of the company and hence the higher the valuation it will receive.  This helps you see how a business is scaling.  Is growth constant or staggered?

The main thing to remember is that startups in the tech industry need to be treated differently than those in the traditional fields of manufacturing, retail, services, etc.  Most high tech startups do not have any revenues for the first couple of years, only create quantifiable value in the later stages of their existence, and are inherently difficult to value.  Experienced investors and entrepreneurs can usually rely on their past experiences to guide them.

I’ll finish with this thought, even if you have an idea of the valuation of your company in mind (and unless you have revenues and have used a financial metric discussed above, its just that an “idea”), you should avoid stating to any potential investors what you think it is.  Initially, you should state how much money you are looking to raise, what your company does, where you are in the development or scaling stage and other general items.  As your relationship with the investor gets rolling, the valuation conversation will come up (or sometimes the proposed valuation will just appear in a term sheet).  Its not something you should bring up too early, as it can turn the investor off right away, and unless your company is super hot with multiple VCs chasing after you, is not advisable.