If you're a fan of Shark Tank, you've likely seen the panel of investors scoff at what a founder claims his business is worth. How do the likes of Kevin O'Leary and Mark Cuban estimate an idea's value? What's the right way for any person to do it? Take some tips from Imran Ahmad. As principal of Chicago-based early stage venture capital firm OCA Ventures, this stuff is second nature. Here's what he says you need to know about a company's valuation.
1. You need to understand the basis of valuation within a particular industry.
Certain metrics are used depending on the space. While valuation for all companies depends on growth and momentum, a Software as a Service business such as Salesforce or Workday typically also takes into account customer churn percentage and multiples of monthly recurring revenue (MRR). Yet consumer companies like Snapchat--especially early in its gestation--are often valued based upon the number of active users on the platform, how much time users are spending per session, and virality. It doesn't make sense to value a company like Snapchat on a revenue multiple because its early focus is on user growth and engagement.
Take a look at Shark Tank, which evaluates businesses across multiple sectors, ranging from food products to software applications. "'Mr. Wonderful' is notorious for taking a very pragmatic approach to valuation based on multiples, but each industry is different," Ahmad says. 'This is why you will hear [him] say things like 'toy companies are worth 1x revenue.' It all loosely correlates with what the company will eventually be purchased for or exit for."
2. Don't price for perfection.
A common theme over the last few years has been to price at the highest valuation. While it gives founders a sense of pride and helps them feel good, at the earliest stage they don't have many metrics. "Founders should keep in mind that while they can ask for as much as they want, they have to feed into that valuation going into future rounds," he says.
3. Momentum matters.
Subsequent rounds should always be larger than the previous round. "Investors like to see momentum going into future rounds, which is why companies don't raise a $5 million round and then a $3 million round," he says. "Investors want to see evidence that you need even more money because of additional users, contracts or pace of expansion."
4. Structure matters.
Founders can't merely look at their top line number for pre-money valuation because other factors must be considered. In the last four or five years the startup economy has been bullish so things like participating preferred pools, large options and anti-dilution protection were out of vogue. "You may see them return if the future gets bumpy," he says. "Make sure your terms are appropriate because a five percent post-money option pool and pre-money pool are very different."
5. Valuation is a double-edge sword for recruitment.
"People are attracted to high valuations," he says. "However, top talent might see lack of upside because the value is already high."