You're ready to raise capital and need to value your company. While business school professors will tell you there are multiple ways to value a company using discounted cash flow, in the real world for emerging consumer companies, there is only one method that matters-comparable company analysis.
First, let me explain why discounted cash flow, or DCF, doesn't usually work for those of us in the consumer startup world. If your company has less than $100 million in revenue, a DCF model relies on too many inputs that are unpredictable for a non-mature business. As a result, the valuation you come up with will likely be off.
A comparable company analysis, on the other hand, will help you set a market valuation that resonates with sophisticated investors. If you're trying to raise money and you haven't done a comparable company analysis, you are making a big mistake. This is the tried and true method for valuing a young company.
Here's what you need to do:
First: Find similar size companies in your industry. Talk to experts; use Google.
Second: Identify the metrics that matter. In consumer and retail, the key metric is net revenue, not gross. Your valuation will be a multiple of net revenue. Depending upon the size of the company, typically 1x-4x trailing twelve month net revenue. This is one of the big reasons I love consumer and retail-valuations are real, driven by actual numbers, not based on hype or guesswork. In tech, on the other hand, valuations swing dramatically up and down-just look at hyped fintech these days.
Third: Find out when each of those similar companies either raised money, if you're raising capital, or when those companies had a full exit and were acquired by a strategic or a private equity firm. Note: a full exit typically is at a higher valuation multiple than a growth equity investment. Stay focused on comparable sized businesses. If you are a shampoo company with $5 million in revenue trying to raise $1 million in growth equity, don't waste your time researching what Procter & Gamble paid for a $200-million revenue shampoo company. It's not relevant to your business and your raise.
Tip: Do a sanity check. If your company has less than $1 million in revenue, then revenue multiples can be a little wacky. For a fast growing company there is not a big difference between $300,000 in revenue and $600,000 in revenue, but there's a massive difference in valuation multiple. So use common sense. Here's a good guide: In early rounds, entrepreneurs shouldn't give up more than 20-30% of their company in any given round. If you're giving up more than that, then you may be undervaluing the company or raising more than the business needs to grow. Conversely, if you give up much less than that, then you may not be raising enough money to last, or the valuation you're using may be too high.
The more comparable companies you can look at, the better. Ideally, you find at least 15 to 20 data points. If you're an early-stage company in consumer and retail, you can use this database, which is derived from the review beginning in 2012 of more than 5,000 consumer and retail companies with revenue of $1 million to $10 million.
Tip: Don't get greedy. Every week, I see at least one great company asking for a valuation far above what the market would suggest is fair, based on comparable company analysis. Despite the great products they may have, these entrepreneurs are shooting themselves in the foot, making a fatal mistake by overshooting valuation.
Here are the two typical pitfalls founders fall into when valuing their company two high:
Overdrawn out, very time-consuming fundraises. We've looked at thousands of companies, and we have helped hundreds raise. The leading reason investors pass on a company is because the valuation is too high. This is also the most common reason we pass on a company. When a lot of investors pass, the word gets around. Your potential investors can tell that you've been raising for a long time. You can't hide it, and it's far from encouraging for investors. Your company becomes just like a house that gets listed for sale at a price out of line with the market, and then sits month after month after month with no offers. The average early stage consumer company that raises takes eight to twelve months to raise capital in the offline world. That's a very long time. If you're asking for a valuation that is meaningfully above average, you can bet your raise will take longer.
The second type of pitfall comes for founders who actually get the too-high valuation they want, really initially raising successfully. If this year's tightening VC market has made anything clear, it's that mega-valuations early on are not always a precursor to long-term success. If you attract investors with a huge valuation, what happens when you need to raise again? Investors and entrepreneurs typically want subsequent rounds to have an even higher valuation, but potential investors in the next round may not be willing to mark the valuation. Now you've upset your existing investors. Their investment has now gone south. The spiral begins: Existing investors lose confidence in the CEO, new investors lose interest in the company and company can't raise the round it expected. It the worst case scenario, board members lose faith in the CEO, and then the CEO is out of a job, all because that he or she tried to reach for a high valuation early in the company's life rather strategically wait it out to maximize the valuation at full exit.
Valuing the company is one of the most important tasks an entrepreneur will face. There is no formula. It's hard work. Do it wrong, and you and your company will suffer the consequences. But if you thoughtfully leverage data and comparable company analysis, use some common sense, and don't get greedy, you'll likely find a solid, real-world valuation that will be good for the company, investors, and the founders.