Sunday, August 12, 2007
(I am writing this post from a small, 11th century chateau that we have rented in the Loire Valley in France. My room is at the top of a tall tower accessed by a stone spiral staircase and I am looking over a beautiful, peaceful river valley. The chateau is picture perfect – from a fairy tale – and my kids and their cousins are in heaven. The French really know how to live…. but even a fairy tale castle has broadband so I keep going ….)
I was approached for advice by the founders of a small company that is building models for hedge funds. Their company is just breaking even but they need cash to expand it to cover the segment of the market they have identified – so their question was how to justify valuation to a prospective investor. I sent them email with my rule-of-thumb and they found it useful so I’ll share it here:
“Valuation is usually a function of stage and expected size ~5 years out. Angel investors often want 5X return knowing that their company is likely to be sold, VCs will usually want to see > 10X return for a high sales price or IPO, but know that only 1 in 10 will make it big.
So in your case I think it depends what the size of your market is. If you are very successful how many customers and how much revenue will you have? Then you can calculate valuation. If your revenue is service revenue (very people dependent) valuation is usually 1-2X last 12 months revenue (LTM), if you have a product that sells for one time revenue and then annual maintenance then valuations are often 3-4X LTM, if you have annual recurring product revenue (like a SaaS model) then valuations can be 8-10X LTM and if it's a really big idea, growing at >50% per year it can be 8-10X next years expectation. In the “big idea” case what a long term investor is valuing is long term expansion of earnings.
So build a model for how much you think you're worth 3-4 years out and that will give you guidance on whether a fair value today is the number your investor has in mind or the number you have in mind.”