Here’s the best way to value your startup

(Editor’s note: Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a law firm specializing in the representation of entrepreneurs. He submitted this column to VentureBeat.)

A reader asks:  I’m the founder of a mobile apps startup, and we’re starting to get some incredible traction.  I’ve been bootstrapping the venture for the last year, but I’d really like to raise about $2 million to scale this thing.  If a VC invests $2 million, what percentage of the company will he own?

Answer: It depends upon the value of your company prior to the investment (commonly referred to as the “pre-money valuation” or “pre”).  The VC’s percentage ownership is calculated by dividing the amount of its investment by the post-money valuation of the company (which is equal to the pre plus the amount of the investment).

For example, if the pre were $4 million, the VC would get one-third ($2,000,000 divided by $6,000,000); on the other hand, if the pre were $1 million, the VC would get two-thirds ($2,000,000 divided by $3,000,000).

The real issue then is — how do you determine the value of your company prior to the investment?  Let’s look at that.

I come from the M&A world in New York, where the valuation of target companies was more science than art.  Indeed, targets were typically valued based upon a discounted cash flow method (DCF) – which basically estimates the net present value of the target’s future cash flow, discounted to reflect risk.

In the startup world, however, DCF doesn’t work because there is little or no historical financial data and projected cash flow is thus pure speculation.  Accordingly, the valuation of startups is highly subjective and is more art than science.  To put it bluntly: your startup is worth whatever the market says it’s worth, which was starkly demonstrated during the dot-com bubble.

So what does this all mean in practical terms?  It means you need to get out there and effectively pitch a bunch of VC’s in your space and get them excited about your venture.  By doing so, you can, in effect, drive the market by creating a competitive environment and playing the VC’s off of each other.  This is akin to what investment bankers do when they’re selling a company: they create a competitive environment (or the perception of one) to drive-up the purchase price and to provide negotiating leverage.

That being said, you should be aware of the following caveats:

• This process is a tricky one – and best done with the help of an experienced lawyer and/or consultant.
• At the end of the day, you will still need to convince the VC’s that you can deliver a 10X return (i.e., that they will make 10 times their investment).  VC’s will thus take into account certain significant factors such as the quality of your management team and the size of your market.
• As I have previously discussed, startups often make the mistake of focusing too much on valuation.  Indeed, there are other important terms that affect the economics of a financing, including the liquidation preference and the size of the option pool.

Startup owners: Got a legal question about your business? Submit it in the comments below or email Scott directly. It could end up in an upcoming “Ask the Attorney” column.

Disclaimer: This “Ask the Attorney” post discusses general legal issues, but it does not constitute legal advice in any respect.  No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  VentureBeat, the author and the author’s firm expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this post.