This article will give you insight into how evaluation is done by a VC. For founders, this may be the most important part of a VC deal. You have to know what percentage of the business you are willing to give away. So when the VC gives you evaluation it is important to know how they got to that number. This will be explained in this article.
Types Of Evaluation
For the purpose of this article, we have decided to give you the evaluation types which are used for startups. Due to that VC’s tend to invest in start-ups rather than mature companies. The list of evaluations will be the top four. There are a lot of methods to evaluate a company, we have decided that the top four are sufficient as they are used most frequently. This should give you a good idea on how to evaluate your own business or how it is being valued by a VC.
Discounted Cash Flow Method
This method is most frequently used for more mature companies. This method involves future expected cash flows. The steps of this method are quite simple; you, first of all, make a forecast of your future cash inflows. Once you have made the forecast you will need to use an expected rate of investment return. To calculate what the future inflows are worth today. But be careful when using an expected rate of investment return. When using this method to evaluate a startup this rate has to be higher than normal. This is because when investing money into startups it is seen as a more risky investment. Please note that it is the least favourable method to use to evaluate a startup. Due to that future cash flows are very hard to estimate for early-stage companies.
Market Multiple Method
This evaluation method is the preference of most investors, so a VC could be using this method. This method compares your startup to similar companies in the market. The goal is to find companies similar to yours that have been bought. Let’s say you make potato chips and one of your competitors was recently bought for 3X sales. This will mean to an investor that for similar company investors were willing to pay 3X the sales. However it could be that your company is slightly different, maybe other flavours or better service. Then a VC has to adjust its evaluation accordingly.
The Difficult part of the market multiple methods is to find similar companies that have recently been acquired. In the case of a niche market, this is even impossible. When this method can be used it is very reliable. So when it could be used a VC will use this method.
As the name of this method suggests, it is based on the cost to duplicate the business. So what would it cost a potential investor to make the exact same company? It could be rather hard to figure this out, especially in the case of tech-related companies. It may not cost a lot of cash to set up a tech company. However, there are a lot of working hours invested in tech startups. These working hours may be rather hard to evaluate.
A downfall of this method is that it does not take into consideration that the company may receive a lot of new sales in the short-term. If a company just finished making their prototype and are ready to launch their product, they may not be valued very highly when using this method. Despite that, the company is ready to start generating sales, which will increase there evaluation.
Evaluation By Stage Method
The last method is to evaluate by stage. This is the most frequently used method by VC’s and angel investors. This evaluation method is based on what stage your company is. However for this model, there are no clear rules, this depends on the VC themselves. For example, VC’s that are investing a lot in start-ups, value idea stage companies a lot higher then other VC’s do. When you are making an evaluation for a VC make sure you know what stages they invest in. If you are a later stage company you don’t want a lower evaluation because the VC normally invest in start-ups.
How To Ensure A Good Evaluation
So how do you ensure that a VC will valuate your company accordingly? Make sure that you apply to the correct VC. Some VC’s may not have a large fund of money and therefore only invest in startups. These VC’s will valuate idea stage companies higher if the foundation of the company/idea is good.
You can also discuss the evaluation you have received from the VC. Ask them how they got to a certain evaluation. For a VC it is also an estimate what your company is worth so they are quite often willing to adjust their evaluation slightly.