Whether you’re an angel investor or a startup founder, it’s important to learn how to properly calculate a startup’s valuation. In a previous post, we looked at the importance and challenges of startup valuations. In this post, we’ll dig into one way to calculate a valuation yourself. Simply using a company valuation that another party provides may not tell the whole story. All sides are biased. This is because each party uses a valuation to serve a different purpose. To get an unbiased understanding of a company’s value, look at the method that party used to arrive at that number. Earnings are an important part of the equation.
What are earnings?
A company’s earnings are its revenue minus its costs for a specific tax reporting period. This is either a quarter, aka three calendar months, or a year. Earnings can be defined as pre-tax income, earnings before taxes (EBT); earnings before interest and taxes (EBIT); or earnings before interest, taxes, depreciation and amortization (EBITDA). For a simple calculation, assume a company made $20,000 in a month. If it spent $7,000 on salaries and operating costs that month, its EBT for the month would be $13,000.
How to use earnings in calculations
All valuation methods contrast expected earnings with potential risks. Many methods also factor in the value of the assets of the company, from tangible assets like computers to intangible assets like goodwill. Many startups do not have assets that are worth a lot of money.
Startup valuation is often seen as “fuzzy math.” This is because valuation methods rely on estimates and comparisons. The Berkus Method assigns dollar values to the amount of progress an entrepreneur has made in bringing the product to market. The Risk Factor Summation Method, a variation on the Berkus Method for pre-revenue startups, compares 12 characteristics of the startup to expected characteristics for other startups. The Scorecard Valuation Method, a more complex variation on the Berkus Method, attunes the valuation for a particular region and the expectation for the company based on seven characteristics. These include the strength of the management team and the size of the opportunity. The Venture Capital Method looks at value based on the expected return on investment.
Examples of company valuations using earnings
There are numerous ways to look at the value of the company. You can assess how much the company is worth before it receives funding, after it receives funding and using the multiple of money the company expects to return to investors divided by the amount the investors provided for the life of the company. Here are a few examples using numbers.
Example A: Before funding
The pre-money company value is assessed without considering outside financing or the latest round of financing. Say the company is worth $1,000,000. The investor provides $500,000.
The value at the beginning of the fiscal year is $1,000,000. The company expects to earn $500,000 before taxes its first year. The annual cost for operating the company for the first year is $250,000.
The value at the end of the fiscal year is $1,250,000 ($1,000,000 value + $250,000 profit = $1,250,000).
Example B: After funding
The post-money company value at the beginning of the fiscal year is $1,500,000. The value at the end of the fiscal year is $1,750,000 ($1,000,000 value + $500,000 investment + ($500,000 – $250,000) profit).
Example C: Multiple of Money
The company expects to take in 25 percent more in revenue more each year for the first five years. Costs should remain static for the first five years. The company expects to return 10 percent of its earnings to investors every year for its first five years.
First year: $250,000 ($500,000 – $250,000)
Second year: $375,000 ($500,000 + 0.25 ($500,000) – $250,000)
Third year: $531,250 ($625,000 + 0.25 ($625,000) – $250,000)
Fourth year: $726,562.50 ($781,250 + 0.25 ($781,250) – $250,000)
Fifth year: $970,703.13 ($976,562.50 + 0.25 ($976,562.50) – $250,000)
Expected return to investors for this first phase
First year: $25,000 ($250,000 * 0.1)
Second year: $37,500
Third year: $53,125
Fourth year: $72,656
Fifth year: $97,070
Total for the first five years: $285,351
Accounting rate of return (ARR) compared to initial investment: about a 57 percent return on investment (ROI) ($500,000 * 0.57 = $285,000).
The numbers above do not reflect how the real world can affect earnings and changes to the ROI. Typically, both parties write what will happen under an extreme change in circumstances into a contract. For example, if the company’s earnings dipped by 75 percent in the third year and stayed at that point, how could the company compensate its investor? What if the startup wants to merge with another company? Both the startup entrepreneur and the investors should expect good and bad surprises along the way. Attorneys can help hammer out the changes to the contract. Equity-based crowdfunding platforms can allow all parties to monitor how the startup fares in the market.
Startup entrepreneurs and investors who are interested in utilizing equity-based crowdfunding sites, including an equity-based crowdfunding platform, should disclose their expectations for investment and the company to one another. This encourages entrepreneurs to be up front about risks and goals. Entrepreneurs should initiate the process by presenting their valuation model. They should present their estimate for the first five years of earnings on the equity-based crowdfunding platform or site.