Did you ever consider the pay-off method for that kind of valuation?

http://www.payoffmethod.com

Thanks for the response and the link, Mikael. Typically, practical investors are looking for something more down to earth. As H. L. Hunt once said: "The secret of my success is never doing anything that required a sophisticated calculation to prove it was profitable." So many web-based businesses have users but hardly any customers -- and we've all seen mind-boggling valuations assigned to some of them. But I agree with you that real options have a place in valuation methodology.

The point in the above was and is that it requires no sophisticated calculations ;) Real options is just one issue in the pay-off method, the more important message is the use of the "distributions" of outcomes as the tool of analysis - real option value is just one "metric" in the whole analysis process, as one of the numbers that one would perhaps look at among others.

David, take a look at this picture for some background on what I am thinking - I am not "thinking" about real option valuation at all here (in the first place) ;)

Unless you have actual revenue or sales $ to report, and no debt, the only meaningful thing to say on value is "Pre-revenue" and Debt =$0" (unless you have prior investors or deferred salary agreements that constitute equity or debt, in which case it gets more complicated fast). However if you have no sales, or no significant sales (Uncle Marty bought 3 for his wife's cousins, and Great Aunt Elva bought a dozen for her grandkids doesn't count as "revenue" or "sales"). Sales in proforma data are entirely fictional. For that matter, unless you have written commitments for manufacturing and other costs, those are just "best guesses" at most, and more probably wishful thinking.

Real life is remarkably similar to "Shark Tank" the television show. You put on your best "poker face" which is a happy (not too happy) grin, and the investor(s) (more than one if you are lucky, or are taking a real gamble on a "showcase" of some sort) scowl. They put on their best version of doubt and calculation, evaluating if your "team" (which may be just you) are the right "partner" to have in the execution of your concept/product, and all the while she/he is thinking: if Dino down in marketing, plus Lou in production, can make me (the investor) a profit, IF I can get Wo Xin in Taiwan to build these for about half of what you think you can manufacture them for in Korea, and if I can get the German bank to do a rollover on the mortgage on the factory in Milan ... then maybe I'll have enough cash to "bet" $100,000 or $2,500,000 on this thing.

That is not to say an exit strategy is not important (although a long term investor who isn't looking to exit, ever, is often very nice to have too). But for a company to actually HAVE value, it has to have hit a sales mark of half a million or a million for at least 2 or 3 years, with steady progress toward profitability. Even better if you have shown a few thousand dollars of net profit EBITDA by the end of year 3 or 4, and especially if that net is actually EBIT while paying off any debt acquired, and putting aside a cash reserve for depreciation and replacement (which is how a really well run business should operate according to the "old school" rules of how a good business "ought" to be done.

At that point some "aggressive investors" (who should perhaps be called "profiteers") may run screaming from the room shouting, "Are you crazy? You didn't 174 those capex items for 3 years?" (And in fact some IRS rules seem to have been written by madmen, but that's another subject.) But savvy investors will be happy to hear your story, and very likely to seriously consider plunking down some real capital when you need it most, to expand on a proven business model..

Sincerely,

Stafford "Doc" Williamson

Whether you're doing convertible debt with an Angel or first-round VC financing, the 'valuation' can be a fraught subject. I agree with you that this is more a matter of negotiation than analysis, but good negotiations remain rational and factual. That's why I'm interested in folk's experience with this. I'm just focusing, here, on the narrow subject of early valuation when the business model emphasizes 'users' rather than 'buyers' - very common in web-based businesses. Thanks for your comments, Doc.

Rational and factual means you have to know the CPM, CPC, CPA for the field your website is involved in, and some "industry" statistics on ad response rates. User profiles would help (at minimum, nationality, referrer, time on site, pages visited and exit info). Comparing CPM to CPC and CPA on your site versus industry can be translated into actual "likely to buy". Monetizing visitors whether they buy or not is a sensible strategy. Narrowly selected ads can also show how competitors ads are clicked from your site which also enhances "likely-to-buy" credibility.

Do some testing, even if it is just "ad-sense", although more professional ad placements and the resulting statistics make a better, stronger argument for your case.

Run some tests, vary the independent variables, and try again.

But the bottom line remains, "Sales in proforma data are entirely fictional." On the other hand, investors know that too, so some like to see a range of projections, "best case" (which should still be conservative), "worst case" which should be something close to a total wash-out, and middle-of-the-road (realistic) numbers, which still might have to represent a "range" with variations for overall economic conditions in your market, country, or worldwide depending on your target, scope and vulnerability.

I hope that is a little more help.

Sincerely,

Stafford "Doc" Williamson

Thanks, Doc. These are solid suggestions, though also a lot of work for the Founder to compute and the Angel/VC to verify. I guess that's why they have kindly professors to call upon to assist for free or nominal fees. Do you have recommended authoritative data sources for the calculation of this?

How to assign zero/negligible value to start-ups?

Thanks for initiating an interesting dialogue on assigning values for financial decision making. The basis for this decision making is fundamentals of financial options.

I would like to link this debate to ‘means-end framework’ (Shane, 2003). This framework takes place in the mindset of the entrepreneur who has observed the changes in a particular industry and discovered an opportunity. ROV may be a method to test whether this framework is workable. The nature of mind is instability and varies with the environment, but not necessarily the variation in industry or technological environment. Mind could be influence by factors that are very remote from the opportunity under consideration. The time you put the values to the selected model both the industry and the mind already changed and outcome of the valuation is no longer applicable to a situation where you decided to exploit opportunity. The quotation of ‘Hunt’ may prove this point.

Moreover, option is a strategy to hedge against financial risk which may emanate from various sources including changes in technology which, in turn, influence the structure of the industry as well as the market. Assigning values to projects in a dynamic industry may not help make sound financial decisions. However, it may be very useful for projects in an industry where dynamism is low. I believe this should be a ‘Rule of Thumb’ when employing models for financial decision making.

Upananda

Thanks, Upananda. The issue as I see it is indeed the founder's vision and the investor's vision, which presumably overlap or there wouldn't be a deal on the table. But then they have to converge on a number that's fair to both sides.

David,

Those kind of answers are "not my field" any more, and when they were, I charged quite a bit of money (or equity) to so that kind of financial modeling (as you say, it takes a lot of time and effort, even just to marshal the forces to get it done).

I am about to become a kindly old professor (I hope) in a few months, but again, not my field any more and after going through the "starving student" mode, not inclined to take a step backward. I do wish you good luck.

If you'd like to tell me the field you are in, and the volume of traffic, I'll be happy to do some back of the envelope, rule-of-thumb estimates for you.

My email address is daodhienergy [at] gmail.com if that would be helpful. (See, I do still have a heart of gold, or at least a soft spot for start up entrepreneurs.)

Sincerely,

Stafford "Doc" Williamson

I'm somewhat in the same situation, Stafford. I'm pursuing this out of intellectual curiosity in my capacity as an interested observer and founder/angel coach. I teach entrepreneurship and business formation at Columbia in NYC. This issue comes up regularly, but I don't have a specific context in mind. For the most part, I monetize my personal expertise doing other kinds of things. Not everyone is lucky enough to live where they can have daily access to real VCs and sophisticated founders, and the questions that generates, so I thought I'd share this question, as an example of where we academics should be trying to bridge the gap between theory and practice.

Venture Capital is a fashion driven business. Valuations of raw (pre-revenue, pre-product) startups are entirely in the eye of the beholder. The best advice I can give you is - welcome to the Turkish Bazaar. In general, Comps are nice but nobody pays much attention to them until a firm approaches exit. As in any business situation, it takes two deals to get one so you'd better have a well thought out plan of how you are going to shop your deal. And randomly is not a plan. Select target VCs based on their demonstrated interest areas, the backgrounds of the particular GP you decide to approach, and the composition of the firm's existing portfolio. Beware of "service providers" who stick their hand out for fees to help you. Anybody who charges you to produce a valuation is a fraud. Any entrepeneur who can't solicit free advice from someone in the field either doesn't know how to network or isn't worthy of being a startup founder. All that being said, typical Series A valuations are in the low single digit millions. You can break into the high single digits, or maybe even the low teens, if you are a serial entrepeneur with a proven track record of making money for investors with a big idea in a hot field. But if that's the case, you are not reading this. If you are a grad student or a professor chasing a pet science project with no clue about how you are going to get a real product to market, be glad if someone offers you money at any price. Or, more importantly, find a real entrepeneur to team up with and let him or her raise the money. There are exceptions to the above but they are very rare.

I think this is pretty good advice you're giving out, Bill. As for valuations for zero/low revenue start-ups, well the silence says something in itself. If you're making money solely on the rare 'blockbuster' in your portfolio, perhaps there is no point in getting too scientific about individual valuations?