What is a startup? A startup is a company or venture with a unique and scalable product or service, led by a new entrepreneur. A business valuation, also known as a company valuation, is a process and a set of procedures used to estimate the total economic value and the assets of a business.

Founders, how many times have you been in the position of coming up with a valuation for your project or company but had no clue how to do it? Investors, how many times have you invested in a blockchain-based project (token sale or equity deal) for a valuation that was too high and asked yourself how the team came up with that huge number?

Well, today I will explain how to properly value your project so that you’ll be ready next time. The valuation of your company depends on many factors, such as the following: the goods owned by the company, the intrinsic value of the business, revenue generated, and forecasted profits for the following years.

Bob wants to start a homemade lemonade business using his grandmother’s recipe. But Bob has no money to incorporate the company, pay expenses, or purchase inventory. Now Bob is looking to raise his first round of investors.

Before incorporating a company, it is advisable to consult with a lawyer and an experienced entrepreneur in the sector to develop a solid business plan and an effective go-to-market strategy. What is Bob’s business worth right now? $0, because this is just a business idea, but Bob has “proof of concept” because other people have run the same business successfully, and this can bring his valuation to $1.

Bob is trying to raise the first round of investors, the so-called “Friends and Family (and Fools, because 50% of the startup does not make it)”. After raising $50,000 from the 3Fs-round (for 20% of the company at a $250,000 valuation, or rather, the possible future evaluation), Bob incorporates the company (by paying taxes and the lawyer), designs his company brand, buys the first materials to start the business (lemons, water, sugar, and Grandma’s secret ingredient), and spends a couple of funds on advertising.

FRIENDS, FAMILY, AND FOOLS ROUND: Usually, during the 3Fs-round, the valuation of the company is very low because of the high risks, and it can range from $50,000 to $500,000. Are the investors in the 3Fs-round a good deal? No, most of the time they bring only money and no experience, and they take a big chunk of your equity.

What is Bob’s business value right now? Between $1 and $50,000. If Bob decides to sell the business after a month because he wants to switch carriers or because it is losing money, he will get between $1 and $50,000, depending on how much risk the investor is willing to take, because he hasn’t made any profits and owns a company that isn’t making money yet.

Let’s assume Bob managed to get a patent for his homemade lemonade; this will increase the value of the company since nobody except his company can manufacture that specific lemonade. After the second month, Bob started making money, and his marketing campaign turned out to be good. He managed to make $50,000 in sales with $30,000 in operation expenses, bringing the real valuation of the company to $20,000 + multipliers, but it is too early to talk about this because Bob is not done. He is confident in his business, so Bob decided to put the $20,000 he made back into the company. After the sixth month, Bob’s business is doing well, with $200,000 in sales (in the first 6 months) and $125,000 in operation expenses, bringing the real valuation of the company to $75,000 + multipliers. After one year, Bob has $500,000 in sales and $300,000 in operation expenses (salary, utility, inventory, marketing, etc.); bringing the company valuation to $200,000 + multipliers.

Before spending funds on advertising, it is very important to build a marketing plan based on the financials of the company. No rush; just because you are spending money today does not mean that you will make it back tomorrow. Door-to-door and word-of-mouth advertising are the best and cheapest forms of advertising because you are selling your product directly to the consumer.

The valuation of the company at the moment is $200,000 (EBIT = Earnings Before Interest and Taxes) because this is the amount of money earned from the business (if there are liabilities or debt, the amount must be subtracted from the valuation of the company), but now we have to take into consideration the multipliers (the number of years with the expected revenue that must be backed by the numbers, the business size, the brand, and the market trends; usually between 2x and 6x) based on the risk of the business. The smaller the business, the higher the risks involved; usually, for businesses with revenue smaller than $1 million, the multiplier is between 2 and 3 (in years).

Let’s say, for the sake of the example, that Bob’s revenue was linear over the first 3 years in the business.
Year 1: $200,000
Year 2: $200,000
Year 3: $200,000
Total: $600,000

Bob expects to earn the same amount in the next three years (the multiplier is 3).
Year 4: $200,000
Year 5: $200,000
Year 6: $200,000
Total: $600,000

For a total of $1.2 million, this is the valuation of the business.

Let’s pretend Mark Cuban (this is just a hypothetical example) is interested in buying Bob’s Company.

How much should he pay? $1.2 million, but usually investors are looking for discounts (from 10–30%) because $1 today is worth more than $1 tomorrow. With a discount, the investor recovers the investment before the end of the sixth year. Here, it is up to Bob to sell the company for the best price possible; however, Bob is confident in his abilities and the company, so he declined Mr. Cuban’s offer.

First of all, I would value the company at least $1.5 million, depending on the value of the goods owned by the company. Second, I would advise him not to sell the company. It is better to sell 10% of the company for a $120,000 investment (at a $1.2 million valuation) to an investor (in an angel or seed round; typically in these rounds the valuation of the company is between $500,000 and $2,000,000) to help Bob improve the business model and the advertising strategy to reduce his operational expenses and increase his margins.

Assume Bob’s new business partner is Chef Wonderful (this is just a hypothetical example), and he manages to increase his revenue by 50% every year (revenue typically grows by 5% to 30% per year).
Year 4: $300,000
Year 5: $450,000
Year 6: $675,000
Total: $1,425,000
After 6 years, Bob’s revenue is equal to $600,000 (first 3 years) + $1,425,000 = $2,205,000 (this may appear exaggerated for a lemonade business, but for a startup, it is not).

He now expects to earn 50% more each year, as he has in the previous three.
Year 7: $1,012,500
Year 8: $1,187,500
Year 9: $2,278,125
Total: $4,478,125

REVENUE VS PROFIT: The revenue is the income generated, including the expenses. Profits refer to the net income earned after accounting for taxes, employee salaries, investor returns, and personal compensation.

$2,205,000 + $4,478,125 = $6,683,125

Bob is tired now and wants to exit the business. He is selling the company to Lori Greiner for $7 million (this is just a hypothetical example) because he still owns the patent and inventory for the next year and because the size and brand of the company have increased. Now Lori is going to make a billion dollars out of it! Classic.

Bob’s exit profits = 7,000,000 * 70% = $4,900,000
3F-round exit profits = 7,000,000 * 20% = $1,400,000 (28x after 6 years)
Mr. Wonderful exit profits = 7,000,000 * 10% = $700,000 (5.8x after 3 years)

I guess Bob’s granny is proud of him!

The 3Fs-round could be structured as a convertible note (which converts to equity at a later stage to delay the company’s valuation) or a SAFE (Simple Agreement for Future Equity) which is a convertible security that has no payment requirement, no maturity date, and no interest rate. Pre-money valuation. EX: $100,000 investment for 10% at a $1 million valuation keeping the valuation at $1,000,000 after the investor has made the investment. Post-money valuation. EX: $100,000 investment for 9.09% at a $1 million valuation brings the valuation to $1,100,000 after the investor has made the investment. Vesting. Both for the founders, in order to ensure that they will continue to work after the funds are raised (between 2 and 4 years), and for the investors. A business idea is not a business. Before making up valuations, think of the expenses and your margins. Do you have a prototype or beta test? How are you and your investors going to be profitable? Once you have the answers to these questions, the product, and the business model, you can get closer to a realistic valuation of your business.

Can we apply the same valuation model to Web3 startups? Yes, we can. Even though valuations in the Web3 space are frequently exaggerated, we can apply the same valuation model to blockchain-based startups. Whether they are selling equity shares or tokens during the sale rounds, the team evaluates their project at a “future evaluation”, which is why investors sign SAFE and/or SAFT agreements.

SAFE & SAFT: Simple Agreement for Future Equity is a founder-friendly alternative to convertible notes, which are used by founders to raise capital in early rounds).

Is there a formula to calculate your future valuation without revenue? No, there is no such thing. This type of valuation is based on two factors:

• Proof of concept: You can get a similar valuation from others who have run a similar business. But that doesn’t make for a fair assessment.

• Non-rational valuation: If the business model is unique, the founders value their company based on the price they are willing to sell it for. But no one would buy a business that does not make money.

So, what should you do? Compromises have to be made with investors or VCs who will buy tokens or equity based on their valuation of the business. However, before assigning an arbitrary valuation to potential investors, it is advisable to consult with industry experts such as Web3 lawyers, financial advisors, product managers, or DevOps professionals. Don’t be greedy; be smart.

Mark ~ Dec 1, 2022

THIS IS NOT FINANCIAL ADVICE: Nothing in this report/analysis constitutes professional and/or financial advice. The shared content is for educational and informational purposes only. Do your own research before investing.