How to Value a Startup Part 4: The 5 Years Out Concept

Before you buy a car you kick the tires and sniff the interior. When investing in a startup, you need to do something similar; even though there aren’t tires to kick or interiors to sniff. You need to figure out what the value of the startup is to help you determine if it’s worth investing in and how much you’re willing to stake.

I don’t believe a single valuation model will act as the panacea that will give you a single bottom-line number to say “Hey, this is how much the business is worth”. (Who wouldn’t want a panacea but it ain’t gonna happen — sorry about that.) High expenses and low-to-no income make accurate valuation tough. Competing ideas of how something should be valued make it tougher. And determining how the market will accept (or reject) the startup’s products make it “tougherer”.

I believe a collage approach is the way to go: Angels will apply several valuation calculations on different aspects of the business to get several pictures of value. Individually, these don’t provide enough data points to act on. But when taken together, they can deliver powerful insight to shape the angel’s evaluation.

In researching this week’s contribution to the “How to Value a Startup” series (part 1, 2, 3), I came across two similar calculations from two different thinkers in the startup field. I’ve called these calculations the “5 Years Out” valuation because angels might very well want to use both.

Ryan Junee, a startup advisor currently working at YouTube, gives this calculation:

(1 + IRR)^years x investment = future value

This calculation says that if an investor wants a specific ROI on their investment, they need to invest a specific amount of money at an anticipated rate of return over a certain number of years. The calculation may look complex but the concept is “investing 101″.

Junee gives the example of a company who needs $2 million. An investor is willing to accept the risk and invest $2 million for 50% ROI over the next 5 years. Plugging the numbers into the above calculation gives the following: (1 + .50)^5 x $2m = $15.2m. Now, you may not be able to determine how much a company is worth today but you may be able to estimate how much a company will be worth in 5 years. [1]

In Junee’s example, if the company is expected to be worth $45 million in 5 years then $45m/$15.2m (the future value of the company divided by the future value of the investment) $15.2m/$45m (the future value of the investment divided by the future value of the company) is 34%. So, if the investor invests $2 million today in exchange for 34% of the company, they are valuing the present worth of the company at about $6 million.

Penny Herscher, of FirstRain, gives a similar “5 Years Out” model in her post “Startup to IPO: Valuing a Small Company for Angel Investment.” To quote: “Valuing is a function of stage and expected size ~5 years out”. [2]

Head spinning? It’s possible that this is more confusing than a game of Twister (and far less hilarious)

[Update: Thanks goes to Andre Charoo of ProspectLinker for spotting an error in the formula.]