Tag Archives: discounted cash flow

How to value a business startup

Richard HayesI met Richard Hayes at the Sydney OpenCoffee Meetup and he’s written an excellent article that he’s allowed me to reproduce below.

All people working in the Startup / Early Stage consistently asked the same question,
“How do you value business?”

The correct answer is there is no correct answer

Without trying to be facetious here is a number of models that may help.

Anyone wanting further information can attend Richard’s BEERonomics in a pub near you.

Courses in advance corporate finances cost you 2 beers / hour (Cheaper than a MBA)

  • Sales Revenue
    Most businesses are valued based upon revenue.
    This means a business with $1 Million revenue would be valued @ $750,000 to $1,250,000
    or values each dollar sales between $0.75 – $1.25
  • Price Earnings Ratio
    This is the number of years of after tax profit it takes to return your investment
    A typical private company sells for a PE of 2-5 where public companies sell for 8-20.
    Google sells with a PE 48Many people use EBIT, Earnings (profits) Before Interest and Tax as a measure of how much extra debt a company can take to help pay for the take over.
  • Discounted cash flow (DCF)
    This technique combines all the cash generated from the business and then discount
    (reduces) them to a present value. (IE A dollar today is worth more than a dollar tomorrow)
    This can be a problem if the wrong interest (discount) it used.
    BTW, The interest rate is ALWAYS WRONG
  • Replacement Value
    How much would it cost to get similar stuff either new or used?In software, many people use COCOMO which is a formula that count lines of code and examines the complexity of code thereby allocating a amount of developers time it would take to replicate it.slccount Is a free COCOMO tool that supports about 27 different languages.

    For many software startups this is a good starting point.

  • Return on Investment (ROI)
    This combines a number of the above techiques to derive a single figure.Many early stage investors Angels / VCs demand +45% ROI as compensation for the higher risk associated with early stage. This is a serious market failure.

A team of 3 developers have written 13K lines of PHP source code to develop a DIY superannuation management software. It has taken 6 months part time (IE 50 hour/wk)

They are all leaving their “real” jobs to pursue their dream.

Sales: Nil

User: 250

Total Cash Spent: $5,800

What is the company worth?

1. Sale Revenue Nil

Future Sales Revenue 2009 $1,000,000 (FV)
Discounted @ 40% pa $510,000

Company valuation $383,000 – $637,000

2. Price Earnings

2009 Sales $1,000,000
2009 Profit $180,000

PE 2 (180K x 2 x 40%) $183,000
PE 5 (180K x 5 x 40%) $459,000

Company valuation $183,000 – $459,000

Replacement value $413,228

The following output is from a real project

Totals grouped by language (dominant language first):
php: 13409 (99.83%)
sh: 23 (0.17%)

Total Physical Source Lines of Code (SLOC) = 13,432
Development Effort Estimate, Person-Years (Person-Months) = 3.06 (36.71)
(Basic COCOMO model, Person-Months = 2.4 * (KSLOC**1.05))
Schedule Estimate, Years (Months) = 0.82 (9.83)
(Basic COCOMO model, Months = 2.5 * (person-months**0.38))
Estimated Average Number of Developers (Effort/Schedule) = 3.73
Total Estimated Cost to Develop = $ 413,228
(average salary = $56,286/year, overhead = 2.40).

As you can see there is no right answer but valuation is much more about art than science.

© 2007 Richard Hayes RHI Ltd reprinted by permission.