Any small business owner or entrepreneur who is in search of venture capital has a great challenge before them. One of those challenges is speaking the same language and terminology as venture capital executives, especially when it comes to valuating your business.

Company valuation is extremely important when it comes to determining how much business capital should be invested. And if you are not familiar with the terms and language, you could face an uphill battle when it comes to negotiating the terms of your venture capital investment. Here are some important terms and methods to be aware of.

TERMS:

Pre-Money Value

This is simply a term that states the value of your business before VC investment. Both you and the venture capital firm must agree upon this figure.

Post-Money Value

This is simply the value of your small business after the business capital is invested. Simply add the pre-money value to the investment amount.

Hurdle Rate

The hurdle rate is the compounded rate of return that your venture capital firm expects to earn from an investment. Keep in mind that the hurdle rate takes into account the stage of the business. For instance, if the business capital is going toward seed funding or first stage, the hurdle rate is higher due to the greater perceived risk. Likewise, a company ready to go public will have a lower perceived risk and a lower hurdle rate.

The hurdle rate is a percentage from 0.1% to 100%, with the higher the number, the greater the risk.

Liquidity Event

This is the term describing how a venture capital firm gets their investment back, plus any returns based on their equity share in the business. Typically the liquidity event happens with an IPO, or the sale of a business.

METHODS OF VALUATION:

Comparables

One of the most used methods of valuation used by venture capital firms is the comparable method. Much like real estate is valued compared to similar properties, a business can be valued compared to a similar business.

Venture capital firms will often research other companies that sell similar products, have similar cash flows, rates of growth, and years in business. They then look at the realized earnings when the comps were start-ups.

Net Present Value

This may also be known as the Discounted Cash-Flow method. This takes into consideration your projected cash flow for the next three to five years. The cash flow is adjusted for items such as depreciation, amortization, interest, and taxes. Then it is adjusted again for the consideration of time-value of money and other risk factors. This gives a general and estimated figure of how much a business is worth now, compared to 3-5 years from now.

If you are in the final stages of talks with a venture capital firm, know the language they are speaking and how they are calculating the value of your start-up business. This will give you an edge in the negotiation process and help you get the most value from a business capital investment.

Once you have successfully presented and interviewed with a venture capital firm, you may undergo a second round of qualification in order to be considered a “finalist” for venture funding.  In this process, one of the important steps a VC firm must take is valuating your start up business.

What is business valuation? And how does a VC firm valuate a company that is not yet earning revenue?

Below are a few ways that a VC firm analyzes your product, people, and markets to determine whether a business capital investment is a good choice. Here are a few steps you’ll encounter in the valuation process:

Comparables

A start up company with no documented revenue history may be valued much like real property – through comps or comparables. A VC firm may determine a business investment opportunity by looking at other existing companies with strong similarities to the one they are considering. They will talk to other investment analysts and specialists, examine 10K reports, and perhaps even research public documents to find good comps.

DCF or NPV Method

Whether a company is earning revenue or not, a VC firm may perform a discounted cash flow (DCF) or net present value (NPV) method to determine current value. By taking the projected cash flow for the next three to five years, a VC firm can adjust cash flow factors, risks, and assumptions to determine if the company is a good business investment opportunity.

Size of Market

VC firms will definitely take a look at the size of the potential market. Knowing whether a new start up company can capture a percentage of an existing market share could give them insight into current venture funding valuation.

People in Your Company

It’s not just the product or service that makes your new company successful – it’s the people too. This is actually one of the top factors VC firms will use to valuate a company. If a new company has an exceptional management team, it is more likely to succeed and meet projected financial targets, and thus, this factor increases the value of your start up. 

Product Qualities

Of course, a good business investment opportunity will solely rest upon the product in question. Your new business idea or product will be heavily scrutinized about its uniqueness, intellectual property or patent potential, and even brand strength.

Be prepared to be flexible and sharing with your information if a VC firm wishes to valuate your company. With your cooperation, you can be sure that a VC firm can make a valid venture funding decision.