What is Your Startup Worth? Three Myths About Valuations

When you start a company, you dream big. Chances are you think your business idea is the most innovative concept around; you may even think you're going to save the world (and maybe you will). Of course, turning that grand vision into a reality takes capital -- and that likely means investors.

As an entrepreneur seeking the first round of capital, you should go in with at least some idea of a business valuation, essentially what your startup is worth. (And no, you can't guess.)

But before you schedule that pitch for funding, experts say make sure you're grounded in reality. Here, we look at three of the biggest myths when it comes to valuing your startup -- and what you can do to ensure your own reality check.

Myth No. 1 - You can Dictate What Your Business is Worth

Reality check: The truth is, your opinion is far from the only opinion that counts. The market that buys your products and services plays a role, as do the investors who fund your venture. After all, without capital and customers you don't have a business.

"What ends up happening is the entrepreneur doesn't have a good sense for what the valuation ought to be, and then conversations [with investors] end early because expectations are not aligned with reality," said Sumeet Jain of CMEA Capital, a San Francisco-based venture capital firm.

So, beware of becoming so entrenched in your own opinion that your "too full of dreams for anyone to believe," added Joey Tamer, a Santa Monica, Calif.-based consultant who has worked with early-stage technology startups for 25 years.

What to do: "Get the perspective of an objective outsider who can look at the business and offer honest, credible feedback," Jain said. You can hire an advisor, seek advice from your attorney and accountant, and do your own research. Find out what comparable companies are selling for in your industry by scouring Web sites such as BizQuest and BizBuySell.

Myth No. 2 - Your Business Isn't Up for Sale Right Now, so You Don't Need a Valuation

Reality check: Experts say, don't wait. Knowing your company's value and how to increase it makes you more attractive to investors and (ultimately) buyers. It also helps you build a better business over the long haul.

"The valuation permits you to think about a sale ahead of time and then allocate the capital and efforts to maximize the value," said Frederick D. Lipman, a partner at Blank Rome LLP, a Philadelphia, Pa.-based law firm.

Several factors can propel the value of your business and you should focus on them early -- certainly at least three to five years before considering the sale of your company, according to Lipman, who is also the author of "Valuing Your Business: Strategies to Maximize the Sale Price."

What to do: Lipman suggests diversifying your customer base so no single customer accounts for more than 15% (although no more than 5% is ideal) of your profits or revenues. Cultivate long-term relationships with your customers and employees; high turnover of either one is an obvious red flag to potential buyers. Lipman says consistent revenues (not lots of up-and-down spikes) and a strong management team are also critical.

"Especially with a fairly young company raising its first funding, there's one thing more important than anything else: it's the credibility of the entrepreneur and the team -- their passion, credibility, previous success, domain expertise," Jain added.

Myth No. 3 - The Higher the Valuation, the Better

Reality check: The higher the valuation, the higher the expectations for the company. And if you don't meet those expectations, your next round of funding will likely be a much bigger challenge. "The next investor will look at the first valuation and may not be able to invest at a valuation greater than the last one," Jain explained.

While you may be confident you can meet the highest of expectations, keep in mind there are factors outside of your control that can easily torpedo financial projections.

"Time to market is likely to be longer than you think and distribution deals and product development can take longer than you think," Tamer said, "so your revenue may not start when you think."

What to do: When you approach outside investors, really think about how much money you need and limit the amount you take. "You can also focus on adding more than one investor," Jain suggested. "You may have one investor who doesn't get it and provides a valuation [that's too high], but you lower the likelihood of that happening if you have two investors in your company."