By Eric Beans
One of the hardest things to do is put a value on a piece of
software before it launches. This
becomes even harder when investors tell you that your software is worth less
than it actually is to set you up for a lovely "one-sided" deal.
How are you supposed to raise money on your company if you
can’t put a value on it and defend it?
Not having a number that can be quantified puts software professionals
and entrepreneurs at a severe disadvantage when talking with “money
people.” The last thing you want to do
when talking to a potential investor is defending your valuation without any
data. The world of investors and capital
is filled with snakes, sharks and vampires.
You will want to be prepared so you don’t get bit!
There is no "perfect formula," but there is a
better way. A simple formula would
benefit the investors as much as the entrepreneurs. The "current system" is predicated
on valuating a company based on guess work.
That "guess work" often includes projections from up to 60 months
away to determine a valuation today. In
software, that is an eternity.
A better way would quantify and value the actual work
performed, the idea, intellectual property and the potential.
Let’s help you put a real value or range of values on your company,
so you can survive in the dog-eat-dog world of investors.
First of all realize there are 4 types of investors:
1) Friends and
Family
2) Angel
3) Peer-to-peer
(crowd funding)
4) Venture
Capital
I left off banks because this entire discussion is pre-revenue. Banks don’t lend money to pre-revenue
companies in 2015.
Friends and family are your low hanging fruit, but don’t
think for a moment they don’t want their money back with a profit just as much
as a Sequoia Capital would (huge VC company).
Doing business with family and friends carries an emotional risk so keep
that in mind.
When you get an Angel or Venture Capital company to invest,
keep in mind you just agreed to sell your company within 5 years.
As a rule of thumb, the Venture Capital crowd looks for
10-30 times return on their investment.
They also expect 7 out of 10 investments to fail. Let’s hope yours is not one of those!
Here are some additional categories of investors to sort
through:
1) Qualified or
“Accredited”
2) Unqualified
Qualified does not mean “they have money,” it means they are
licensed to invest in SEC/Stock and high-risk items. This is a good transition
into investors:
1) With real
money.
2) Like to act
like they have money.
Yes, some “investors” don’t actually have money and will
never invest, but they ask a lot of questions and request a lot of
information. I will never figure it out.
Don’t forget there are two kinds of investors:
1) Those who
understand software.
2) Those who
don’t.
Real estate investors in particular seem to have a very hard
time with software. They want to put a
value of ZERO on anything not on a plot of land or generating revenue. The educational process is long and tedious
as they are very much used to "assets." If your investors come from real estate you
will want to be aware of the inherent challenges because software goes against
everything they have ever known. That
said, finding people with real money who will listen is never something you walk
away from when trying to build your company.
Finally you have:
1) Will offer
you a fair deal.
2) Pull out the
Vaseline.
Some investors watch "Shark Tank" a few times and
want to emulate “Mr. Wonderful” (who is actually a very skilled and fair
investor). Some of the deals I have been
offered are so one-sided it makes one question the world we live in. Desperate moves are almost always bad
moves. Keeping in mind you have
something of value and believing in yourself (and sometimes a higher power)
never hurts.
Now that you know what to look for, it’s time to put a value
on your company. Please feel free to
provide feedback, as opinions can and do vary.
I scoured the internet and found a lot of information. Most of the information is not of much use by
itself but I put it all together to try and create a helpful tool for software
companies and startups.
I read a number of articles on valuations for pre-launch
companies to try and price an offering appropriately and found a lot of
information that was helpful, but it is not an exact science.
Based on the articles I read the main factors to determine
value are:
1) Sweat Equity
2) Intellectual Property
3) Potential
NOTE: The most common
way to value a company is projected revenue.
Projected revenue is always a factor, but to rely on it exclusively
leaves a lot of room for expensive errors.
I am going to skip the valuation formula which allows you to back into a
number based on revenue projections 3-5 years from today. The reason I am going to ignore that way of
coming up with a value is because:
a) It's too easy for
the person most likely to benefit from a higher value to manipulate by
increasing hypothetical sales.
b) Even if the person
creating the pro forma is incredibly honest, the number is going to be
incredibly inaccurate without a lot of luck.
c) We are trying to
quantify REAL value based on what is together TODAY. Long term value is included in this formula,
but is not (and cannot) be the only factor as it is a "guess." You do not want the entire value of your
company riding on a "guess."
d) The investor
should put their own number on "potential," and not rely on a biased
source.
e) The formula below
helps investors separate "real software" from "all sizzle, no
steak." Let's minimize the
mistakes and level the playing field, shall we?
Too much emphasis is on long term revenue and investors
almost never "pop the hood to look at the engine." Right now, a pretty design with 3000 lines of
HTML/CSS/JavaScript could easily be valued the exact same as a product with
300,000 lines of real code. This makes
NO sense.
This would be like putting the same price on every computer
that looks the same, and ignoring RAM, Processors, etc.
Don't get me wrong, potential is a huge factor but should
not be "the only" factor.
So on to other ways to value your company...
1) SWEAT EQUITY: This
can be quantified in a number of ways.
The general billing rate for IT people is $80-$250/hour (a big range).
Using the sweat equity formula, here are hypothetical
numbers for a company with 1 founder and 4 employees scattered in duration with
a new hire every 6-12 months.
- Employee 4 has been on board for 6 months.
- Employee 3 has been on board for 18 months.
- Employee 2 has been on board for 24 months.
- Employee 1 has been on board for 30 months.
- Founder has been on board for 36 months.
2,080 hours a year equates to 173.33 hours a month.
This would mean (first number is $80/hour, second is
$250/hour):
Employee 4:
$83,198.40 - $259,995.00
Employee 3:
$249,595.20 - $779,985.00
Employee 2:
$332,793.60 - $1,039,980.00
Employee 1:
$415,992.00 - $1,299,975.00
Founder:
$499,190.40 - $1,559,970.00
Total: $1,580,769.60
- $4,939,878.00
Mean: $3,260,323.80
2) INTELLECTUAL PROPERTY: This is where most of the value of
a software company lies. The
intellectual property includes:
* Patent
* Trademark
* Code
PATENT: To attempt to
put a value on a patent is the toughest part.
The value is in the upside of the idea and the actual money spent on
obtaining the patent but this is hard to quantify. Investors do need to fall in love with the
idea, and having something that is proprietary only helps the valuation.
TRADEMARK: The
branding, marketing and name of the organization have value. Do you have marketing videos? Each video can be valued between $2,000 and
$6,000. Do you have training
videos? Each training video can easily
cost $1,000/minute. Have you trademarked
the logo? That has value.
Social media does have value and investors will want to know
the numbers. Unless this IS your company
value, don’t expect a massive valuation for having a few thousand
followers. Only calculate this if it’s a
high source of conversions (i.e., you are not “pre revenue”).
For this example company, let’s assume they have 30 videos
at $2000-$6000 including training and other informational material, a trademark
and a patent.
Value of videos:
$60,000 - $180,000
Trademark Cost: $1000
Patent Cost: $15,000
CODE: Code is the
centerpiece of your product. This value is closely tied to the "sweat
equity" number, but as a multiple of the sweat equity. What that "multiple" is depends on
the upside of the idea. I have broken
out the valuation of code in more detail below.
This is the key piece for any software company.
3) POTENTIAL: The best way to gauge potential is through
your projections for gross and net revenues.
Do you have an exit strategy number?
Is it a number supported by similar valuations? Be realistic.
This is NOT going to be included in the formula. Let’s assume our hypothetical company has a
30 times return on revenue projection (which would be a 1X as this is in the
range of ROI that major investors look for).
These are how the numbers work out:
Sweat Equity: ~3.26M
Patent: $15,000
minimum
Brand: $61,000-$181,000
Potential: 1X
(remember, this is standard 30X return - 60 times return would be 2X)
Estimated Valuation Using This Method: ~3.34M-~3.46M
Mean: ~3.4M
CODE, WHERE THE MAGIC IS
One of the common ways projects get valued is CPLOC or
"cost per line of code." (Line of code is also called
"SLOC").
There are four main issues with using CPLOC for evaluating
work or using it as a valuation method.
1) It's hard to know exactly how many lines a project will
have BEFORE or DURING development.
2) A company could pad the lines of code to increase
costs. If you are reading this and
thinking “we need more lines of code,” you will fail horribly well before you
raise money.
3) Code varies greatly in quantity and quality. There are great and horrid programmers. Less is often more.
4) Different languages/environments can create different
results.
For the purpose of this article, we are going to assume your
product works. It is far more accurate
when you have a product and your programmers have worked hard to reduce the
lines of code, which is what good programmers do.
I found this matrix on CPLOC "cost per line of
code."
The cost range they came up with is that it costs $15-$40
per line of code.
$15 is for the easy stuff (yes, "stuff" is an
industry term).
$40 is for the complicated stuff.
A second site came up with:
$12 is for the easy stuff.
$103 is for the complicated stuff.
So now that you understand and can validate the formulas,
how does this translate to your company?
Plug in your numbers off your GitHub account.
Here is some information on how to pull this data off of
your Git:
Let’s use a hypothetical and plug in the numbers.
Our imaginary company has a healthy 300,000 lines of good
code. "Good code" is defined
as code being used for the purpose of the product…no junk. Our hypothetical company has a fairly
complicated application directly in the middle of easy and complicated.
The value of our hypothetical code using the first formula:
Low End: $4,500,000
High End: $12,000,000
Middle: $8,250,000
The value of our hypothetical code using the second formula:
Low End: $3,600,000
High End: $30,900,000
Middle: $17,250,000
You might be wondering whether embedded software is easier
or more difficult than E-Commerce software.
It is easier per government data:
Embedded vs. E-Commerce 2:58: 3:60 as a linear productivity
factor.
What this means is that the numbers produced under the first
formula are slightly low, but we are going to stick with them for simplicity.
The formula used to price out a project that is not yet
developed is:
Linear Productivity factor*KSLOC= X Person Months
3.60*300=Effort=1080 Person Months (feel free to check these
numbers inside the link).
Using this formula and an average salary of $60K (which is
low), our project could have been billed out $64,800,000 to develop!
This is NOT going to be used for your valuation, but could
be used for bidding out future projects.
So now you have a lot of real, quantifiable information to
take to an investor.
Using these numbers we came up with:
Formulas:
A) (Sweat Equity +
Intellectual Property + Potential) ¯x= 3.4M
B) {($15 x LOC
(300K)) + ($40 x LOC (300K))}/2 = 8.25M
C) {($12 X LOC
(300K))+ ($103 X LOC (300K))}/2 = 17.25M
FACTORING IN RISK FOR THE INVESTOR
This article would not be complete if we ignored investor
risk and did not factor that in. The
reality is the over 2/3rds of software projects never work. In the examples above we have a product that
works, which significantly reduces the investor risk. Investors need a way to protect themselves
against investing in a concept that never quite finishes. Adding a simple formula to the end of the
"final valuation" that multiples based on how much of the project is
done allows the investor to capture that risk.
Currently, the investor looks at the team and tries to use their
"gut" to answer the question "can they get this done?" Let's quantify it, and cover the risk.
For example, if the project is about half done and investor
would multiple the valuation by .5 to cover the risks. Risks can also be managerial, revenue and/or
regulatory. The risk multiplier will
always be a number <1 (as there is always risk) and would be lowered the
closer the product was to being released.
This gives investors another honest and fairly quantified
method of protecting their capital.
In our product below the software works and is ready for
launch. For simplicity sake let’s make
the risk factor a 1.
FINAL VALUATION:
Formula {(A+B+C)/3} * Risk = Final Valuation
{(3.40M+8.25M+17.25M)/3} * 1= 9.63M
So we are saying that our hypothetical company is worth
9.63M.
What does it mean?
Not much unless your idea can back it up. In this example we have a LOT
of code. The space shuttle has 400,000
lines of code. 300,000 lines of
meaningful code should be valuable.
Keep in mind the average “app” has 50,000 lines of
code. Most companies will NOT be worth
almost 10M before launching.
For a VERY BASIC example, a 1-person company for 1 year and
50,000 lines of code would be:
(343,200+1.375M+2.875M)/3 * RF1=~1.5M
The formula is spot on.
Fully developed applications routinely raise money between 1-3M before
launching, which means most experienced software investors would not flinch at
this valuation (assuming the product/idea is not a bad one).
If this app were half done, the risk factor of *.5 would be
applied bringing the valuation down to $750,000.
This again is not an "exact" number, but it does
factor in and quantify elements of a project that have previously been left to
guesses, instincts, intuition and looking in a crystal ball.
CONCLUSION
The entire point of this exercise is that you need to know
the value of your own idea, be able to quantify it and defend it when an
onslaught comes from the people with money.
When you are in negotiations, you will often be faced with some tough
decisions.
Some snakes are going to try and bite you. Your job as an entrepreneur is to make the
best decisions you can for your company.
If your idea is good, your valuation is realistic and your
connections are right, you should be positioned well to raise money. That still doesn’t mean it will be
easy…people turn into vampires when money is involved.
We all wish someone would just throw money in our direction
and say “I trust you!” The reality is
you need to be smart, know your value and target the right investors for your
product.
At least now you hopefully have some good ammunition to
support a strong negotiating position so the snakes, sharks and vampires don’t
get the best of you.
At the end of the day, it's up to the people with the money
to come up with a number they are comfortable with and for you to agree to that
number. At least now you will have a few
cloves of garlic to keep the vampires at bay! Good luck!
Eric Beans
CEO Texting Base, Inc.
No comments:
Post a Comment