Valuating A Pre-Launch Software Product
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
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”
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
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?
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
2) INTELLECTUAL PROPERTY: This is where most of the value of a software company lies. The intellectual property includes:
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 t shirt shop granville island 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
Potential: 1X (remember, this is standard 30X return – 60 times return would be 2X)
Estimated Valuation Using This Method: ~3.34M-~3.46M
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”).