Last night we were talking about getting angel investment, and valuation, which is one of if not the most important points in the discussion. Valuation is essentially price.

Say you want to bring in $150,000 from an angel investor. The immediate question from the investor will be something like: “at what valuation?” Sometimes that’s called “pre-money valuation,” because the instant the deal happens the valuation will change into post-money valuation, which is always higher — because your company just got some new cash.

Your answer sets your deal equivalent of an asking price. If you say $500,000, then you’re offering the investor 30% of your company for $150,000. If you say $300,000, you’re offering 50%. If you say $1 million, then you’re only offering 15%.

Which leads to the question:

So how do I know? How do I set valuation appropriately? What is that based on? Is it some multiple of sales, or intellectual property, or what?

And that’s a good question, and very hard to answer. Sure, you want some compromise between what you want to give, as a percent of ownership in your company, and what investors would want to buy. Investors will simply say no if it’s not an attractive offer. But that’s still very vague.

• In the case of an existing business, with some history, you do have some formulas you can use. For a great site on that business interpretation of valuation, for existing busineses, I suggest bizequity.com, the zillo of small business.
• When we’re talking about startups, however, you don’t have history and you can’t really apply formulas based on sales, or revenue, or even intellectual property (although that could be more relevant).

So here’s my concrete suggestion:

1. Calculate starting costs. That’s two lists, the expenses you have to incur and the assets you have to have at the starting point — except cash. Leave that blank for a bit.  Add those all-except for cash assets to the starting costs, to get an amount, a number in dollars.  Click here for a lot more on that.  

   So, for example, in the illustration here, that would be about $40,000. Yes, I know it says $38,750, but this is just an estimated guess; always round up. You never guess just right.  

2. Calculate cash flow through the lean period at the beginning, before your sales cover your costs.  Make a good guess at how much money you need to cover the deficit spending to get you to an operational month-by-month break even level of cash. That’s where the cash requirement number in the illustration came from: it seemed like this company would need about $400,000 to survive from startup to break-even.  You can’t see much in the chart below, because it’s small, but it shows a projected 12 months of cash flow (in blue) with a minimum balance, a deficit (in red), of about $400,000.

   

3. That gives you a number. In this case, it’s $400,000. That’s what your cash flow shows you you’ll need to get to cash-flow break-even. In the last two months, the cash flow is positive, so the negative balance starts shrinking. With that estimate as a best guess, you go back into your startup costs calculation, and add in the cash required. It’s $400,000. You can see what that does to the startup costs worksheet in the next illustration here.
4. Having done that, you now know that you need about $500,000 from investors (again, technically it’s $458,750, but you’re using best-guess estimates, so round up.) Set that as the amount of investment you’re seeking. Then — and here it gets hard, to be sure — you need to decide how much of your company you’re going to offer to an investor in exchange for that $500,000.

5. Get some help here if you can. Ask somebody with experience in startups, or dealing with angel investors, or both. Ask an attorney you can trust, who should also be somebody with experience. The thing is, how much of your company you offer to investors is about a compromise between what you’d like — none, free money — and what will entice the investors to write checks.

   At this point a lot depends on your overall business offering, the cards your company brings to the table. Investors want as high return as possible, with as little risk, but in relation to return. How experienced is your team? How defensible is your product? How rich is the market? All these factors determine what kind of a deal will be acceptable to investors.

   • Let’s say, in this case, you’re new at startups, you have very little track record, and you want to attract an active angel investor as a partner. So maybe you set your initial valuation at $750K, meaning you’re offering to give away 2/3 of your ownership to get the money you need. You’re being realistic about what will attract an investor. You better really, really, like that investor, because he or she will essentially own your company. But this is a hypothetical case, and without a lot of experience and defensibility, that may be the best you can do.
   • Or maybe you’ve got better cards to play: you’ve got a team with startup experience, and a defensible new product, with some intellectual property, and it looks like an attractive market. That makes you able to set a stronger valuation, and maybe — we hope — still make it an attractive offer to investors. So maybe you say you’re valuing it at $1.5 million. You’re offering investors one third of your company for $500K.

So there’s a quick and (I hope) simple summary of how you set the initial (pre-money) valuation when you want to attract investment.

If you’re thinking about starting your own business, any type of business, one fundamental will be expenses that you will need to cover before you open your doors, launch your website, or sell your first product or service. The timing of starting expenses is what distinguishes them from ongoing expenses that you track each month in the course of doing business.

As part of your estimates for starting costs, you will also want to plan for a cash reserve to cover the actual costs of doing business during the first few months, until your sales are sufficient to cover your operating costs.

Types of Starting Costs

Expenses
How do you know what your starting expenses will be? This will vary depending on the type of business. If you’re planning to have a website, you may incur site development costs ahead of opening the business. If you’re planning to have a traditional storefront, there may be initial lease costs or deposits that must be paid for up front. Common starting costs would be:

• Legal
• Stationery/business cards
• Product or service description brochures
• Lease deposit
• Consulting
• Insurance
• Expensed computer equipment **

**In the United States a computer purchase can be treated either as an asset or as an expense, depending on conditions set forth in federal tax law. When you can choose, you normally want to expense your purchases because then you can deduct those expenses from income.

Cash Reserve
In addition to the expenses that must be paid before your business is up and running, you also want to estimate the amount of cash you need to have in your account to support the company during the early months, before sales reach a break-even point.

Starting Assets
Starting assets might be inventory, vehicles, buildings and equipment that can be depreciated over time.

Starting Costs Example

Here’s an example of a listing of starting expenses, cash reserve and assets:

The Total Requirements shows how much money is needed to cover starting costs.

How to use the Starting Costs Calculator

The Bplans Starting Costs Calculator lets you estimate total starting expenses, cash reserves and assets to be purchased. It then automatically calculates your Total Requirements.

Startup Expenses

• Click on the Edit button for Initial Expenses; this displays a listing of sample expenses
  • Double click within each expense cell and type in the expense amount (use whole numbers, without punctuation)
• Click on the Done button to transfer the combined total for Initial Expenses

Money in the bank as reserve for losses:

• Click on the Edit button for Money in the bank; this displays a listing of expenses that you will incur in the first few months you are in business
  • Double click within each expense cell and type in the estimate amount (use whole numbers, without punctuation)
• To adjust the number of months for your reserve, click and drag the circle on the sliding bar to adjust up or down between 1 and 12 months. Your total reserve will adjust depending on how many months you select.

Start-up Inventory, Other current assets, Long-term or fixed assets:

• Double click on each cell and enter your estimated total (there is no additional breakdown of assets)

The Calculator will determine your Total Start-up Requirements. Repeat the procedures above to adjust any of your estimated expenses.

Businesses spend money before they ever open their doors. Start-up expenses are those expenses incurred before the business is running. Many people underestimate start-up costs and start their business in a haphazard, unplanned way. This can work… but is usually a harder way to do it. Customers are wary of brand new businesses with makeshift logistics.

Use a start-up worksheet to plan your initial financing. You’ll need this information to set up initial business balances and to estimate startup expenses. Don’t underestimate costs.

• Startup expenses. These are expenses that happen before the beginning of the plan, before the first month. For example, many new companies incur expenses for legal work, logo design, brochures, site selection and improvements, and other expenses.
• Start-up assets. Typical start-up assets are cash (the money in the bank when the company starts), and in many cases starting inventory. Other starting assets are both current and long-term, such as equipment, office furniture, machinery, etc.
• Start-up financing. This includes both capital investment and loans. The only investment amounts or loan amounts that belong in the Start-up table are those that happen before the beginning of the plan. Whatever happens during or after the first month should go instead into the Cash Flow table, which will automatically adjust the Balance Sheet.

Timing is everything
Some people are confused by the specific definition of start-up expenses, start-up assets, and start-up financing. They would prefer to have a broader, more generic definition that includes, say, expenses incurred during the first year, or the first few months, of the plan. Unfortunately this would also lead to double counting of expenses and non standard financial statements. All the expenses incurred during the first year have to appear in the Profit and Loss statement of the first year, and all expenses incurred before that have to appear as start-up expenses.

Don’t count expenses twice: they go in Start-up or Profit and Loss, but not both. The only difference is timing. Don’t buy assets twice: they go into the Start-up if you acquire them before the starting date. Otherwise, put them in the Profit and Loss.

Expenses vs. assets
Many people can be confused by the accounting distinction between expenses and assets. For example, they’d like to record research and development as assets instead of expenses, because those expenses create intellectual property. However, standard accounting and taxation law are both strict on the distinction:

• Expenses are deductible against income, so they reduce taxable income.
• Assets are not deductible against income.

What a company spends to acquire assets is not deductible against income. For example, money spent on inventory is not deductible as expense. Only when the inventory is sold, and therefore becomes cost of goods sold or cost of sales, does it reduce income.

Generally companies want to maximize deductions against income as expenses, not assets, because this minimizes the tax burden. With that in mind, seasoned business owners and accountants will always want to account for money spent on development as expenses, not assets. This is generally much better than accounting for this expenditure as buying assets, such as patents or product rights. Assets look better on the books than expenses, but there is rarely any clear and obvious correlation between money spent on research and development and market value of intellectual property. Companies that account for development as generating assets can often end up with vastly overstated assets, and questionable financials statements.

Another common misconception involves expensed equipment. The U.S. Internal Revenue Service allows a limited amount of office equipment purchases to be called expenses, not purchase of assets. You should check with your accountant to find out the current limits of this rule. As a result, expensed equipment is taking advantage of the allowance. After your company has used up the allowance, then additional purchases have to go into assets, not expenses. This treatment also indicates the general preference for expenses over assets, when you have a choice.

Why you don’t want to capitalize expenses
Sometimes people want to treat expenses as assets. Ironically, that’s usually a bad idea, for several reasons:

• Money spent buying assets isn’t tax deductible. Money spent on expenses is deductible.
• Capitalizing expenses creates the danger of overstating assets.
• If you capitalized the expense, it appears on your books as an asset. Having useless assets on the accounting books is not a good thing.

Types of start-up financing

• Investment is you or someone else puts in the company. It ends up as Paid-in Capital in the Balance Sheet. This is the classic concept of business investment, taking ownership in a company, risking money in the hope of gaining money later.
• Accounts payable are debts that will end up as Accounts Payable in the Balance Sheet. Generally this means credit-card debt. This number becomes the starting balance of your Balance Sheet.
• Current borrowing is standard debt, borrowing from banks, Small Business Administration, or other current borrowing.
• Other current liabilities are additional liabilities that don’t have interest charges. This is where you put loans from founders, family members, or friends. We aren’t recommending interest-free loans for financing, by the way, but when they happen, this is where they go.
• Long-term liabilities are long-term debt, long-term loans.

Expect a Loss at Start-up
The loss at start-up is very common…at this point in the life of the company, you’ve already incurred tax-deductible expenses, but you don’t have sales yet. So you have a loss. Don’t be surprised; it’s normal.

Cash Balance on Starting Date
Cash requirements is an estimate of how much money your start-up company needs to have in its checking account when it starts. I general, your Cash Balance on Starting Date is the money you raised as investments or loans minus the cash you spend on expenses and assets. As you build your plan, watch your cash flow projections. If your cash balance drops below zero then you need to increase your financing or reduce expenses. Many entrepreneurs decide they want to raise more cash than they need so they’ll have money left over for contingencies.

However, although that makes good sense when you can do it, it is hard to explain that to investors. The outside investors don’t want to give you more money than you need, for obvious reasons—its their money!