There comes a time in every startup’s journey where they need to decide on an exit strategy. Some early investors may even ask for your view as the founder as part of their investment diligence.. Those looking for acquisition into a bigger company should start working on laying a multi-year foundation for sale, through partnering, product development and other means. For those planning to grow and build a stand-alone, profitable, business, raising large rounds of financing and managing financials will be critical, and that means understanding market capitalization.
Understanding your value as a private company is more than just determining your assets and potential value of your products or services, it includes non-tangible items like market position, legal considerations and much more. It’s critical to determine not only the types of investors to target, but why your company matters in a very crowded audience. As you work through your capitalization story, it’s important to understand your value proposition, and how you can leverage that into future growth.
A Quick Market Capitalization Definition
For publicly traded companies, market capitalization is defined as the number of a company’s outstanding shares. It doesn’t necessarily measure how much of a company is for sale, but rather the equity value of a company – the value available to owners and shareholders.
For private companies, measuring and understanding equity value is important for several reasons. First, the more equity value you sell to investors, the less ownership you have in your company as a founder. While it isn’t a bad thing by itself, it does give investors more of a say in how you do business. If you have a vision and you are looking for guidance, then it would be wise to understand just how much cash you truly need and how much of your company you are willing to sell to get it.
While bootstrapping may seem attractive from a control standpoint, and it is a perfectly viable growth method, a majority of tech companies will sell equity in exchange for capital investment from venture capitalists. VCs bring a wealth of connections, knowledge, and experience to help your business (and their investment) grow. To scale a company rapidly, you need both capital and people, which is why many young private companies opt for institutional investment.
What is the Market Capitalization Formula?
For publicly-traded companies, the market capitalization formula is visually represented as:
MC = N x P
In the equation, N represents the current number of shares outstanding, while P is the closing price per share. When you multiply those two numbers together, you get the current market capitalization of the company.
For example: Let’s assume Brand X currently has 10 million outstanding shares – the total number of shares of stock. If the price per share is $10 each, the company has a market capitalization of $100 million. Either factor can cause the price to fluctuate: If the outstanding shares increase and the price stays the same, market capitalization grows. Equally true, if the price increases but outstanding shares do not, then market capitalization grows. But if either number goes down, it could hurt market capitalization – which can impact compensation packages, shareholder confidence, and much more.
How Do I Determine My Private Company Valuation?
Market capitalization is often used to measure the value of a company that is opening fundraising through mezzanine investing or private equity, or the value of a company trading publicly on a stock market. If your business isn’t quite there, or you are investigating making the leap, how do you determine your company valuation before going to potential investors or venture capital firms? There are three common ways companies can determine their equity value before starting an investing round.
First is the comparable company analysis (CCA). Using this method, you can assume that your company operates comparably to competitors in the same industry. This requires creating a peer group based on company size, operations, revenues, and other available financials. From there, using the known financial data from those companies, you can create an average valuation of each using different multiples (i.e. revenue, EBITDA, gross margin, etc.). Using their average and median multiples, your financial team can create and defend a valuation of your own based on that of your peers.
Another way to determine valuation is the discounted cash flow method (DCF). The DCF method begins by understanding your potential revenue growth over the next five years, compared against projections of your peer group of companies. After that, financial teams need to compare the upward trajectory against debt, current equity, and the costs associated with them. Although DCF is a much more complex way to determine private valuation, it can also provide a deeper look into how you value your company, giving them more confidence in seeing your operations as an asset. This is a more advanced modeling-based approach which will likely require a financial professional to properly model and adjust assumptions.
Finally, the First Chicago Method is a hybrid of both the CCA and DCF. Instead of comparing company analytics, the First Chicago Method creates projections based on three different potentials: the best-case scenario, the worst-case scenario, and the middle-ground base case scenario. In these situations, companies and founders use past performance to predict future returns.
Generally, you should consider sharing two to three scenarios for each, modeling out a low, medium, and high case. Determining which valuation method is best for your startup is based on your goals, and which terms will help you achieve your goals. Founders and financial teams should work together to determine which practice works best.
Why Does Market Capitalization Matter?
Regardless of whether your startup is publicly traded or privately held, market capitalization is a direct reflection of the business, it’s owners, and its trajectory. Market capitalization is the standard measurement of where a company is in their business development and their overall value to equity investors.
Most startups opening their first rounds of financing will find themselves at either the nano-capitalization or micro-capitalization stage in public company terms. Companies will likely stay here through their Series A. While public nano-cap stages have a value of less than $50 million, micro-cap companies are typically valued under $300 million.
In most cases for private tech companies, these definitions won’t matter as much, since companies can stay private for far longer before they need to access public markets for capital, often raising billions of dollars from VCs, PEs, and other institutional sources in late-stage financings. Staying private also allows companies to retain control, avoid dealing with the SEC or other public market requirements, retain access to capital, and target the right market timing for a potential IPO. There are many reasons to stay private, but a large consideration is the ability to avoid excessive scrutiny, reporting, and bureaucracy while trying to grow.
Companies with small capitalization are often considered a high-risk investment, because of the lack of resources available to them and the lack of comparable market data. Small-cap companies are often valued under $3 billion, and are still in the startup or post-startup stage However, with the right valuation and history of strong returns, small-cap companies can represent a high-reward option for the right investors and venture capitalists. Startups in the small-cap stage can also benefit from the right stakeholders providing leadership and guidance into their companies, giving them both the assets and connections needed to get to the next step.
Bigger privately-held companies may also fit into the midcap category, where they are valued between $3 billion and $10 billion, experiencing rapid growth through offering their suite of technologies and services. Investors primarily look at midcap companies for growth opportunities, because they are using their market share to become more competitive in their industry. Companies in this round of funding may not need leadership support, but rather additional funds to expand resources including manpower, technology, or location growth. To earn investors, companies in this group need to create a strong argument for their valuation, and ultimately prove to investors their trajectory is sustainable well into the future, creating a strong return-on-investment.
Defending Capitalization & Valuation to Venture Capitalists
No matter where your company is at in its growth– defending your capitalization and value is critical. Without the ability to show investors why your startup will be valuable at scale, and how your team will get it there, investors may walk away. Ultimately any startup success story includes an investor seeking a return, which naturally, requires an understanding of present day value versus future value.
Measuring your valuation and driving the numbers behind it can help your company find what it needs to move to the next stage. Regardless of where your company stands, AirCFO can help your leadership get a grip on how your business is trending, and can help you stand and deliver in the boardroom and in front of new investors. Get started today, and start putting together a plan your team can be proud of.