Once you have a potential investor excited about your team, your product, and your company, the investor will inevitably ask “What is your company’s valuation?” Many entrepreneurs stumble at this point, losing the deal or most of their ownership, by having no answer, saying “make me an offer,” or quoting an exorbitant number.

I’ve written about this before, but it’s a mysterious subject, and I’m always learning more. This time I’ll use a hypothetical health-care web site company named NewCo as an example to illustrate the points.

Two founders have spent $200K of personal and family funds over a one year period to start the company, get a prototype site up and running, and have already generated some “buzz” in the Internet community. The founders now need a $1M Angel investment to do the marketing for a national NewCo rollout, build a team to manage the rollout, and maybe even pay themselves a salary.

How much is NewCo worth to investors at this point (pre-money valuation)? What percentage of NewCo does the investor own after the $1M infusion (post-money ownership percentage)? Well, if the parties agree to a pre-money valuation of $1M, then the post-money investor ownership is 50% (founders give up half interest, and lose control). On the other hand, if the pre-money valuation is $4M, the founders ownership remains at a healthy 80% level.

So what magic can the founders use to justify a $4M valuation (or even the $1M valuation) at this early stage? Here are the components and “rules of thumb” that I recommend to every startup:

1. Place a fair market value on all physical assets (asset approach). This is the most concrete valuation element, usually called the asset approach. New businesses normally have fewer assets, but it pays to look hard and count everything you have. NewCo might be able to pick up an initial $50K valuation on this item.
2. Assign real value to intellectual property. The value of patents and trademarks is not certifiable, especially if you are only at the provisional stage. NewCo has filed a patent on one of their software tool algorithms, which is very positive, and puts them several steps ahead of others who may be venturing into the same area. A “rule of thumb” often used by investors is that each patent filed can justify $1M increase in valuation, so they should claim that here.
3. All principals and employees add value. Assign value to all paid professionals, as their skills, training, and knowledge of your business technology is very valuable. Back in the “heyday of the dot.com startups,” it was not uncommon to see a valuation incremented by $1M or every paid full-time professional programmer, engineer, or designer. NewCo doesn’t have any of these yet.
4. Early customers and contracts in progress add value. Every customer contract and relationship needs to be monetized, even ones still in negotiation. Assign probabilities to active customer sales efforts, just as sales managers do in quantifying a salesman’s forecast. Particularly valuable are recurring revenues, like subscription amounts, that don’t have to be resold every period. This one doesn’t help NewCo just yet.
5. Discounted Cash Flow (DCF) on projections (income approach). In finance, the income approach describes a method of valuing a company using the concepts of the time value of money. The discount rate typically applied to startups may vary anywhere from 30% to 60%, depending on maturity and the level of credibility you can garner for the financial estimates. NewCo is projecting revenues of $25M in five years, even with a 40% discount rate, the NPV or current valuation comes out to about $3M.
6. Discretionary earnings multiple (earnings multiple approach). If you are still losing money, skip ahead to the cost approach. Otherwise, multiply earnings before interest, taxes, depreciation and amortization (EBITDA) by some multiple. A target multiple can be taken from industry average tables, or derived from scoring key factors of the business. If you have no better info, use 5x as the multiple.
7. Calculate replacement cost for key assets (cost approach). The cost approach attempts to measure the net value of the business today by calculating how much it could cost for a new effort to replace key assets. Since NewCo has developed 10 online tools and a fabulous web site over the past year, how much would it cost another company to create similar quality tools and web interfaces with a conventional software team? $500K might be a low estimate.
8. Look at the size of the market, and the growth projections for your sector. The bigger the market, and the higher the growth projections are from analysts, the more your startup is worth. For this to be a premium factor for you, your target market should be at least $500 million in potential sales if the company is asset-light, and $1 billion if it requires plenty of property, plants and equipment. Let’s not take any credit here for NewCo.
9. Assess the number of direct competitors and barriers to entry. Competitive market forces also can have a large impact on what valuation this company will garner from investors. If you can show a big lead on competitors, you should claim the “first mover” advantage. In the investment community, this premium factor is called “goodwill” (also applied for a premium management team, few competitors, high barriers to entry, etc.). Goodwill can easily account for a couple of million in valuation. For NewCo, the market is not new, but the management team is new, so I wouldn’t argue for much goodwill.
10. Find “comparables” who have received financing (market approach). Another popular method to establish valuation for any company is to search for similar companies that have recently received funding. This is often called the market approach, and is similar to the common real estate appraisal concept that values your house for sale by comparing it to similar homes recently sold in your area.

Remember that all the components, except the last, are cumulative. Even if a given investor excludes some of the components from consideration in your case, your credibility will be bolstered by the fact that you understand his interests as well as yours. In any case, the analysis will prepare you for the heavy negotiation to follow.

Precision is not the issue here – the task for the entrepreneur is to build a company that is worth at least $50M before thinking about an exit — no investor wants to spend more than five minutes arguing the fine points of the last valuation dollar.

So what is a reasonable valuation for a company like NewCo? My advice for early-stage companies like this one is to target their valuation somewhere between $1.5M and $5M, justified from the elements above. A lower number suggests that the founders are giving away the company, while a much higher number may suggest hubris or lack of reality on the part of the owners.

Of course, we have all read about the “new” company with $100M valuation, but I haven’t met one yet.

One of the first tough decisions that startup founders have to make is how to allocate or split the equity among co-founders. The easy answer of splitting it equally among all co-founders, since there is minimal value at that point, is usually the worst possible answer, and often results in a later startup failure due to an obvious inequity.

Another common “failure to start” situation I see is one where the “idea person” insists that the idea is 90% of the value (and 90% of the equity). In the real world, the “idea” is a very small part of the overall equation. A startup is all about “execution” – meaning the equity should be allocated based on the value that each partner brings to the table in each of these dominant variables:

1. Experience running a startup business. Running a new business starts with building a solid and credible business plan, working the investor funding process, and building an organization from nothing, with minimal resources. Successful Fortune 500 executives need not apply, since most would not have experience with any of these tasks.
2. Domain expertise and connections. If you are recognized as an expert in the business area of your startup, with a good reputation, and you know all the key vendors and customers, your value is huge. Building a product doesn’t get it distributed and sold. Expertise can be marketing, technical, financial, or sales.
3. Pre-existing intellectual property. Ideas are not intellectual property, until they have been converted into patents, trade secrets, trademarks, or copyrights. In many cases, one founder has started earlier and brings an important completed piece of work to the table, and that can have great value.
4. Sacrifice and time commitment. A part-time commitment, while holding down a “real” paying job, is obviously not the same as a full-time executive role, especially if the cash compensation is nonexistent, deferred, or at high risk.
5. Funding. Providing the major funding source for an early-stage startup is a totally different dimension, but it usually trumps all the items above in demanding some equity. For purposes of commitment and business decision making, I always recommend that execution partners retain control of at least 50% of the equity.

An arbitrary, but perhaps rational equity factoring approach would be to assign each of these five items as 20% of the total, and allocate equity based on each partner’s relative contribution to each. For example, if your rich uncle is providing all the initial funding, but has no active business role, it might be smart to offer him a 20% slice of the pie.

Equity allocation is usually the first point in a startup where outside help should be considered (legal counsel, potential investors, startup advisors), as they may be able to provide experience and more importantly, an unbiased view that the entire team can trust.

An important key is NOT to dodge the discussion up front, come to some agreement quickly, and write it down. If you and your potential partners can’t get through this discussion in a timely fashion and come to agreement, then it’s unlikely that your startup can ultimately survive anyway. Startup decisions only get harder later, never easier.

Even still, regardless of the initial equity split, you should seriously consider vesting your founders shares over at least two years. This means they will be meted out month-by-month, and a partner who changes his mind or defects early will not walk away with half the company.

The next big challenge for a multi-partner startup is the allocation of roles. Who will be the CEO, CFO, and CTO? The same variables apply, but here skills and experience are paramount. If you are an inventor and have the key patent in hand, that doesn’t mean you should be CEO. Of course, holding key assets and money always provide leverage to management rights as well as economic rights.

All partners should never forget that their allocated shares are only the beginning, and will be diluted proportionately when outside funding is later required from angels or venture capitalists. Investors will be quick to remind you that a small percentage of something is worth more than 100% of nothing. The same logic applies to splitting equity with co-founders.

Due diligence should always be a two-way street. A while back, I published an article on “Understanding the Dreaded Investor Due Diligence,” describing what investors do to validate your startup before they invest. Here is the inverse, sometimes called reverse due diligence, describing what you should do to validate your investor before signing up for an equity partnership.

I’ve had startup founders tell me that it’s only about the color of the money, but I disagree. Particularly if you are desperate, keep in mind the person who finds a good-looking partner to take home from the bar at closing time, but then wakes up in the morning wondering “What did I just do?” Taking on an investor is like getting married – the relationship has to work at all levels.

Due diligence on an investor is where you validate the track record, operating style, and motivation of your new potential partner. Maybe more importantly, you need to confirm that the investor “chemistry” matches yours. Here are some techniques for making the assessment:

1. Talk to other investors. The investment community in any geographic area is not that large, and most investors have relationships or knowledge of most of the others. Of course, you need to listen for biases, but local angel group leaders can quickly tell you who the bad angels and good angels are, and what kind of terms they typically demand.
2. Network with other entrepreneurs. Contact peers you have met through networking, both ones who have used this investor, and ones who haven’t. Ask the investor for “references,” meaning contacts at companies where previous investments were made. Don’t just call, but personally visit these contacts.
3. Check track record on the Internet and social networks. Do a simple Google search like you would on any company or individual before signing a contract. Look for positive or negative news articles, any controversial relationships, and involvement in community organizations. Check the profile of principals on LinkedIn and Facebook.
4. Spend time with investors in a non-work environment. As with any relationship, don’t just close the deal in a heated rush. Invite the investment principal to a sports event, or join them in helping at a non-profit cause. Here is where you will really learn if there is a chemistry match that will likely lead to a good mentoring and business relationship.
5. Validate business and financial status. Visit the firm’s website and read it carefully. Look for a background and experience in your industry, as well as quality and style. Conduct a routine credit and criminal check, using commercial services like HireRight. Be wary of individuals or funds sourced from offshore.

If you think all this sounds a bit sinister and unnecessary, go back and read again some of the articles about Bernie Madoff and recent investment scams. Remember, if it sounds too good to be true, it probably isn’t true. Entrepreneurs are optimists by nature, so I definitely recommend the involvement of your favorite attorney (usually the pessimist).

I recognize that it has been tough to raise capital these last couple of years, but don’t be tempted to take money from any source. This can be a big mistake, with common complaints running the gamut from unreasonable terms, constant pressure, to company takeovers. Be vigilant and ask questions.

A successful entrepreneur-investor agreement better be the beginning of a long-term relationship. If you don’t feel excited and energized by your first discussions with an investor, give it some time and do your homework. If the feeling doesn’t grow, it may be time to move on. It’s better to be alone than to wish you were alone.

After you have successfully attracted angels or venture capital with your business case, your million dollar product idea, and you have a signed term sheet, there is still one more hurdle to overcome before investors write the check. This is the dreaded “due diligence” process.

For no good reason, this process seems shrouded in mystery, when in fact it is nothing more than a final integrity check on all aspects of your business model, team, product, customers, and plan. In my view, understanding due diligence can only improve information flow, and leads to a better long-term partnership with your investor.

Remember that up to this point, the investor has primarily seen and talked to the founder and CEO, and studied written documents. Before smart investors write a check, they, or a trusted consultant, will want to meet and talk with your key team members, several customers, and evaluate the real product. If results don’t match what they have been told, all bets are off.

This is where they find out if your team is all behind you, your customers are truly excited, your product is ready to ship, and there aren’t any ghosts in the closet. All private equity groups go about due diligence in their own way, but there are a few key areas of focus that entrepreneurs should always expect:

• Team strength and health. For small teams, every team member will likely be interviewed. Investors are looking for your depth of talent, loyalty and commitment, strengths and weaknesses, teamwork, and management style. A dysfunctional team, or even one naysayer in a critical position can stall your investment.

• Product or service readiness. Technical due diligence typically starts with a full one or two day review with the engineering and product marketing staff. Investors are evaluating your process as well as your product. The goal is to feel 100% confident that the product has the features and quality you assert, and the team and process to keep it true in the future. Finally, they need to validate intellectual property protections and status.

• Market need and size validation. A good investor can do a lot to help a company, but can’t make customers buy products. Investors will likely talk to dozens of potential customers, starting with your reference list (undoubtedly well prepped). They will also speak to technical leaders and industry contacts where they have prior relationships. No validated pain, no deal.

• Sustainable competitive advantage. The kiss of death is for investors to find unanticipated competition you neglected to mention. They try to confirm from industry analysts that your differentiators are indeed unique, and that there are no future competitors or big gorillas in stealth mode just around the corner.

• Business and financial status. How well have you met previous financial and business milestones? Investors will validate pre-existing investments and stock ownership to create an accurate market capitalization sheet for your company. Founders with bad credit, active lawsuits, or recent bankruptcies dramatically increase the risk.

As you go through the due diligence process, there are some practical tips to keep in mind. First, be proactive in asking if you have answered all the key questions, and ask how you compare to others. Get to the truth early. Waste no time. Use the feedback to strengthen your presentation and your company.

Secondly, conduct your own due diligence of the investor. This process is the foundation for the long term partnership, so both sides need the same level of comfort and trust. The investor relationship is akin to marriage. It’s nice to have a little mystery in your marriage, but you better understand each other on the fundamentals.

Every investor is looking for the “dream team” of executives to put his money on. Often I find that experienced investors flip to the management page of a business plan, even before they read the product description. That’s how important the people are. What are investors looking for in the CEO and the rest of the top executives?

• Been there, done that, and won. This may not seem fair to all you first-time entrepreneurs, but wouldn’t you choose to bet on a horse that has been in races before, and won, rather than an unknown in his first race? The size of the race is also important. Fortune 1000 CEOs usually don’t make good startup CEOs, and vice versa.

• Experience and expertise in this business area. You may have great credentials as a public servant in your home town, but that won’t get you money to build a job board on the Internet, or start a software company. You can learn a lot about a new technology from Wikipedia and scouring the Internet, but probably not enough to qualify you as CEO of a new company in that area.

• Network of followers and business associates. Introverts and loners need not apply. Your job as CEO involves heavy doses of selling the merits of your company, lobbying (begging) for money, and convincing other executives to help you or join you.

• Bundles of energy, money, and talent. The startup road is guaranteed to be long and hard. Investors look for someone who is able and willing to put “skin in the game”, looks and sounds like he can weather the storm, will always see the bright side despite adversity, and never gives up.

• Able to communicate a vision. To be respected at the top of the pyramid, a CEO must be able to clearly communicate the vision of the company to inspire investors, the team, and customers. Of course, before you can communicate a vision, you have to have one.

• Relentlessly resourceful. Not merely relentless and passionate about your journey, but able to overcome novel difficulties (per Paul Graham). Being relentlessly resourceful is definitely not what you learn in big companies, or in most schools.

• “The buck stops here.” The CEO has to be confident and clearly the final decision maker. Investors don’t like “equal partner” situations, or worse yet, family pairs in top positions. The CEO is expected to make the presentations to investors, and answer questions decisively.

What if you can’t convince Jim Clark (Silicon Graphics, Netscape, WebMD, MyCFO, Juniper Networks) to run your startup? The most common solution is that you “bootstrap” your business, or fund it yourself, at least to the point that your “traction” is evident (you have a product, you have customers, you have revenue). Another alternative is to rely on that famous first tier of investors, called friends, family, and fools.

Everyone loves that dark horse who comes from the rear to lead the pack and win the race, but very few people will bet on him up front. But don’t let that discourage you. Even Jim Clark started as just another associate professor of electrical engineering, but he teamed with some bright people, and proved he could beat the odds.

If you don’t have the credentials today, team with someone who does. The strength of your idea alone won’t suffice to bridge the funding gap. There is no substitute for experience and mentoring. The quicker you get it, the sooner you can be the next Jim Clark and write your own check.

If you are looking for an outside investor, you need to know how they see you. Different types of investors look for startups at different levels of maturity. If your startup is at the wrong stage for the investor you are approaching, the courting is a waste of time for both of you.

For instance, if your company is only a few weeks old and you have zero customers and your product offering is still in design, don’t expect someone to hand over $10 million to fund your efforts. It wouldn’t work anyway, since your valuation at that stage would be less than the funding, meaning you would have to give away all ownership for the money.

You also will find that the stage your startup is in dictates where you go to seek funding. Funding sources specialize in certain growth stages. Angel investors typically provide early-stage funding, while venture capital firms typically come in at later stages.

Of course, growth and development are really a continuum. Yet most investors will tend to categorize your progress into one of the following five stages:

1. Idea stage. This is the initial excitement period, the time when you dream of riches and fantasize the life of a business owner, but you have no real plan. At this stage, no professional investor will touch you unless you have a beautiful track record of success with previous startups. Funding will only come from you, or friends, family, and fools.
2. Early or embryonic stage. Investments at this stage are typically called seed investments. Funding of $250,000-$1 million is available from angels, if you have credentials and have done the homework of a good business plan, financial model, and executive presentation. Anything less the $250,000, or any amount at this stage with no credentials, still has to come from friends and families, loans, or federal grant sources.
3. Funding or rollout stage. This is the realm of venture capital professional investors, with funding amounts of $1-10 million, often referred to as the “A-round,” or first institutional funding. At this stage, your startup better be selling a commercial offering, have price and cost validated, with significant customer sales and a real revenue stream. Lesser amounts remain in the angel realm.
4. Growth stage. Additional funding rounds for growth are often called the “B-round” through “G-round”, with each being in the $5 million to more than $50 million from venture capital and other sources. Companies at this stage must have a large market, good traction, and be focused on scaling infrastructure and market adoption. This normally means more then 30 employees, and more then $1 million in revenue.
5. Exit stage. This is the final stage of investment in venture opportunities, and is the point where investors expect to see the return and gain from the original investment. At this stage, you need investment bankers to negotiate a merger or acquisition (M&A), go private, or help you go public with an Initial Public Offering (IPO).

As startups pass through each stage, they must attract appropriate financial partners that can provide the increasing credibility, capital, and industry networks to support movement to the next stage. Typically, they must also change and tune their executive team, to keep up with the increasing demands of a growing company on process discipline and sustainable success.

Another important thing to remember when selecting investors is that not all money is the same. VC money, for example, usually comes with high expectations of milestones met, board seats, and dominant control. Angels may be less demanding, but typically add less value. Friends and family hopefully believe fully in you, and just want you to show them success.

Obviously, if you bootstrap your business, you can avoid all these stages and the investment implications. Otherwise, not paying attention to the expectations associated with each stage will likely jeopardize your one chance to make a great first impression on potential investors. Do it right and enjoy the journey.

In reality, so-called “founder’s” shares are simply common stock, issued at the time of startup incorporation, for a very low price, and normally allocated to the multiple initial players commensurate with their investment or role. But that’s only the beginning of the story.

These shares are allocated and committed, but not really issued and owned (vested) until later. Typically, vesting in startups occurs monthly over 4 years, starting with the first 25% of such shares vesting only after the employee has remained with the company for at least 12 months (one year “cliff”). Vesting always stops when an employee leaves the company.

Even though the class is common stock, founders can negotiate special vesting and other terms as part of their stock restriction agreement upon venture investment. Here are some typical special terms for founder’s stock:

• Negligible par value. Since founder’s shares are usually issued at the time the company is incorporated, they essentially have no par value. As the company builds value, shares allocated later for employees or partners will have an appropriate price.

• Vesting starts now. Most founder vesting is not subject to the one year cliff because founders should already know and trust each other. Thus, most founders will start vesting their shares from the date they actually started providing services to the company.

• Acceleration clause. They might also have special terms in the case of termination or demotion that accelerate vesting. These have less to do with the type of stock and more to do with who the person is and how strategic they are to the organization.

• Stock survives investment. While most employees would see their vesting rest when the “Series A” round closes, a founder might retain some percent of their shares. Everyone wants to minimize dilution of shares, so special clauses are often included.

Unfortunately, founders often make the mistake of waiting until they have received a strong indication of interest from an investor before they decide that it is time to incorporate. Forming a company so close in time to raising capital can create a significant tax issue.

For example, if founders issue themselves stock for one cent per share when they form the company, and then within a short period of time outside investors jump in at $1 or more per share, it might appear in an IRS audit that the founders issued themselves stock at significantly below the fair market value per share.

The difference in value between what the founders paid and the fair market value of that stock based on actual sale to outside investors will be characterized as compensation income resulting in what could be significant tax liability to the founders.

The way to avoid this risk by filing an “83(b) election” with the IRS within 30 days of the purchase of your founder’s shares and paying your tax early on those shares. Failing to file the 83(b) election is common mistake of founders that you should avoid.

There should be no tax concern for a founder investing more of his own money any time in the process. All the tax concerns relate to “outside” investors coming in shortly after incorporation. Valuation has very little meaning until an outsider invests.

So my advice is to incorporate and allocate founder’s stock as soon as you are starting real work on the company, but at least six months before you anticipate any outside investors. But don’t incorporate too early, as investors will measure your growth and progress since the incorporation date. Several years of apparent inactivity since incorporation will make it look like there is a problem with you or with the company.

Of course I have to add my caveat that I’m not a lawyer, and these comments do not constitute a legal opinion. See a qualified business attorney if you anticipate multiple investors or a complex company structure. Don’t let a positive investor decision take the joy out of your future.