Home » General Health » 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

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.

http://betterembsw.blogspot.nl/2010/10/embedded-software-costs-15-40-per-line.html

A second site came up with:

$12 is for the easy stuff.

$103 is for the complicated stuff.

http://www.crazyontap.com/topic.php?TopicId=242135

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:

http://stackoverflow.com/questions/4822471/count-number-of-lines-in-a-git-repository

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.

http://www.drdobbs.com/estimating-software-costs/184414658

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.
Textingbase.com

Published at: Recent Health Articleshttp://recenthealtharticles.org

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