This is an edited crosspost with BOOSTMENA.

There are hundreds (if not thousands) of posts on the subject of valuation, specifically related to tech companies given the hype surrounding recent valuations and acquisitions we are seeing in this space.

There are no real assets involved in these businesses and a lot of emphasis is on the future potential.

There are also several methodologies that one can use to conduct a valuation, including the discounted cash flow method, comparables method and the Berkus method (and many more). We’ve built our own iteration of the Berkus method, which I will share in future posts.

Today, I’ve tried to simplify the process into six key steps that should give entrepreneurs a good idea of how to look at valuing their startup when trying to raise funds.

(Image via Pieria.co.uk)

The Total Addressable Market (TAM) provides an indicator of the potential size of the business in the future, and is something that we look at in detail when we invest in startups.

We always look for bottom-up sizing, rather than top-down because it provides a much more realistic and measurable indicator of size. An example of a top-down analysis is, the size of food and beverage spend in MENA is $10 billion and if I can capture 2 percent of that market, my business can reach $200 million in sales. As you can see, it’s very subjective and macro in nature, without going into the actual market that one can sell to.

An example of a bottom-up analysis is, if I am selling real estate listings to brokers and there are a total of 10,000 real estate brokers in my market, of which 1,000 real estate brokers are sellable, where I can charge them $1,000 per month, then my addressable market is $12 million (here is a link that gives a more detailed description). It’s more clear and measurable in description and provides a realistic estimate of what your business can generate if all goes to plan.

Once you’ve identified the total addressable market and therefore the potential size of the business, you are on your way to building the foundation of your valuation.

Step 2: Find comparable companies

When looking for comparable companies, they do not have to be in the exact same sector. What’s important is that they possess a similar business model to the company you are building.

For example, if you are building a software-as-a-service business, then it would be useful to look at companies such as Open Table, Sales Force, DropBox, Box and others. You would need to look for data related to Sales, EBITDA and Valuations (or market capitalization / enterprise value if you are looking at public companies) of public or private companies.

Typically, early stage companies are loss-making, and so Sales can be used as a proxy even though it’s not a real driver of value (compared to EBITDA, given that EBITDA is a closer proxy to cash flows and inherent value). The next step would be to take an average of the Price/Sales or EV/Sales, and EV/EBITDA ratios for those companies, and attach a discount rate to account for the liquidity risk, market risk and other factors related to the market you’re in.

For MENA, at least a 30 percent discount rate is appropriate. You will then arrive at your multiple, which will be important when assessing the valuation.

Step 3: Develop valuation scenarios

The idea here is to determine projections of your business over a five to seven year period. We like longer horizons at BECO, given that we are a holding company, not a fund, and therefore do not have a finite life.

Your projections should have already been built ahead of this exercise. The important thing is to understand how big the business can be, both in terms of Sales and EBITDA (since as the company matures, it should become profitable and reach somewhat stable margins). Develop at least three different scenarios for these projections – we call them POOR, GOOD, GREAT (and sometimes we include a HOMERUN scenario). These different scenarios allow you to account for execution risk and potential issues with market-uptake or other things that can impact the growth of the business, and therefore the overall outcome.

Once the projections are complete, the next step is to use the Sales and/or EBITDA figures and attach the multiple created in the previous step to come up with valuation scenarios.

For example, in the GOOD scenario, your company will generate $20 million in year six, and companies similar to yours trade at 5x sales. If you apply a discount rate of 30 percent, you will have an average ratio of 3.5x sales, and therefore a valuation of $70 million.

Knowing how investors think will help entrepreneurs value their startups when raising funds. (Image via Consultadd.com)

Step 4: Factor in the required return

The return profile is essentially driven by the stage of the business, since they are a determinant of risk and therefore return. Earlier stage companies require a higher rate of return for investors, since there are various risks that are prevalent in those growth phases. These include market risk, product risk, growing pains, execution risk and others.

We have minimum return profiles for the different stages, based on research we’ve conducted on the market. This factors in the risk and also the holding period of each stage, since earlier investments are held for longer periods. I have summarized them below:

• Seed stage = > 20x or > 70% IRR (7 year holding period)

• Late Seed = > 10x or > 60% IRR (6 year holding period)

• Series A = > 8x or > 50% IRR (5 year holding period)

• Series B = > 5x or > 40% IRR (4 to 5 year holding period)

• Series C = > 4x or > 30% IRR (3 to 4 year holding period)

With these expectations, and the previous steps complete, we have created all the variables required for us to reach an indicative range on valuation.

Step 5: Build a cap table

When looking to invest in a startup, the first thing we do is build a capitalization table, which shows the different funding rounds that have been raised by the business, the investment and the number of shares (with percentages) owned by each shareholder.

Once the historical cap table is built, and you’ve reached the current shareholding, you need to insert the new funds required and provide an assumption for the valuation. This should help generate a price per share for investors.

Once we have established a working model (here is a useful link for that), we would then make an assumption on the number and sizes of the future rounds required (since we invest early, there is likely to be a further two or three rounds of funding).

The future rounds, if all goes well, will be done at higher valuations, but will also dilute all shareholders, including the investor. When we invest, we assume that we would at least participate on a pro-rata basis (meaning we would invest the required amount that will keep our shareholding at the same level).

As a rule of thumb, entrepreneurs should give up anywhere between 15 percent and 33 percent in the earlier rounds of funding (15 percent is just enough to give investors skin in the game, and 33 percent can indicate that the entrepreneur is not that excited about his/her business because they’re giving up a significant chunk).

Step 6: Test scenarios to reach a fair valuation

So now we have our model, with expectations of the future size of the business and implications on future rounds to the investor’s shareholding. The next step is to link the two together. The idea here is to pick a valuation scenario, typically the GOOD scenario, and then projection the investor’s shareholding of that valuation (after the future funding rounds and dilution).

So, if you are looking for $1 million in funding at the late seed stage, we would need to get $10 million in the next six years. If you’re business is going to reach $70 million, but requires two rounds, each diluting the investor’s shareholding by 20 percent, the investor requires about 14 percent upon exit in order to generate $10 million.

The cap table will allow you to project the dilution and impact of future rounds. Therefore, if you know you have 2 rounds with 20 percent dilution, and you work back to the existing round to set the shareholding that ends up with 14 percent after the future funding, the result is approximately 20 percent, implying a pre-money valuation of about $4 million and post-money of $5 million.

I’ve tried to summarize the above as easy as I can, which I hope people find useful.

In truth, we care about valuation, but we care more about execution, and love backing entrepreneurs that can demonstrate real passion, desire, ambition, experience and domain expertise that give us the belief that they can build large and successful ventures.