Perhaps the biggest mystery facing an entrepreneur is how to value the business. For many founders, the valuation of the enterprise is cloaked in mystery and is often left to others to calculate. A founding entrepreneur may feel that the company is worth millions of dollars while a potential investor is thinking in the hundreds of thousands.

The valuation process is especially difficult for a "pre-revenue" company - a firm without any sales, i.e. no track record. The founder is excited and believes in rapid and continuing growth, while the investor is thinking that it will take "twice as long and cost twice as much" to develop the enterprise than what is being forecast.

An entrepreneur recently presented his business plan to a large group of investors. The business was pre-revenue and showed great promise. When asked what he felt his company was worth, the entrepreneur produced a "valuation analysis" that he had paid several thousand dollars to a consultant to produce. The analysis indicated a current value of $14 million. The investors were shocked, feeling that the firm might be worth about $2 million in its present phase. The analyst had used a discounted cash flow approach, making no adjustment for risk. Since the proforma income statement projected high growth, it yielded a high value based upon the method utilized. The meeting ended with no investor interest.

Several alternative methods are available to assist in estimating value: the cost approach (value of company is closely related to its book value); discounted cash flow (several variations exist in using this method); the venture capital method; and comparing the company to similar companies in the same market using ratios such as earnings before interest, taxes, depreciation and amortization (EBITDA) compared to the value of the comparative enterprises.

The basic premise for this approach is to determine a future value for the company based upon some number (earnings, revenue, etc.), the approximate point in time when a liquidity event will take place (example: five years from the date of investment), what kind of multiple on the investment will be required for the investor based upon the inherent risk, and what percentage ownership is needed today in order to make the investment.

An example will help illustrate the method. Let's assume a company is seeking a $3 million investment and that the entrepreneur and investor agree that the company will have $50 million in sales in five years, at which time the company will either be sold or go public. They also both agree that the company will have $10 million in EBITDA in year 5.

Similar companies in the same general market category today sell for nine times EBITDA; therefore the future value of the venture may be worth $90 million dollars (9 x $10 million). Given the risk in building the company and competing successfully over the next five years, the investor wants a 10 times return on the investment, or $30 million in this example (10 is a common multiple in today's market and may increase if economic conditions change). The value of the new venture today is then worth $9 million (future value of $90 million divided by the multiple of 10). Therefore, the investor will ask for 33 percent ownership interest in the company for the $3 million investment today ($3 million investment divided by the $9 million present value). The above is a simplification of a more detailed process, but serves as an outline of the venture capital method.

Assumptions involving future financing rounds, stock option programs and other variables will change the final calculation.