In my previous post I alluded to the importance of keeping your valuation grounded. Let me be very clear, I am not advocating underselling yourself. When I say grounded, what I mean is connected to some rational equation, as opposed to some arbitrary heuristic. Easier said than done, I know, especially for companies that are early in their growth cycle and are experiencing accelerating market traction. Further, young consumer companies often lack known comparables to base a valuation off of.

Valuing a profitable and established operating business, is a more straight forward exercise, as one can rely on precedent transactions analysis, comparable public company analysis, discounted cash flow analysis and inputted IRR calculations. Performing a DCF for an emerging growth business where the terminal value comprises the majority of the valuation is not good fundamental finance. Alternatively, applying transaction or trading multiples to a small base of operating results is not much better. While there is no formula for overcoming these challenges, some heuristics can be helpful in guiding one through the thought process.

Before we get into the point of heuristics, let’s go the opposite direction and talk about some of the most eye popping pre-money valuations that have been reported recently:

– October 24, 2007: Facebook raises $240 million on a $15 billion pre-money valuation;

– January 18, 2008: Slide raises $50 million on a $500 million pre-money valuation;

– March 19, 2008: Federated Media raises $30 million on a $200 million pre-money valuation; and

– April 21, 2008: Ning raises $60 million on a $400 million pre-money valuation.

– May 5, 2008: Meebo raises $25 million on a $200 million pre-money valuation

So what are the common strings. First, several of these companies own dominate or near dominate market positions in the fast growing on-line world where growth rates dwarf those of traditional businesses. Second, a number of these companies were founded by and are run by folks who have created substantial investor wealth in the past. Ning was co-founded by Marc Andreessen of Netscape fame. Slide was founded by Max Levchin, of the PayPal lineage. Third, the Facebook deal was strategically motivated. Some say Microsoft was valuation agnostic, a fact I don’t believe. Finally, most of these companies did not need the money and therefore they could dictate the terms of the investment. The point I am trying to make is that even these absurd valuations could be rationalized given the market positions, growth rate or strategic importance of the transactions. While deals like the above, grab headlines they are far from the norm, but rather the exception.

With that out of the way, we turn to how to derive your own valuation. A good place to start is to understand how others will look at your business. Experience has told me that you can break up a company’s drivers into tangibles and intangibles. Tangibles are things are observable or can be estimated with some degree of accuracy like actual financial performance, addressable market, distribution footprint and profitability levels. For the most part, these factors are observed traits or have corollaries that can be observed based on historical experience. Intangibles relate to observations that are open to more interpretation — quality of management, first mover advantage and brand value. The value ascribed to these factors will vary between potential investors based on their perceptions; tangibles less so. I have summarized my own view of this hierarchy below.

Now that you know what investor will be looking for, you can sketch out a realistic expectation of your pre-money valuation. For a consumer business idea that is raising money on a business plan, I’ve generally seen valuation ranges of up to $5 million for first time CEOs, and up to $20 million for proven management teams on their second go around (think Clairisonic, which was founded by Sonicare (Optiva Corp.) vets David Giuliani and Jack Gallagher – ed note: I have no idea what their pre-money was on any financing) Where a company’s falls in the range between $0 – $5 million or $0 – $20 million should be based on an honest assessment of intangible factors.

For an operating business, one should add a tangible valuation component. Generally, I base this a multiple of historical revenues and forward 12 month revenues. In a capital raise you can sell based on forward run rates. The multiple I rely on is based on precedent transaction and trading multiples where the point in the range I select is based on the tangible business factors that do not show up in the financial results. For example, Sambazon, a producer and marketer of Acai, a so called “super fruit”, based beverages controls the supply of Acai from the Amazon rainforest. This is in marked contrast to its competitors and quality control in the Acai beverage market is very important. Bad Acai is commonplace and leads to a poor customer experience. Based on this thought process, much of which can be observed and verified, I would value Sambazon, if I was doing so, at the higher end of the range. I would tick down similar rationales for all the tangible valuation factors.

Once, you have completed your analysis sum of the parts gets you a good sense of where you should be aiming. All of the above notwithstanding, I encourage company owners to focus on finding the right partner first and valuation second. Communicating a sense of openness on valuation is important even if a healthy debt as to what if fair ensues thereafter.

Happy hunting.