As an entrepreneur embarking on the exciting journey of building a startup, one crucial aspect that demands your attention is the valuation of your company. Determining the value of an early-stage startup can be a daunting task, often fraught with complexities and uncertainties. However, understanding the key factors that influence valuation and adopting best practices can significantly impact your fundraising efforts and future growth prospects.
With the creation of your pitch deck you have the information in place that defines the valuation of your early-stage startup. But you may not have customers and revenue, which makes valuation a complex and subjective process.
Let's start with some considerations to approach valuation that are great for more established startups.
Understand the Basics: Familiarize yourself with the common methods used to value startups, such as the discounted cash flow (DCF) method, comparable analysis, and the venture capital (VC) method. Each approach has its own strengths and limitations.
Market Analysis: Conduct a thorough market analysis to understand the size and growth potential of your target market. Identify comparable companies or startups in your industry and region to get a sense of their valuations. This will provide a benchmark for your own valuation.
Build a Strong Business Plan: Develop a comprehensive business plan that outlines your market opportunity, revenue model, growth strategy, and financial projections. A well-structured and realistic business plan can help justify your valuation and attract potential investors.
Seek Expert Advice: Consider consulting with experienced professionals, such as investment bankers, financial advisors, or startup mentors, who have expertise in startup valuations. They can provide valuable insights and guidance based on their industry knowledge and experience.
Focus on Key Metrics: Investors often consider certain key metrics when assessing startup valuations, such as revenue growth, user/customer acquisition, market share, and engagement metrics. Highlight your company's performance in these areas to support your valuation.
Assess Intellectual Property and Assets: If your startup possesses valuable intellectual property, patents, or proprietary technology, it can positively influence your valuation. Assess the uniqueness and potential value of your assets and communicate them effectively to investors.
Consider Future Potential: Early-stage startups are often valued based on their growth potential rather than current financials. Highlight your unique value proposition, competitive advantage, and scalability potential to support a higher valuation.
Proof of Traction: Show evidence of early traction, such as user adoption, revenue generation, partnerships, or customer feedback. These indicators demonstrate that your business model is viable and can attract investors.
Be Realistic: While it's important to be ambitious, be realistic about your valuation expectations. Overvaluing your company can lead to challenges in fundraising and attracting investors. Conduct a thorough assessment of your company's current stage and market conditions.
Negotiation and Flexibility: Valuations are often the subject of negotiation between startups and investors. Be open to discussions and consider adjusting your valuation based on investor feedback, market conditions, and the terms being offered.
While these points make a great check list. For early stage startups, with no or few customers, there are some additional steps to consider.
A startup seeking investment is in essence selling shares in the company. What are those shares worth? As a founder you need to understand what valuation means. It’s not a metric from a spreadsheet, or an analysis by a valuation consultant. The valuation is the amount investors are willing to pay. The only way to find a suitable valuation is to ask lots of investors. Think of it as auctioning off shares in the startup.
The best way to think of company valuation, is more like an auction than the sale of a product or even the purchase of public stock like Apple or Tesla.
How much is a Van Gogh painting worth? Like a startup, each one is unique. An expert appraiser can make a good guess based on the prices paid for other Van Gogh's, as well as recent sales of similar artists and trends in the art market in general, then attempt to apply that to the specific work. But that’s just an educated guess. In the end, the valuation is whatever buyers are willing to pay.
For established companies you can determine valuation by using metrics models. You have real data to work with. Early stage startups don’t have much historical data, only projections. In addition, models don’t factor in failure rates. That’s why metrics model are not great for determining value.
How do (early stage) investors look at valuation?
For an early-stage startup, where the risk of failure is high, an analytical approach to valuation will have three key elements:
Probability of Success
Exit Valuation
Time to Exit
It’s a not very exact thought process of estimating the future value of your company, chances of successful execution of your plan, and how long it will take for exit opportunities. The investors pick the startups they think offer the best reward for the risk profile. Bear in mind that many investors specialize in sectors, stage and geographies which impacts their appetite and valuation.
How to Set the Valuation?
Founders who haven’t spent years listening to pitches have no way to know what the market will bear. The only way a founder can set an appropriate valuation is by talking to investors.
Each investors has their opinion of your valuation so you need to speak with many investors to find the middle ground.
Once a proposed valuation is defined, the founder can start pitching. Rather than coming in with a fixed number, present the valuation as a negotiable. A typical approach is to start a little high, but making it clear the number is negotiable. Instead of specifying a valuation of $5M, for example, say “targeting $6M.” It might turn out $6M is fine, or you might get beaten down to $5M, but so long as the number is close, interested investors will negotiate.
Typically a startup needs multiple investors to fill a round. Going with the highest valuation may not be the best one to get the round filled. Even if the lead investor agrees, other investors may not want to come on board at that price.
Going with an underpriced valuation can be the better option as investors will become eager to invest in your company. You can fill the round far quicker and choose the investors you want to spend the next 5–10 years working with instead of accepting the highest offer.
Remember pitching to investors is like selling stock in your business. If the price is too high, they will walk away. If the price is low, you’re leaving money on the table. The only way to find out the best price is to talk to investors.