- The most basic valuation method is based on comparison. Essentially, establishing a valuation that is “on scale” with those of other early-stage companies.
- High valuations comes with high expectations. Miss the milestones needed to justify an inflated valuation and a company might be looking at a down round, if not worse.
- There is no agreed technique to facilitate valuation; instead it is best to consider all methods.
We’ve all seen episodes of Dragon’s Den. The entrepreneur goes in claiming their startup is worth millions. This is often backed up with very little in the way of product development or sales strategy. We then endure some very awkward viewing as the founder attempts to justify what the idea or company is worth. But outside the world of TV drama, the truth is that setting a valuation is not an exact science. Instead, it is a complex process with many techniques at play. Here we will explore some of these and establish how to quantify a startup’s value without getting laughed out of the den (or investor’s office).
Apples for Apples - comparison creates valuation
In an established business, establishing a valuation is relatively straightforward. There’s revenue, cash flow, growth rates and other financial metrics to help decide its worth. But this is not the case for a young tech company, which likely has little or no revenue and maybe not even a finished prototype.
For these startups, the most basic valuation method is based on comparison. Essentially, establishing a startup’s valuation that is “on scale” with those of other early-stage companies. The more similar the startup — be it its sector, location or potential market size — the better.
Fortunately, comparisons are easy to find. You only have to look at the first page of Google to see a plethora of reports and management consultants detailing the criteria for Seed A, B and up to E level funding. The downside? Businesses are unique so the accuracy of this method is low.
Money, money, money
As a consequence, investors often turn to another key method for valuations - cash. They reverse engineer a startup’s post-money valuation based the amount of cash the founders are seeking, and the ownership stake the investors need to warrant their time and money.
“I need an ownership stake big enough that I can justify to my investors taking a board seat and taking time on a company,” says Jason Mendelson.
For example, if the founders are asking for £4 million and they need a 25% ownership stake to rationalise the investment, then everyone agrees that, on paper, the company is worth £16 million.
That’s been the experience of Peter Pham, cofounder of Science, an incubator in Santa Monica, California behind Dollar Shave Club and Bird, among others. “Valuation is really based on how much money the founders think they need,” says Pham. “Every round you might be giving up 20 or 25 or up to 30%.” That rule of thumb, he says, helps guide every valuation negotiation.
Collaboration is key
As you engage in calculations based on comparisons or the amount of funding raised, another figure may affect the outcome of the valuation: the size of a potential pay-out. This is a figure your investors will be particularly keen to think about. Investors need to be able to project the likely value for a company at the time at which the company may generate liquidity. They will then discount that future value to the present value based on the rate of return they are hoping to achieve.
Of course, the size of an exit like an IPO or acquisition is impossible to predict. But that doesn’t stop investors from making back-of-the-envelope estimates. And those calculations will be affected by the mood of the public markets. “I’m not sure why issues like Uber falling on its first day of trading has any effect on early stage valuations, but I can tell you after doing this for twenty years, it does,” Mendelson says.
High valuation, high expectations
There’s no disputing that trying to maximize your valuation can be good for you and your company: it means investors will pay more for a slice of it. But founders need to be careful to not seek too high a valuation, as it can set expectations that could prove impossible to fulfil.
Frankly, a high valuation comes with high expectations. Miss the milestones needed to justify an inflated valuation and a company might be looking at a down round, if not worse.
This is what happened to Loot, a digital banking service aimed at solving financial problems for students. Loot raised $10m in venture funding. However, despite strong customer acquisition, it failed generating sufficient revenues to meet its ongoing costs. Investment ran dry and the company went into administration.
Maybe it’s best to stay SAFE
An increasingly popular option for founders who are still searching for a business model and revenue is to postpone any decisions on valuation. Financial instruments like a convertible note or a SAFE (Simple Agreement for Future Equity), which was popularized by Y Combinator, allow companies to raise modest amounts from friends and family or angel investors while putting off a decision on valuation. The SAFE or notes will convert into equity if and when the startup raises its first priced round, presumably at a time when it will have actual metrics to determine a fair valuation.
Valuation is not an exact science
Valuing a startup that has no revenue, and perhaps not even a product, is a difficult business. There is no agreed technique to facilitate valuation; instead it is best to consider all of the methods outlined above. However, ultimately, investors and founders will have to get comfortable with some amount of uncertainty. Each valuation is based on factors such as how big or crowded the market and how public offerings are performing. An educated guess might be all you can hope for until the business is more established.