“Everything you want in life has a price connected to it. There’s a price to pay if you want to make things better, a price to pay just for leaving things as they are, a price for everything.” – Harry Browne
Everything has a price in business.
So, what’s the price for your startup? What’s yout startup valuation?
A business needs to have a value but determining this value can be tricky. It’s almost closer to art than science – you are essentially painting a picture of your worth without showing any tangible evidence for it yet.
Why does valuation matter then and what are the elements that influence startup valuations?
When does startup valuation come to play?
Everything has to start from valuation. Not just your business ventures and deal-making, but also this post I’m writing.
What is valuation?
Merriam-Webster defines it as “the estimated or determined market value of a thing”.
To put it another way, valuation tells the worth of your business.
For an established business, coming up with a sound valuation is not that difficult – not that it is particularly easy either. These businesses have revenue, possible profits and customers that help determine the value with a higher certainty.
Essentially, they have tangible figures they can use to calculate the market value of their business.
However, what do you do when you don’t have these figures?
Your startup might not have any customers, you might not have any revenue coming in, let alone profit. In fact, you might have more expenses at this stage if nothing else!
Does this mean your startup is valued at zero?
Well, no. As the quote stated at the start, everything has a price.
We’ve all seen the figures in recent years. Startups with hardly any revenue have been valued at figures exceeding $10 million. Indeed, in 2016, pre-money valuation for seed stage companies reached $5.9 million on average.
So, how then, do these valuations come about? And more importantly, why does it matter?
Let’s first examine the situations when you need to know the value of your startup.
There are three main situations when valuation comes into play.
#1. Raising capital
Since startups are all about scalability and growth, you often need money to support this growth.Unless you are a millionaire and willing to risk your own money, you probably need investors. Click To Tweet
And so, you turn to investors, such as venture capitalists and angel investors. But instead of just patting you on the back and handing a check of $100,000, these investors want to understand what your company value is.
Indeed, by simply adding $100,000 to your startup, the investor is increasing the value of your business.
But investors don’t just give you money; they want equity – a stake in your business – in return for the capital.
In order to give equity, you need to have something to give this equity from – you clearly can’t give it from the $100,000 they are investing. They are giving all of it and so they would need 100% – i.e. they would be buying your startup not investing in it.
So, you determine a value to raise capital from investors.
At this stage, there are two key concepts you need to understand: the pre-money valuation and the post-money valuation.
Pre-money valuation refers to the value of the company BEFORE the next investment round.
This valuation is crucial because it helps determine the percentage of ownership the investor receives following the investment.
Let’s assume your startup’s pre-money valuation is $4 million. An angel investor comes along and gives you $1 million. The pre-money valuation remains at $4 million and you can determine the angel’s slice of the cake by using the formula:
If we take the example figures, we could calculate the percentage, which would be 20%.
However, post-money valuation refers to the valuation of the company FOLLOWING the investment.
So, with the above figures in mind, your post-money valuation would be $5 million.
It’s essentially just:
So, in our example the simple calculation would look like this:
When valuation is determined and investments are taking place, pre- and post-money valuations cannot be considered or looked at in isolation. You need to consider what the post-money valuation would be in order to get the pre-money valuation right.
#2. Selling the business
Valuation doesn’t just come to play when startups are looking to raise money. It’s also important when you are looking to sell the business.
Now, selling the business is essentially the final step in the startup funding cycle. This is the moment your startup is mature enough to become a ‘real’ business. You’ll start focusing on maintaining the market position rather than just continued scaling.
Selling the business tends to follow these three routes:
- Trade sale – sale of the business to other companies, which is why trade sales are often referred to as business-to-business sales.
Trade sales are often done by strategic businesses, such as Facebook, Yahoo and Google. In essence, the big company buys a startup that might help it gain market access or own an innovative technology in order to prevent a challenge to the company’s market position.
- Secondary sale – which is the sale of restricted holdings by an investment company to another investor. A secondary sale is often between a financial investor and a private equity company.
- Initial public offering (IPO) – the company becomes available to the public by offering its stock in the stock market.
In each situation, you need to determine the value of the startup in order for the sale to go through. In terms of valuations, IPOs tend to generate the highest valuations.
#3. Paying taxes
The final situation when valuations come to play is related to taxation. Again, for traditional firms, this is much easier since you are looking at the figures – revenue, profits, assets and so on – but for startups, this can be a murky subject.
For startups, the problems often come from having a high valuation while incurring losses. Therefore, taxation might be high even though the company is not making any kind of money – naturally a big problem.
I don’t quite have time to go into this subject. It’s worthy of its own post, really.
However, taxation doesn’t really affect the main gist of the post – how startup valuation works.
If you want to know more about taxes and startup valuation, I recommend you explore the following posts:
So, you have three instances when valuation matters but what is it about?
Startup valuation is trying to assess the value of a company TODAY based on the future projections of the entrepreneur and the investor.
You are, essentially, peering into the future and trying to understand the worth based on the capabilities you are currently presenting.
In a sense, you are painting a picture of what will be using the elements you have available right now.
Signs investors will give your business thumbs up
So far, we’ve looked at the brief view of what startup valuation is about – assessing the value of the company TODAY bases on the future projection of the entrepreneur and the investor.
So, what are the elements that can influence the future projection?
There are certain signs investors and you as an entrepreneur should focus on, as they can point to positive future projections, which could signify higher future growth opportunities.
These signals are used when there aren’t many figures to go by. As I’ve talked before, a traditional business can base valuation on things like profits, revenue and assets.
However, since your startup doesn’t yet have these figures or the figures only go back a month or so, you need to consider the future outlook.
So, what should you focus on in determining valuation and especially signals that could result in enhanced valuations?
Investors are looking for:
The hotness of the industry
The most obvious boost to valuation comes from the industry in which your startup operates. If your industry is currently full of high-value players, then you are likely to receive a good valuation with your business.
Think of it like this: investors are pack animals. When one investor finds an interesting target, the other investors also take notice and start circling the target. The more interest there is, the higher the valuation will be.
It’s essentially about demand – the more demand (investor interest) you have, the higher you can set the price (the valuation).
What this means is that market forces influence your valuation.
Remember startup valuation is based on the future prospects based on the current situation. This is not just in relation to your startup but ALSO the larger industry or market.
A startup operating in a distressed market won’t reach such a high valuation because the investor is not just looking at the business but the wider picture.
Imagine that your startup is able to showcase growth potential and good traction. However, you operate in an industry that is rather small and in itself doesn’t offer much growth.
While your business has potential, the market as a whole will limit the startup’s potential – leading to slower valuation.
Tomasz Tunguz, a venture capitalist, has crunched numbers on this phenomenon and found the markets that are currently increasing valuations and the ones that are suffering.
You can see the Series A and seed funding movements from the graphic below:
Source: Tomasz Tungez blog
If you’d look for hot sectors, your startup valuation would benefit from operating in industries like Big Data, SaaS, and cloud computing.
On the other hand, advertising is witnessing declining valuations both at the seed and Series A stage.
The abilities and capabilities of your team
Of course, investors can’t just examine the external markets.
Startup valuation can also improve depending on your team – if you can convince the investor the team is able to achieve high growth and increase value, you will attract better valuation as a result.
In essence, with the right team you can tell the market what you are worth.
How do you gain this authority?
You, of course, must build reputation amongst investors – you need to be the ‘talk of the town’.
Reputation is largely down to two things: your ability to network and your ability to build yourself up as an influencer.
Since it would take too long to go over in detail how both of these issues work, I suggest you check out the video below and read articles like Entrepreneur’s 5 Qualities VCs Look for in Your Startup Team and Sujan Patel’s How to Build Authority Online.
However, the key is to ensure your team is able to market itself as reputable and influential – you want to be able to convince the investors that the team will be capable of creating value and scale the startup.
In essence, this requires the right type of talent and the right number of people in the startup.
Indeed, according to Jeff Bezos, the founder of Amazon:If you can’t feed a team with two pizzas, it’s too large. - Jeff Bezos Click To Tweet
Each member must be able to add a different value to the team, understand what the vision is and know how to best achieve growth.
A team too big and this becomes difficult – you have too many cooks making the same pie.
A team too small and you make it hard to focus on the right things – there aren’t enough people to take care of the important aspects of growing and you might burn yourself out.
A functional product that solves critical customer pain points
Investors also evaluate the product when they consider the value of your business.
It all boils down to the business idea – what problem is your business going to solve? And for what customer segments?
The scalability of your product largely depends on this.
If your business can help consumers or businesses solve a range of critical problems, it will have a large growth prospect. The larger your growth prospect, the higher your future earning potential and therefore, valuation.
A product with limited benefit to its customers is not going to attract a high valuation because it offers a more limited market space.
The competitive advantage and its sustainability
Now, the above directly relates to another important element influencing valuations: the competitive advantage you have.
How does the above relate to startup valuation?
If your business can showcase competitive advantage potential, it naturally can attract higher valuations.
Simply, the better your competitive advantage, the more customers you can attract.
In addition, if the competitive advantage is sustainable – meaning that it’s hard for your competitors to start replicating it – you can improve the valuation even further.
Your startup has good prospects if you have exclusive access to a valuable technology (for example due to intellectual property or team skills), customers (for example due to exclusive distribution arrangements), or economies of scale (you have lower purchase costs for materials, customer acquisition, or customer service).
The distribution channels
I think it’s also worth mentioning one final element that can boost valuation for startups: existing distribution channels.
Now, this doesn’t mean the sales channels matter to the investor more than the ability to grow quickly.
However, by being able to showcase you have distribution channels available, you show the startup is able to grow faster.
Let’s imagine you’re a tech expert who’s been operating in the industry for ten years. If you’ve worked as a tech consultant who is now looking to launch a product to provide cloud-based storage for companies, you might have a distribution channel available.
You are, essentially, already ahead of another startup.
Therefore, distribution channels can help provide value for your business because they can make revenue creation easier.
Signs savvy investors will rather run than invest
But it’s not just about creating an environment of positive signs that can push up the valuation – there are also certain signs savvy investors will view negatively and therefore, lower valuations or make it harder for you to obtain investment.
The signs you and investors should be wary of:
Highly commoditised sector
As I mentioned above, the market tends to largely determine your startup’s value. If the market is expected to grow and you are surrounded by other highly valued businesses, your startup is more likely to receive a higher valuation.
This naturally means that if you are in a market with low future prospects, the valuation won’t be as high.
Investors, in short, are not looking to invest in an industry that’s not producing high returns and which doesn’t seem to offer high yields in the future.
In essence, a highly commoditised sector or poorly performing sector will drive down valuations. It’s just about the markets – if the markets are low, the startup valuation will be low.
Unscalable business model
Of course, just as your business valuation can be pushed higher with internal elements, it can also be dragged down by these.
The most obvious is a non-scalable business model.
Remember, a startup is about scalability – if you can’t show how, when and why your business can scale, an investor isn’t going to give it much value.
Startup valuation is largely driven by the potential – the potential of scaling the business. Now, if you don’t have this potential, let alone any evidence to support it, the valuation won’t be at the high end of the spectrum.
Make sure to convince investors that you are ready to scale (e.g. team, customer acquisition, processes, IT) from day 1 after you receive their investment.
High division of equity
So, your startup valuation won’t remain static – at different stages of the startup funding process, you will receive different valuations.
Generally, the more mature your business, the higher your valuation can be. At the seed stage, you often just have an idea – the valuation is based on the prospect of the idea.
At the Series A round and beyond, the startup has a bit more proof to back the valuation – perhaps a product that’s already selling or proper IP rights.
Successful fundraising at any stage tends to increase the valuation in further rounds – indeed, you are adding more value to your business with the investment.
However, as the startup gains investments, it has to hand out equity.
Handing out equity means the startup’s ownership and control becomes fractioned. This can have a negative effect on valuation because investors don’t like to invest in companies with high division of equity.
It tends to mean higher cost purely in terms of the legal requirements and paperwork.
It can also make leadership more difficult. If the business has handed out a lot of its equity, control will also be divided and this can slow things down (e.g. major strategic decisions such as pivots, divestments, or acquisitions). Instead of just making decisions, you might need the approval of investors.
The seven methods to calculate your startup’s value
So far, I’ve been discussing the wider picture behind startup valuation. Like I said at the start, it is often more like an art form rather than science.
As the above chapters show, there are plenty of drivers determining whether the valuation is high or low. These help paint the big picture.
However, you do require a bit of science as well.
Just like artists need the right types of pencils and stencils, startup valuation uses methods that help determine the right valuation using calculations and formulas.
Below are seven widely used methods that can help you to calculate a more accurate valuation for your startup.
Valuation method #1: Comparables or Multiples
The most common method is to find a valuation for a startup by comparing it with others.
The basic principle behind the method is about valuing your startup in comparison with another similar business.
Think of it like a real estate sale – you often get the value of your home by looking at the sale prices of homes in the same building block or street.
Let’s say you were a technology startup, about to start selling business software.
The comparable method would examine startups in the same sector – perhaps with similar products on offer – and consider what their valuation means for your startup’s value.
For example, the other company might have received a valuation of $15,000,000 during its initial public offering (IPO). You’ll also know that its software has 500,000 active users.
With the comparable method, you could calculate the value of the user base. For the other company, this would be $30 per user.
Now if you already had traction with users, you could use the figures and calculate the estimated company value.
With 250,000 users, your startup could be worth $7,500,000, for instance.
Naturally, the comparison can take place in other ways – different industries can use specific indicators. For example:
These are industry-specific indicators to use, but you can also opt for the usual options of sales, gross margin, EBITDA and so on.
The good thing about the comparable method is that depending on the indicator, you can use it for both pre- and post-money valuations.
You’d ideally be adding the known information about the other company in comparison to your company, coming to a valuation:
Now, above you have an example of the different appropriate comparables you might be examining. The most used comparable method utilises the EV/Sales ratio to calculate the value.
This is essentially the enterprise value divided by the annual sales.
Put it another way, you can calculate it with the formula:
For this method, you would get the most accurate results if you have annual revenue – even though it is possible to use projected cash flow or even monthly revenue if figures are available.
Let’s assume your startup is currently making $500,000 in annual revenue.
You find another company similar to yours that was just sold for $50 million with revenue about $15 million. The EV/Sales ratio would be 3.3 using the formula above.
By using this ratio for your startup, you would get a valuation of $1,65 million.
Now, to increase the accuracy of the comparable method, you’d want to consider using different multiples. So, instead of using just the EV/Sales ratio, you would also examine the User/Sales ratio and so on.
Valuation method #2: Conformity
Conformity is a valuation that only focuses on the investor preferences. In short, the investor has certain investment preferences and these will be used to find the startups that ‘conform’ to these ideals.
Now, what does this mean?
If you were an investor wanting to invest around $100,000 to $250,000 in a startup and as a result gain around 10% in equity, you’d find ventures that conform to these rules while providing you with the specific exit strategy you might have.
In terms of your startup valuation, you might encounter an investor who wants to invest $120,000 for 7% equity of the post-money valuation. The implied valuation here would make the company valued at around $1,7 million.
While this is not necessarily that helpful for startups, startup accelerators and incubators often use this kind of approach.
Indeed, the above figures are exactly those from Y-Combinator’s dealbook.
This valuation approach is the least scientific method of the seven, if I may say. This is down to it being more about what the investor is comfortable with rather than what the startup is actually worth.
Essentially, it’s not so much about considering startups on an individual basis, but finding those that conform to the investor’s ideals.
Valuation method #3: Discounted Cash flow (DCF method)
Now, startup valuation can also be derived from specific cash flow projections.
The idea with this approach is to consider the startup as the ownership of any other investment vehicle, such as real estate.
You estimate and discount your startup’s future cashflows in order to arrive at TODAY’s valuation.
You might have noticed a dilemma here.
How does a startup use cash flow, when the financial history of earnings and expenses is not yet established?
Perhaps more importantly, how to use the method when your startup is most likely losing money rather than making it in the coming years?
You’d be right – the method is not useful for startups with any sort of financial record.
However, you can use hypothetical cash flows and discount them back to the present later on in order to get a valuation. This can work in the later rounds in the funding cycle when you’ve established some solid financials and a higher predictability.
Valuation method #4: Venture capital method
You could also combine the three previous methods – comparable, conformity and cash flow and use the Venture Capital Method.
You use the comparable method to come up with an exit valuation for your startup. You then use this valuation to move backwards in the investment rounds to draw a valuation that would conform to the investor’s preferences.
Let’s look at an example to understand how the venture capital method works in practice.
Assume an investor wants to invest in your startup and his ideal exit time would be three years.
To come to the current valuation, you would need to look at your expected revenue in three years’ time. You’ll then take the revenue and multiply it with your revenue multiple to come up with the terminal value (what the company could feasibly be sold for in three years either due to a trade sale or IPO).
Let’s imagine your startup will make $2 million in revenue in three years’ time and your revenue multiple is 15.
The terminal value would, therefore, be:
Your investor would also have an expected return in mind or the Internal Rate of Return (IRR). Now, this might be 30% – a common figure for startups.
So, if your investor had invested $1,500,000 initially to the business, their exit value need would amount to roughly $3,300,000.
Using the calculation:
With this information, you can calculate the percentage the investor would need when the company is sold:
So, your investor would be looking at around 11%.
However, your startup is likely to have other investment rounds in the meantime, so the figure would need to be higher – their ownership would have of course diluted during these rounds before selling the company.
A common VC investment dilutes investments by 25%. If we use this figure, the starting equity stake would be:
This would round it up to around 15% of the company during the initial investment round.
After all this, we finally have the chance to calculate the current startup valuation.
With an initial investment of $1,500,000, which is worth around 14.6% of the company, the post-money valuation would be:
The pre-money valuation can then be calculated by substracting the investment from the post-money value. This would give your startup a pre-money valuation of around $8,700,000.
The venture capital method is sometimes referred to as the First Chicago Method.
Now, the methods are actually a bit different.
The First Chicago Method is essentially about creating an average valuation, based on the likelihood of different valuations.
So, you consider the lowest possible valuation, the most likely valuation and the best-case scenario valuation.
As you can see in the above image, the squares are of different sizes. This is down to probability.
The chances for a high valuation are rather low – you’d really need to hit it big to get $5 billion, for example. However, your chances of having a really bad valuation are also not likely (if you’ve done your homework!), although it’s generally more likely a startup is undervalued rather than overvalued.
The most likely scenario is to have an average valuation based on your current business model.
Valuation method #5: De- or re-construction
You could also take a straightforward approach and calculate your startup’s value based on deconstruction or reconstruction of the venture.
Deconstruction would look at the raw liquidation of the venture – for instance, due to insolvency.
In short, you’d be looking at the sellable assets of the startup and calculate their worth. This could mean any office space or furniture, technology owned by the startup and so on.
If your startup is young and hasn’t had time to acquire any assets worth mentioning, this method would naturally not be very useful. Deconstruction doesn’t take into account the value of your business idea or other such intangible assets.
Reconstruction, on the other hand, approaches valuation from the ‘build it or buy it’ perspective.
This means examining the core asset of the startup and basing the valuation on what it would cost to replicate it – i.e. reconstruct the asset.
Your startup’s core asset might be a technology you’ve built. At its core, it would take around 2,000 hours of labour to rebuild it. The cost of the startup would simply be the cost of those 2,000 hours of labour.
Therefore, you can use the reconstruction model even when you don’t have tangible assets.
Valuation method #6: Combination
Intuitively, startup valuation can’t just rely on a single method, right?
Since the data you are working with is limited, it makes sense to consider different elements of the startup together.
Now, this is exactly what the combination method is all about.
The method is also known as the Berkus Method. It sums up the perceived value of different elements of your startup in order to come up with the present value.
You can even read the model originator’s thoughts about it here.
The method is rather close to the comparable method – you take 5 key criteria for creating a good startup and you compare your startup in those to other similar startups.
In essence, you are evaluating the possible value of the startup by considering what others might be able to make if they owned the individual elements.
For example, a similar startup might have been valued at $2 million. You take the five elements (there might be other elements that are driving the valuation) and assess their impact on the valuation. You then compare them to your current situation:
Valuation method #7: Competitive loss
Finally, you have the flipside of the combination approach: competitive loss.
This particular startup valuation method looks what the financial loss would be like if a competitor gained the benefits from the acquisition of a venture.
For the valuation, your startup has to be viewed as separate entities – you essentially chop it to pieces and see what losing one aspect of the startup would mean to the whole of the business.
Let’s say you have software in the pipeline. Now, with the method, you would evaluate the financial loss your startup would suffer from if another business were to acquire the software from you.
The valuation for the software product would, therefore, be the financial loss you would suffer by losing the software.
You could essentially use this method even in terms of your team – how much would it hurt your startup to lose your co-founder to a competitor, for instance?
Now, selecting the right valuation method for your startup will depend on your business, the point at which you are in terms of fundraising, and the investors your startup is attracting.
Most venture capital and angel investors are using comparables and the venture capital method while most accelerators are using the conformity method.
Like I’ve said, the valuation process is a mixture of art and science – you look at the broad elements influencing your startup, as well as the specific calculation methods that might be suited for your venture.
Yaiks! Do I need a $5 billion valuation and be a unicorn?
In the era of unicorns, it’s rather easy to feel pressured into receiving a high valuation. Since investors often look at the market and use the comparable method, valuation tends to fall on the high-end of the scale.
Just look at the image below, it shows how startup valuations have risen overall in recent years.
Source: Quartz article
But does it have to be so? Do you need to ensure your startup is valued at $5 billion or more to succeed?
The short answer is ‘no’. A high valuation is not a guarantee for success.
Indeed, some venture capitalist are arguing aggressively against the current valuation market, stating that valuations are too high.
In a Both Sides of the Table post, venture capitalist Mark Suster explained how he thinks valuations are about the crash soon – even though this isn’t what investors want.
So, current high valuations might not be a mark of anything other than an over-valued market – you shouldn’t be afraid if your startup is not attracting the highest valuations; it might be a sign of sensible investors.
In addition, high valuation can be problematic because it adds too much pressure on your startup.
Let’s say your business is valued at $5 billion in the seed round (don’t worry, that will never happen).
Now, the valuation forces you to grow a lot until your next investment round. This means you can’t burn this money too quick, as it would show you need a lot more money without really showing any traction.
Now, if you can’t grow the business as you were expected to due to the valuation, your shares will be valued lower the next time around.
This means the next venture capitalist will get a bigger slice of the equity pie due to the specific liquidation preferences. For you, this means fewer profits in the years to come and potentially getting nothing although you have been working 80+ hours per week for the last 5 years in order to grow your startup.
However, you also don’t need a high valuation to succeed because startup fundraising isn’t the only road to startup success.
You can succeed through the process of bootstrapping and skip the time consuming fundraising process altogether. That can be a good alternative for less capital intensive business models where you can validate your business model and achieve break-even with less than $200k.
You’d essentially keep the cost down and only use the resources your business generates in order to grow – eventually, you’d achieve a point where your business would be valued based on the traditional methods, i.e. the financial figures you’re producing.
Now, the problem with thinking your startup needs a high valuation is also evident in another way. It assumes you can just plug the number out of thin air.
While startup valuation is surely somewhat more like art than science, the valuation is based on careful analysis and calculation of the possibilities. As the seven methods above highlighted, calculations always take into account numerous things – your startup’s value is what it is actually worth.
Therefore, a low or a high valuation doesn’t mean your startup is valued ‘wrong’ – it’s just what it’s worth at that moment in time.
It is rather simple if you think about it. Your startup is valued at what it’s potential is in the eyes of the investors and/or the market.
The bottom line: nailing down startup valuation
Everything in life has a price – your startup might not yet be worth $700 billion like Apple, but it certainly has some value.
The problem is how do you determine this value when you don’t have anything more than a business idea.
I’ve hopefully been able to convince you that startup valuation is not a world of make-believe. While there’s plenty of art behind it – valuating the different elements surrounding your business and determining the potential more than the actual – startup valuation also deals with science.
You can use models and strategies to derive a sound valuation. You don’t want to end up with a random figure, but carefully analyse what will be based on what is there now.
So, what do you think? Are startup valuations the workings of a mad scientist or modern day Picasso?
Which startup valuation method are you currently using and what problems did you experience with using it?