Business valuation of any kind is never cut and dry. For startups with little or no revenue and an uncertain future, assigning a valuation is especially tricky. For mature businesses that are publicly listed and have a steady revenue, there are specific facts and figures to use to determine a value. However, a startup is much more difficult to value since it is likely nowhere near making relevant sales. If you need to raise capital for your startup, it’s important to determine what your startup’s value is. But do how to best value your startup?
A startup in the BI space I mentored in 2013, found themselves in some hot water with their funding strategy, which started out when they determined their series A valuation. They thought that it would be better to value their startup aggressively, rather than modest. Now, while they ended up raising $5 million at a $25 million post-valuation, when raising their Series B round, because their poor growth rate they had to raise at a down round of $15 million. Ouch!
The lesson learned was expensive for all involved parties — and their funding evolution was hit by a major drawback which caused also one of the founders to step out of the venture.
Importance of Valuing Your Startup
It’s been said that valuing a company is more of an art form than a science. This is even more true for valuing startups that have much less data to work off of. In short, your startup is worth what someone is willing to pay for it. However, it is possible to master the art form and assign a value to your startup that both makes sense to you and is in line with investors’ expectations.
Approach investors with financial forecasts
While it’s decidedly difficult to forecast a startup’s revenue, you will need to have some idea of financial projections to determine value and to defend your value to investors. Step into the shoes of potential investors to understand the importance of this step. You need to get them excited about investing in your startup instead of the hundreds of other startups they see throughout the year.
Investors are searching for their next 10-times return startup opportunity. Your five-year financial forecasts should show growth that can afford them that return.
Do your research
You can value your company, even in the earliest startup phases, by looking at similar companies in your industry and geographic location and their valuations. This will give you an idea of the potential you have in your market.
You may see a multi-million dollar potential to your business idea, but your investors will need to be convinced of your potential and your startup’s worth. Knowing the comparable facts will give you a leg to stand on in defending your valuation.
To find out how much other businesses in your industry are selling for, you can use resources like BizBuySell or BizQuest. Additionally, accountants and lawyers make excellent advisors to help you determine the value of comparable startups at your stage. Be sure to talk to both, as one tends to overvalue and the other tends to undervalue startups.
Pick a financial advisor’s brain
If you are struggling with the research portion and you are having trouble finding the relevant valuation statistics for your industry, a financial advisor can assist you. Ask them to help you find valuations determined in recent financings, or recent M&A transactions in your market.
Investors and Startups both need to know the value. Having solid support of your value is important when it comes to raising capital. You will not be able to raise money from investors if you don’t know at what value you are raising funds. So do your homework before meeting investors.
Supply & Demand
One of the most basic economic principles is that of supply and demand. You can use this principle for valuing your startup. As the name implies, the more scarce a supply, the higher the demand.
For your startup, that means if you are part of a much-talked-about new patented technology startup, you could drive up your valuation by attracting multiple interested investors competing for the deal.
Most startups won’t be fortunate enough to experience multiple investors courting them for a deal. However, even if you don’t have real demand from investors, you can create a perceived demand when dealing with one investor. To do so, don’t let them think that they are the only investor interested in your startup, as that can decrease your valuation. Work to portray your startup as new and unique to create the scarcity needed to maximize your valuation.
What’s Your Value?
The market determines your value. You might have a number in your head for what you think your startup is worth. When you go to investors, though, they might give you a different number.
For example, while you think that $5 million is a fair valuation based on liquid assets or receivables, investors are telling you that your startup is worth $1 million. If you are unable to raise capital with a higher valuation, even if you are worth more, you will have to accept your value at what the market says it is.
On the flip side, if you raise money from friends or family rather than professional investors, it’s likely that your startup is overvalued. Your father or old roommate might be willing to pay $20 per share, but future investors may not pay more than that, even as you grow.
You can influence the number the market puts on you
While this may seem contradictory to the previous point, you do have some influence in your market value. You’ve likely given investors a reason to believe your startup is only worth $1 million rather than $5 million. Find a way to value your company on something other than historical performance, since you don’t have a history yet. Use comparables and financial projections to raise your valuation.
If you haven’t made a profit, look to the future for value
Without a history showing profit or revenue, your startup has very little to no liquidity. Without cash flow, it is difficult for startups to determine their valuation. It’s going to take time to become profitable, so you will need to look to your future success to determine a value. Ask yourself a few key questions:
- How many years will it take you to be profitable? If you can get there quicker, you valuation will be higher.
- How much are comparable companies valued at when they become profitable?
A company may be worth a fraction of the number they are valued at when they reach profitability. Factors like likelihood of success and the quality of the management team should be taken into factor.
Your industry makes a difference
Each industry has its own way of valuing startups. For example, an VR/AR Startup would have a much higher valuation than a SaaS CRM. Research the valuations achieved in recent investments or M&A transactions in your market before you approach investors.
Some angel investors and venture capitalists use a “rule of thumb” value to quickly come up with a range of startup value. The values are typically set by the investors, and they depend on the startup’s stage of development. Simply put, the further along the startup has progressed, the lower the investor’s risk and the higher its value. Examples of stages of development include:
- A startup has an exciting business idea
- A startup has a stunning team of engineers and a great business person
- The startup has a Minimum-Viable-Product (MVP) with early adopters
- The startup has partners, a customer base and a pipeline of prospects
- Revenue growth and an obvious pathway to profitability is shown.
What Grade Are You?
Another way to look at the developmental stages is by breaking it out into four stages similar to the four years of high school education. The stage you are in is a key factor in determining your value.
- Freshman: an idea, team and a prototype. Bootstrap financed and raised $50 thousand to $0.5M.
- Sophomore: MVP with early adopters. Seed stage angels financed from $500 thousand to $1.5 million.
- Junior: Experiencing user or revenue growth and displayed a full proof of concept around the startup. Nearing up to $1 million in revenue. Series A venture capital financed from $1.5 million to $5 million.
- Senior: Reached multi-millions in revenue and ready to scale up with a capital raise. Series B/C venture capital financed from $5 million to $50 million.
Investors will be much more open to your valuation expectations if you can be specific on why you need the funding and how you will use it. Unless you are ready to back up a high valuation with growth potential, and you are ready for the roller coaster ride, stick to a modest valuation.
One way to prove your value to investors is by testing your idea out a few times. Get enough results that you can show to potential investors and prove that, with some investment, you have something to offer the industry and can grow and meet expectations. If someone is going to give you money, it is important to them that they can see that your idea works and they will earn a return on their money.
Be upfront about your plants, whether you are looking to go all way through or you plan to exit with the first opportunity. It’s important for investors to understand your mentality.
Compare your venture assets such as team, KPIs and IP to other players on the market — and understand at how much the competitive landscape raised. Sites such as Crunchbase and CB Insights are of great help to do so.
While it is tempting to give your startup the highest valuation, remember that you will need to meet the growth expectations to stay at a high valuation. Hence, if you are unrealistically high on your valuation, it could make your startup life difficult down the road.