Startup Valuations equates to what someone is willing to pay.
The biggest determinant of your startup’s value are the market forces of the industry & sector in which it plays, which include the balance (or imbalance) between demand and supply of money, the most recent capital raising and the size of recent exits, the willingness for an investor to pay a premium to get into a deal, and the level of need of the entrepreneur looking for money.
Startup Valuations are dependent on:
1. The size of the opportunity — as measured by the market growth rate
2. The team — members’ domain expertise, track record, reputation, and history of prior success
3. Traction — this might be measured in users, revenues, downloads, or by some other yardstick
4. Your capital needs — how much you plan to spend, on what assets, for what expected impact
5. Option pool — the key determinant is size. The larger the option pool the lower your valuation
6. Preferred stock participation preference
7. How hot the space is at any given moment aka market sentiment
8. Comparable based on recent financings/exits
9. Revenue earned to date.
Source: Foresight Valuation Group
Why does Startup Valuation matter?
Valuation matters to entrepreneurs because it determines the share of the company they have to give away to an investor in exchange for money. At the early stage the value of the company is close to zero, but the valuation has to be a lot higher than that. Why? Let’s say you are looking for a seed investment of around $100, 000 in exchange for about 10% of your company. Your pre-money valuation will be $ 1 million. This however, does not mean that your company is worth $1 million now. You probably could not sell it for that amount. Valuation at the early stages is a lot about the growth potential, as opposed to the present value.
How to Determine Valuation?
The valuation of your business can increase at every equity raise the enterprise value is calculated by the investment amount and the equity a business issues during each round. For example, if you take an equity deal that surrenders 25% equity in a company during a capital raising, then the cash investment would increase the value of the business (and thus shares) to four times (4X) such an investment amount. A diligent structure can allow subsequent rounds to be raised at a higher valuation increasing Enterprise Value.
Early-stage valuation is commonly described as “an art rather than a science”. Let’s see what factors influence valuation.
1. Traction: Out of all things that you could possibly show an investor, traction is the number one thing that will convince them. The point of a company’s existence is to get users, and if the investor sees users. 2. Reputation: There is the kind of reputation that would warrant a high valuation no matter what his next idea is. Entrepreneurs with prior exits in general also tend to get higher valuations. But some people received funding without traction and without significant prior success. 3. Revenues: Revenues are more important for the B-to-B startups than consumer startups. Revenues make the company easier to value. 4. Distribution Channel: Even though your product might be in very early stages, you might already have a distribution channel for it. You might have run a Facebook page of cake photos with 12 million likes, now that page might become a distribution channel for your baked products.
5. Hotness of industry: Investors travel in packs. If something is hot, they may pay a premium.
Some of the valuation methods are
· The DCF (Discounted Cash Flow): DCF analysis is a method of valuing a project, company, or asset using the concepts of the time value of money.
· The First Chicago method: The First Chicago Method or Venture Capital Method is a context specific business valuation approach used by venture capital and private equity investors that combines elements of both a multiples-based valuation and a discounted cash flow (DCF) valuation approach
· Market & Transaction Comparables: Comparable transactions consider the past sales of similar companies as well as the market value of publicly traded firms that have an equivalent business model to the company being valued.
· Asset-Based Valuations such as the Book Value or the Liquidation value
It is also useful to have several valuation methodologies in your tool box to provide a rational basis for determining reasonable pricing. There are no scientific methodologies for establishing a valuation for early stage ventures.
Better practice dictates that we use multiple methods for estimating the valuation for investment purposes, then based on those results chose a final pre-money valuation (by averaging multiple methods, perhaps after eliminating outliers).
Ten Top Techniques for Startup Valuation