The most common question I hear from founders is: “How do I calculate the valuation of my startup?” Ah, if it was only as easy as putting numbers in a spreadsheet like they teach in business school.
The number 1 reason you will or won’t get funded is your valuation — most challenges of your current situation: not enough traction, a skeletal team, too small a market, can be compensated with a lower valuation; conversely, too high a valuation can turn a great business into a bad investment. So what valuation is right?
Theoretical models like discounted cash flow, replacement cost, or liquidation value are fine for established businesses, but produce absurd results for early-stage startups. The only correct answer is that the right valuation is the one that attracts investors. Which only raises more questions than it answers.
From an investor’s point of view, the valuation is the Risk x Reward, but that’s the same as any other investment and doesn’t provide any guidance for setting your valuation. However, it’s important to keep risk-reward in mind since this is the underlying principle. As you gain traction, build out the team, granted patents, and generally make progress, the risk of failure decreases, so your valuation should increase over time. However, the macro-economic environment could shift under you, increasing the perceived risk or lowering the expected acquisition price, reducing your valuation even as the business continues to make progress. In that regard, it’s no different from investing in the stock market or buying real estate.
“Valuation is Risk x Reward. Not much help.”
Investors will see hundreds of pitches before selecting the one or two to invest in with the best risk-reward profile. So your valuation really comes down to how attractive investing in your startup is compared to all the other startups. I’ll return to a real estate analogy — an apartment is listed for rent at $4,000 per month. Do you take it? To determine if that’s a fair price, you could try to do an analysis of the cost to build the unit, plus interest, taxes and expenses, adjusted for the expected gain in value over some time period and turned into a monthly payment based on a discounted cash flow analysis. Good luck with that. Instead, you’ll go online, scroll through a hundred units in the neighborhood, filter for your budget and size range. Then you’ll pick a dozen to look at in more depth and visit your top five choices in person before choosing the one you think is the best for the price. Investors are doing exactly the same with your pitch.
This, of course, puts you at a disadvantage. We’re listening to hundreds of pitches and have a sense of where you fit in. Unlike real estate, there’s no Zillow or Hotpads you can refer to. But there is Pitchbook and Crunchbase, plus daily announcements of fundings, though unfortunately, for early stage companies, they rarely include the valuation. There are also crowd investing sites like SeedInvest and Start Engine where you can peruse other startup investments. But what you really need is the equivalent of a real estate agent — someone who knows the local market and can give you guidance on a suitable price. This is the role of your advisors. Use them. Accelerators and incubators, in particular, will have a good sense of exactly where you stand. Instead of pitching VCs, ask them for guidance on what they think would be an attractive valuation. Talk to your earlier stage investors. It’s no different than surveying customers on an appropriate price for your product, only what you’re selling is your company’s stock.
In the end, your valuation is the amount investors are willing to pay. In other words, it’s a negotiation. When you open your round, set your ask a little high, but make clear it’s a “target valuation” and open to negotiation. See what response you get. In our screening sessions, we’ll often go back to the founders afterwards and say, “At $8M nobody is interested, but at $6M there’s some interest and at $5M we can bring in a large group of investors.”
Once you have a lead investor with a signed term sheet, your valuation is set and is generally no longer negotiable. Other investors in the round only have the choice of accepting the same terms or passing. A lead investor that offers a high valuation may seem like a cause for celebration, but if the valuation is too high, it can make it difficult to find other investors to fill out the round.
Too high of a valuation can have another problem. You’ll likely need to raise more money later. For obvious reasons, investors like to see an increasing valuation in each round. If you overprice an earlier round, when you open the bigger round with sophisticated investors, if your traction has not progressed dramatically, you may have trouble justifying a substantially increased valuation. A small increase in valuation is a red flag for investors, and will anger earlier investors (who may also be some of the next round investors) who will get diluted more than they expected. For these reasons, my advice is to end up underpricing your valuation a little.
Another way to look at valuation is as the inverse of the raise. A raise is typically around 20% of the post-money valuation. Less than that and investors feel their involvement is too inconsequential, and more than that leaves too little upside for the team. If you need to raise $2M, you need a pre-valuation of $8M (post-money $10M). If the business isn’t worth $8M yet, you’ll have trouble finding interested investors even at a lower valuation.
Lastly, the valuation you set is a choice between how much time you want to spend trying to wring out the highest valuation versus getting the raise done quickly so you can get back to working on product development and customer sales. At a low enough valuation, investors may be begging you to be allowed into the deal, giving you the ability to choose your funding partners or increase the size of your raise.
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