How to value a startup – Complete beginner’s guide
To grow fast, you need quick cash to fuel your growth (You cannot bank on the operating cash flows for an exponential growth)
In the endeavour to become a market leader, you opt for funding leaving the bootstrap path (Your equity dilutes with each funding round). Once you decide to raise funds for your startup ,the first and the most important question that you confront is “On what valuation you should raise funds.”
What is the value of your startup? Is it necessary to know the value of your startup?
If yes, then how value your startup which is a couple of months old and earns no revenue? What is decided first- the valuation, or the equity, or how much money you will raise?
What is Valuation
Valuation = Estimating Value
As mentioned, valuation of your startup becomes an important fish to fry when you decide to raise funding vis-a-vis bootstrapping.
No matter at what stage your startup is, it has got some value.
With the term value here, we refer to the price that market is willing to pay for your company (if you want to sell it).
Valuation is not solely based on the present performance of the company rather it’s the potential value of your startup in the future.
Companies like Apple, Google, Tesla are valued by a combination of their present performance and their capability to innovate and consistently deliver mind-blowing products in future.
Valuation- A Mix of Art and Science
When we say that valuing a startup is more of an art than science, what we meant is that the most scientific methods of valuation Discounted Cash Flows (DCF), Net Asset Value (NAV), Comparable Method, etc. seem to fall apart when it comes to startup.
- Most of the startups are pre-revenue and focuses on growth more than positive cash flows
- Some are creating their own niche and thus, no comparable exists
- Some are just an idea which has yet to be fully accepted by the end users
The above list is endless as every company is different, every co-founder is different and every market is different.
Investors take decisions based on their gut and intrinsic experience of investing in different startups across industries and geographies.
When I mention that valuing a startup is an art more than science, I didn’t mean it to be a wild guess or pure hunch; rather, it’s a mix of a calculative decision and a natural intuition that investor have been able to develop over a period of time after experiencing investing in many such startups.
Based on these intelligent hunches and a mix of scientific tools some startups being valued as high as $62.5 billion?
Below is the snapshot of valuations of some of the successful startups in the world.
This chart shows the world’s most valuable startups as of October 2015
How to value your startup
The most common method is through the expectations of the founders on the amount to be raised and equity they are ready to dilute.
Let’s again take an example.
If founders are clear in their mind that they need to raise $1 million to support the venture for next 12-18 months and in turn are willing to part with 25% of their ownership (equity). This effectively means that for $1 million investment in the startup, investors will get 25% of the post-investment valuation.
Suppose post-investment valuation is x million dollars then in this case pre- investment valuation will be (x-1) million dollars.
1= 25%* x
=> x = 4 million dollars
Hence, the pre-investment valuation of your startup is 3 million dollars, and post- investment valuation is 4 million dollars.
This is simple, right? But hold on. It is not always that simple as you have to defend the valuation of 4 million dollars to your investors.
Is higher valuation always good?
It’s difficult but somehow due to the VCs investment frenzy and FOMO (Fear Of Missing Out) if at all you do get an unreasonably high valuation, then this high valuation might be the beginning of a new end.
Such examples of unreasonable high valuations are not impossible to hunt. Take an example of Flipkart 15 $ billion valuation in its last round and the difficulty it is facing to raise next round at that kind of high valuation.
If you are biting more than you can chew, it might have two dire implications.
- You will be pushed hard by the investors to reach that unrealistic valuation in the future course of time, leading you to take a more risky decision which in turn can jeopardize your entire venture.
- If you have overvalued your company, then you might face problems in raising next round of funding. In the next round, you and your existing investors will have an expectation of higher valuation, whereas the new investors might think it’s not viable to invest at that valuation. So you may end up raising a “down round.”
Timing is always critical. You should know when to get investment. Do not raise funding just for the sake of it or just because other companies are doing it. You should first decide at what point in time you are going to raise funding and what you are going to do with that. End use of funds should be clear in your mind before raising the funds.
Instead of the valuation (which is the output) they will negotiate over the % of the equity, which will automatically change the valuation of your company.
Since negotiations over the amount of investment doesn’t make sense as you have already told the investors that this is the minimum amount you need to get to the next level. And they, as investors, want to help you achieve your goal, and it’s their job to make sure that money is not a constraint.
So, at this stage, it’s not the amount needed which you negotiate with the investors but the % of equity you are going to dilute.
You can defend your valuation by projecting your future cash flows and discounting them with a factor.
First, we will discuss the factors on which valuation of your startup depends. The word “depends” is very tricky as this can lead to two persons coming up with pole apart valuation of the same startup.
Although you would be able to guess the valuation of your startup by the end of this article, but remember valuation is a serious domain to the extent that so many smart people are earning their bread and butter only by projecting valuations.
In this article we will discuss the art of Valuation.
Below mentioned are some of the important factors on which the valuation of your startup depends.
1. Founding team–
The founding team is the most important factor among others that every investor look for in a startup before investing. Just imagine if Mark Zuckerberg (Facebook co-founder), or Jan Koum (WhatsApp co-founder) comes up with another startup idea then what will be the willingness of investors to invest in such company irrespective of the product.
Successful entrepreneur means a VC-backed entrepreneur who succeeds in a venture (starts a company that goes public).
You become one of the coveted founders if you have successfully run and sold a startup before. Successfully exiting from your startup is considered the next best thing that can happen to your startup after IPO, which is very rare.
If your founding team has a geeky tech co-founder and a core sales guy, then it’s comparably easier to attract investors than a team which has no tech co-founder and relies solely on freelancers and outsourcing.
If you have an experienced team with a good track record, then you may need a lesser amount to reach the same point in same time than the naive founders. Hence, it automatically increases the valuation of your startup as investors would be willing to invest for a lesser percentage of equity.
Irrespective of that Instagram, Facebook, Pinterest, and there are many other examples where the entrepreneurs were the first timers and still got easy access to the deep pockets of their investors. Investors of Instagram and Pinterest mentioned in an interview that they followed their intuition. As mentioned above these are much intellectual intuitions than a pure guess.
I think now you got my point.
2. Stage of startup (Idea, beta phase, fully developed product)-
If your company has already developed a product, then you are in a better position and can save 10-25% of equity dilution in exchange for the investment, as compared to the startup which is still in its ideation stage.
Someone backing only an idea is attracting higher risk of implementation, hypothesis testing, time overruns. Hence, as a practice investors will ask for more equity stake for the same amount invested.
As you move up the stage of startup, your valuation tends to increase. Below is the illustration of the kind of amount that you can raise for the similar equity dilution at various stages.
- Baby stage: when your startup is just a piece of paper or beta site (bootstrap financed—raise $50K to $500K).
- Kids Stage: when you have the beta site or full production site with initial users (seed stage angels—raise $500K to $1MM).
- Teen: is the stage when you have achieved a full proof of concept around the business, with rapid user or revenue growth, approaching up to $1MM in revenues (Series A venture capital—raise $1MM to $5MM).
- Full Grown Adult:is when you have grown to multi-millions of revenues and are ready to materially scale their businesses with a significant capital raise (Series B venture capital—raise $5MM to $50MM).
Burbn (Instagram) was valued $2.6 million at the prototype stage when it raised an enormous amount of $500,000 seed round from Baseline Venture and Andreessen Horowitz.
The next factor that matters is the industry you operate in. How attractive that industry is? For example “ social media”, which has many forms, including blogs, forums, business networks, photo-sharing platforms, social gaming, microblogs, chat apps, and last but not least “social networks” is the hot industry.
Your product could be a hot selling product provided you qualify the next factor. You may get valued 10x of your revenue.
On the other hand, if you are a new restaurant in the prime location of the city you may get valued at 3-4x EBITDA.
How big is your market?
Numbers in millions
For Facebook, the whole world population is the market, except for people who are too young or too old. Facebook was the first social network to surpass 1 billion registered users, and currently it sits on the 1.59 billion active users as in April 2016.
Are you catering a small city or country or the entire globe? It basically depends on your product and services, which you offer.
If your startup has the capability to scale and reach THE diversity of masses ranging up to 100 millions of users, you can command a premium in the market compared to a niche product targeting a segment of few millions of users. That is the reasons why Facebook acquired WhatsApp for 22 billion dollars just after 5 years of its inception.
Another significant aspect is your competition.
If you want to start another e-commerce company to challenge biggies like Amazon or Flipkart, then investors can laud you for your bravery but might not show any inclination as your competitor is gigantic and the market has also saturated. On the other hand, if you have a patented algorithm which can do web search faster than Google then find yourself dining with the biggest investor in your town the next day.
Check out how your competitors are raising money. Although, except for the industry, and market size rest of the factors would be specific to your startup but a little research about your competitors can give an idea about their valuation.
Most of the times startups do not reveal the valuation figure, but the amount raised is often mentioned in the news. One good source to get an idea about how much your competitors have raised in seed funding is Crunch Base.
5. Traction and expected revenues–
Traction is the proof of your product/service demand. Traction could be anything like revenues, users, customers. Since most of the startups do not have income in the start, users are considered to be a good proxy for profits.
Compare your traction with your competitors. Compete.com is an excellent site to track your competitor’s unique visitors.
However, there are multiple ways of showing traction:
1- Revenues/ Profit
2- Customers/ Users
4- Paying Customers
6- Advisory Board
6. Option Pool-
Option pool is the chunk of equity reserved for future hires. It generally ranges between 10-15%.
Option pool can lower the overall valuation of your startup. Let us find out how.
You might get a term sheet that says that a 15% “fully diluted post money” option pool needs to be in the pre-money valuation.
So, in the case of $ 4 MM post money valuation, that means there needs to be $600k (15% of 4MM) worth of options in the pre-money valuation. If the pre-money valuation is $ 3MM, then that means the true pre-money valuation to the entrepreneur is $2.4MM.
So, the investment of $1million is not 25% dilutive but 40%.
|Founder 1||37.5%||$1.5 MM|
|Founder 2||37.5%||$1.5 MM|
|Valuation for the founders = $3MM (pre-money)|
|Founder 1||30%||$1.2 MM|
|Founder 2||30%||$1.2 MM|
|Option pool||15%||$0.6 MM|
|Valuation for the founders = $2.4 MM (pre-money)|