- There are a number of different approaches and methodologies to startup valuation. This will depend on your company and the industry it operates in. In valuing a startup, you need to understand the industry and your competitors.
- A valuation will change as the company, product, market and team changes – it is important to value frequently the company to reflect a true valuation.
- Heading into valuation negotiations, co-founders need to understand the difference between pre-money valuations and post-money valuations. The post-money valuation sets the bar as the current value of the company immediately after receiving funding.
Importance of Startup Valuations
Every startup at some point must be realistic in placing a value on the company, whether it is for a pitching competition, an investor, a merger or acquisition, or to have the number in mind when growing the business. Valuation is the process of defining what a startup is worth.
At the early stages of a startup’s growth, a valuation does not reflect the true value of the company. Rather, it shows how much of the company an investor (or investors) can obtain for their investment. If you exchange 10% equity in the company for $100,000, your start-up’s pre-money valuation will be $1 million. However, this does not mean your company could be sold for $1 million now. Rather, it is about the growth potential.
What Investors Look For
From an investor’s point of view, the first point they will consider is the startup’s exit (how much they can sell their shares in the company for). Next, investors will think how much total money it will take the co-founders to grow the company. Finally, investors will look at the percentage that they own of the company. Many venture capital firms will want to own a significant percentage of the company to make their investment in time and money worthwhile.
In terms of methodologies to value a business, investors will consider:
- revenue, cash flow or net income multiples from recent financings in your industry;
- revenue, cash flow or net income multiples from recent M&A transactions in your industry; and
- a discounted cash flow analysis of forecasted cash flows from your business.
- Founders with prior success in successfully building businesses will likely obtain a higher valuation.
- There are various approaches to valuation, including a market approach, income approach and asset-based approach. The valuation method will depend on your business and the industry sector in which it operates in.
- Key performance indicators (KPIs) can assist in justifying a valuation. KPIs can include user growth rate, customer success rate, referral rate and daily usage statistics.
How do startup valuations work?
In calculating valuation, investors will start by finding similar companies and calculate their valuation to revenue ratio, known as the multiple. This is determined by finding out how many times valuation is bigger than revenue. Investors will multiply your company’s revenue by that multiple. While this is a common method, there are a number of methodologies to value a company, and this will depend on the buyer/valuer and the industry.
Potential investors are interested in the traction of your startup. Traction is determined by the number of users your startup is obtaining, and the rate of growth. The faster you obtain users and members, the more your startup is worth. Forecasted earnings growth and traction is a key driver in any valuation.
Startups managed by co-founders with prior strong valuation exits tend to attract higher valuations. Investors will also look at the founding team. If founders are excellent engineers or salespeople, this will be looked on favourably.
Revenue growth is obviously a key factor investors will look at when deciding on whether to proceed with an investment.
Industry, Market and Competition
The more scarce supply for your business, the higher the demand as there are more interested investors competing for the deal and driving up the valuation in the business. The more potential users and lack of competition, the higher the valuation. Investors will pay a premium in an industry that is booming.
Frequently Asked Questions about Valuing Startups
Q: What is a down round?
A: A round of financing where investors purchase stock from a company at a lower valuation than the valuation placed upon the company by earlier investors.
Q: What is the EBITDA?
A: Earnings before interest, taxes, depreciation and amortization, or “EBITDA,” is one measure of a company’s operating efficiency.
Q: What is pre-money valuation?
A: Pre-money valuation is determined by the post-money valuation of a company at a financing round minus the amount raised at that round.
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