• There are several 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 vital to frequently value your 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 your company’s current value immediately after receiving funding.
  • Pre-money valuations can be more of an art than a science. They incorporate assigning value to non-monetary considerations such as the founding team, market traction, industry potential, and innovation in the business idea.

Importance of a Startup Valuation

Every startup 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, you must be realistic. Valuation is the process of defining what your startup is worth.

At the early stages of your startup’s growth, a valuation does not reflect your company’s true value. Instead, 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 growth potential.

How Does a Startup Valuation Work?

In calculating valuation, investors will start by finding similar companies and calculate their valuation to revenue ratio, known as the multiple. They will determine this figure by finding out how many times the valuation is bigger than revenue. Investors will multiply your company’s revenue by that multiple. While this is a standard method, there are many methodologies to value a company, depending on the buyer or valuer and the industry.

Traction

Potential investors are interested in the traction of your startup. Gaining traction in the market will often suffice as proof of concept in these early stages and negate any deduction in its valuation associated with a perceived product risk. You can determine traction by the number of users your startup is obtaining and its growth rate. The faster you obtain users and members, the more your startup is worth. Forecasted earnings growth and traction is a critical driver in any valuation.

Reputation

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, investors will look on this more favourably. Similarly, startups with a diverse mix of expert collaborators or co-founders will typically be viewed more favourably by investors at this early stage.

Revenue

Revenue growth is a key factor that investors will look at when deciding on whether to proceed with an investment. Suppose your business model or product has a high-profit margin with an attractive growth forecast. In that case, this will typically be more favourable to an investor at this pre-valuation stage.

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 business’s valuation. The more potential users, and lack of competition, the higher the valuation. Investors will pay a premium in an industry that is booming. 

For example, investors may see businesses and products in the emerging technology and energy industries as having unlimited potential. Hence, investors may be happy to pay a premium in this respect despite not yet having a proven financial record.

What Investors Look for During Valuation

From an investor’s point of view, the first point they will consider is the startup’s exit. This is how much they can sell their shares in the company. Next, investors will think about 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 share 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;
  • a discounted cash flow analysis of forecasted cash flows from your business; and
  • scorecard approaches which weigh up the perceived overall percentage of a number of factors including the team, opportunity potential, product and need for additional future investment.

Key Considerations

  • Founders with prior success in successfully building businesses will likely obtain a higher startup valuation.
  • There are various valuation approaches, 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.
  • There are many different valuation methods for startups, and this process can often be more of an art than a science. Common approaches to startup valuations usually consider perceived risks with any area of the business as well as value added by experienced founders, an attractive group of founders and a proven concept or product.

FAQs

What is a down round?

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.

What is the EBITDA?

Earnings before interest, taxes, depreciation and amortization, or “EBITDA,” is one measure of a company’s operating efficiency.

What is pre-money valuation?

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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