How much is your startup worth? Well, the simple answer is “exactly what someone is willing to pay for it.” Like any economics exercise, this is really about supply and demand. In a recent article in Entrepreneur.com, it discusses just that. I also like what Seed Camp says, and I quote,
“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 recency and size of recent exits, the willingness for an investor to pay a premium to get into a deal, and the level of desperation of the entrepreneur looking for money.”
You can find valuation “calculators” on the web, but I think these are generally very suspicious. What you are trying to determine is the intrinsic value of your company. Even in the public markets, stock price does not always reflect the intrinsic value of a company. It is even more difficult in the private equity markets because the is limited or no liquidity, and typically significantly more risk for startups. However, more sophisticated Angel investors and VCs consider themselves experts in assessing risk/return for private companies, and they will ultimately determine the value of your company by using a business valuation formula. They might also be able to help you to determine your 409a valuation which could come in handy for your start up.
So what do private investors like Angel investors and venture capitalists look for when determining the valuation of a company for purposes of an investment?
Well, the first thing they will look at is a financial forecast from the company. This is the basis for any financial planning and analysis exercise. The financial forecast needs to be in the context of the market opportunity for the company’s product or service. As you approach VCs and Angels for financing, it is important to have a financial model. It should have a set of assumptions about the market, and the amount of money you want to raise. It is also a good idea to have reasonable upside and downside cases to your base plan. You may even want to consider a so-called reduced case, in the event that you raise less money in the current investment round. You will want to demonstrate that you have a plan, but also that you have some flexibility in that plan.
Some of the most common valuation metrics include:
Multiples of Earnings like the Price to Earning ratio or the price to EBITDA or price to Revenue ratios. However, most startups don’t have profits and many don’t have revenue.
Investors will look at comparable deals in your sector to get some benchmarking data. You should do this as well.
Some investors will use traditional Discounted Cash Flows from your financial model. There can be some challenges in this, especially when selecting a discount rate. Although many VCs will run a DCF, their valuation metrics will be more based on the uniqueness of your product, the value that it has to customers, and the potential market size and growth. There is a good white paper published by New York University about DCF, but if you are not a finance person, hire one to do your financial modeling. You should instead be focused on running the business and getting customers.
Venture capital and Angel investors most commonly look at Internal Rate of Return, or IRR. They also look at Return on Investment, or ROI, over a given timeframe. Generally, early stage VCs won’t get too excited about investing in a company unless there is the potential for at least a 10X ROI, and the ability to put enough cash to work to “move the needle” on their fund. You should understand this when looking at your financial model. From an IRR perspective, VCs like to see IRRs in excess of 30 percent. Your financial model must be based in some real work about the potential market size and growth and your expected market share. Stating your assumption in the financial model is extremely important. By dong so, it is much more straightforward for potential investors to run sensitive and scenario analysis. You should do this as well, so you know what outcomes the prospective investors are likely to get when they do their analysis.
Some of the softer factors that investors will look at include the value and uniqueness of the team, the value of your intellectual property or patent portfolio and how well you have protected your intellectual property. Investors will also look at the maturity of the product as measured by customer traction. If you do have customer traction, they will want to see you sales funnel during the due diligence process, and may even want to do some reference calls with some of your top customers and prospects.
Rarely are VCs interested in the value of your assets, your book value, or the liquidation value of your company.
As an entrepreneur, you should also understand the underlying dynamics of supply and demand as it relates to investors. It is critically important for you to garner interest from more than one of the right “smart money” investors, and hopefully have some “scarcity” relative to your deal. By scarcity, I mean that you have more people interested in your deal than you need money from. If you are in a HOT sector, you have a unique value proposition, and a strong competitive position, that will create interest and buzz. Investors will look at the team and you as an individual as well. Do you have credibility? Do you and your team have the capability to execute on your plan? Do you have a track record of achieving key milestones? If you have all of these things, then you may be able to command a healthy valuation. However, the key is to get the “right investors” involved in your deal at a fair valuation.
Ultimately valuation is also determined by the amount of money investors are willing to put into the company. Most commonly in any given investment round, the new investors will own somewhere between 15 to 25% of the company.
Another key considerations when you are raising outside capital is to put the right equity incentives into place for the team. You should also consider the other deal terms, and not just valuation. Make sure that you understand what is typical in deals getting done, and what is special. A financing is as much about deal terms as it is about valuation. I think that covers the basis of startup valuation. I wish you all the best in raising the next financing round for your startup.
If you’d like to get a complementary assessment of your business plan or investor presentation, or you’d like to register for one of our virtual coaching workshops, please contact us at , or to QuestFusion Virtual Coaching to learn more about virtual coaching and to register for a workshop. At QuestFusion, we love working with entrepreneurs, and we will work hard to help your company become the next great startup success story.
This is Patrick Henry, CEO of QuestFusion, with The Real Deal…What Matters.