Valuing a startup is more of an art than a science. There are no hard and fast rules and there are a lot of variables, tangible and intangible that go into valuing a startup.
The thing to keep in mind is that an early stage startup valuation is a negotiation. The valuation that an investor will accept depends on how well you present the opportunity but also the other opportunities that they see. Remember that you are sellig a business to a buyer and the price depends on supply and demand. The more you can show limited supply of the type of business you are offering and stoke increasing demand – the higher the price or the valuation.
With the wrong valuation, you may end up losing an incredible investor or selling a large chunk of your business for an insignificant investment. Don’t take the risk. We’ve crafted a comprehensive guide on how to go about determining your pre-money valuation and how to justify it to your potential investors. Dive in and make the right choice.
First, understand the Pre-Money Valuation
In valuing your business, the first thing you need to understand is how much your business is worth before the investment. This is known as pre-money valuation (PMV).
Pre-money valuation = Value of the business after investment – money invested.
For example, if your post-money valuation is $10 million and the investor gave you $3 million, your pre-money valuation amounts to $7 million.
You will hear people talk about pre and post valuations. They do this mostly becuase it sounds cool and makes them feel important. Pre-money is what matters. And “post” money is just the pre-money plus investment.
(This is asbsurd because if you need invesment to grow your business then the value is actually zero without it and much more than pre-money plus the investment with it, but this is a tangent that I will explore elsewhere…).
So know your pre money valuation
It’s crucial for entrepreneurs to figure out their PMV before approaching investors for several reasons. For starters, the value of your business pre-investment allows you to decide how much you’re willing to sell for funding. What’s more, it’s an excellent indicator of a worthy investment for potential investors.
The academic way to determine your PMV is through a discounted cash flow model. Using the discounted cash flow you project the cash from your business up front and discount it back to today. This gives you the present value of future cash flows.
This would be great but it is completely useless for startups. Everybody knows that the cashflow model is built on myriad assumptions that really amount to guesses. You should make these guesses and forecast your cash, you must in fact, but don’t expect anybody to believe that your model represents reality.
Some startups have no clue how to determine their pre money valuation and go with the “give me an offer” approach. But this doesnt work for two reasons:
- it looks unprofessional. If you can’t take the time to even guess at future cash flows why would anone believe that you will do the work to deliver those cash flows.
- it weakens you negotiation position. Since valuation is a negotiation, if you capitulate completely from the beginning you put the success of your business in the hands of others. And this is likely to raise concerns (see point 1 above).
The other mistake many startups make is picking an unrealistically high pre-money valuation
We have had companies with no revenue and a vague idea of what they want to build come to us with $50 million valuations. This is so absurd that the conversation typically stops right there. It is okay to lead negotiations with a high number, but too high just shows you have not understanding of what you are doing.
The Angel investing rule of thumb – 30% of your business for the cash you need
The best valuation methodology I have come across for angel investors is this: angel investors will take 25% to 30% of your equity for the amount of cash you need to get to the next level of investment.
So, if you need $1,000,000 to get the business developed enough to raise a series A round of funding, then your business is worth about $4,000,000 in the eyes of angel investors. I have seen countless valuation methodologies and processes arrive very close to this eventual destination.
Therefore the trick in valuation is to show what you need to do to get to that next level of investment and give investors the confidence that you will get there.
Howo to justify a startup valuation to angel investors
Decide How Much Money You Need
Genius is one percent inspiration, ninety nine percent perspiration.
– Thomas Edison
As much as predicting the future is wrong and valuations are made of guesses, you can’t derive your valutiona from thin air and hope the investors agree. Do the work to determine why you need the money, what you will use it for and how much you need before pitching to any investor.
As a rule of thumb, you should plan to raise at least 12 to 18 months of funds before you need to raise more money. This is because, ideally, you’re going to need to be on the fundraising trail at least 6 months before you have money in your account.
To get new investors interested, you need to show signs of growth during that time. Therefore, before you set a number, figure out how much money will provide enough breathing space and keep your operations running smoothly. Strike a balance between going too high that it becomes impossible to meet expectations and aiming too low that you run out of money before you get anything done.
To calculate how much you need, consider your monthly expenditure, how many people you plan to hire, cost of development, advertising, and other costs. Next, multiply the amount with the number of months you need, making sure to account for the unknown, which are quite common in startups.
This is where the cash flow model comes in very handy. Everybody knows that these are guesses, but the logic behind the guesses is just as important as the guesses themselves. So know what you are asking for and why.
Figure Out What Percentage of Your Business You’re Willing to Sell
Angel investors are likley going to want 25% to 30% of your business. They have to account for dilution and future valuation. Since they are looking at a 5 year time frame and expect you to raise a couple of rounds of money between now and their payout, they need a substantial stake.
The reason for this valuation is the fact that they consider startups as high-risk, high potential ventures.
Investors often want more than just the equity stake. They will want some opportunity to influence your businesses and provide their expertise. This helps them minimize their risk, but it also helps you maximize your opportunity so ultimately you want this as well.
If you cannot find a solution with investors for the money you need see how you can break up the investment. We have seen startups think they need $2 million for an initial invesment. With some work they find that quarter of that suffices to prove their concept and improve their chances for the next round.
Rely on and believe in the potential of your product
If you’re in the pre-revenue stage, it may be challenging to justify a high number valuation. The investors will probably want to know how you arrived at the numbers without any prior sales. This is where you need to sell your product.
Many investors have hard and fast rules about not investing in pre-revenue companies. And then they invest in pre-revenue companies. If the product is inspiring enough they may break the rules and make the investment.
The key word is inspiration. Nobody cares about how your product works, how long you have spent developing it or the
Therefore, take the time to consider all aspects of your product that make it stand out. Test it out. Get feedback and tweak to make it even better. This way, the investor won’t have any other choice but to bet on your product.
Bet on Your Team’s Skills and Execution Capabilities
Another factor investors look for is ability to execute. You may not have any sales for the startup you’re pitching, but if you have experience and show promise, many investors are bound to take the leap. For starters, if you’re a serial investor who has attained exceptional success in all your business ventures, the investor will be more likely to take the risk.
Investors are also more likely to trust your valuation and invest if you’re backed by a strong team of professionals with success in various ventures as well. Therefore, don’t sell yourself short just because you’ve not made any sales. Rely on your non-monetary assets – skills, talent, and experience.
Go With Your Gut Feeling – Risky but Often Pays Off
If you’re in a “hot” sector, you should also use that to your advantage when justifying a valuation. Investors who are late to the game will be willing to pay more for a piece of the cake because they’re convinced it’s the next big thing.
However, they won’t just jump in because you’re selling something they want. They’ll still need to see your ability to execute, a viable business plan, and numbers that make sense. Therefore, in addition to trusting your gut, make sure you support that with numbers and reliable projections. You’re more likely to get them on board this way.
Mirror Your Competitor’s Approach
When in doubt, it’s also an excellent idea to borrow a leaf from your competitors’ book. As they say, success leaves clues. Head on to Crunchbase and search for your nearest competitors. Next, evaluate their fundraising history and tweak it to determine your valuation.
You can raise or lower it depending on whether you’re in pre or post-revenue, pre or post-launch. Afterward, factor in your projections and expectations in terms of market changes and other unforeseen circumstances to find out if the valuation is correct.
Understanding these factors allows you to have a strong argument when defending your valuation. After all, you don’t want to say you copied from someone else.
Gain Enough Traction
It doesn’t matter if you have the greatest team in the world and a phenomenal product if you can’t prove to the investor your business is “going places”. Every potential investor will want to know if people are interested in your business.
Are people taking about it? Are there preorders? What’s the feedback? Such information gives the investor an idea of how successful your business will be. After all, you can’t sell without customers. Therefore, another excellent way to justify your valuation is to ensure you have enough traction going in. If you don’t already have enough traction, there are several ways to go about it. These include:
Remember newspapers? Yes. Traditional advertising is an excellent way to get word about your business out. This method of advertising is especially important if you’re targeting a broad audience. The older generation is more likely to prefer this method of advertising and you’ll reach them faster.
Besides, it’s affordable and you get to choose which page your coverage goes on depending on your budget. However, seeing that most people are moving from this type of advertisement, it may be best to combine it with other modern methods of advertising.
The benefits of social media cannot be overestimated. There are numerous platforms to take advantage of and you can reach millions of people at the click of a button. For this reason, it’s an excellent way to build traction for your startup.
You have several options here. You can create a page for your business and market it to get followers and subscribers or rely on your already established network to get your word out there. Again, you can’t rely on social media alone. It’s best to combine it with other methods of advertising and lead them back to your social platforms to increase your following further.
Search Engine Optimization
Search Engine Optimization (SEO) is fast becoming one of the best digital marketing strategies. For this, you need a website where you’ll provide information about your product or service that’s targeted to a specific audience.
For SEO to work for you, you’ll need to use specific keywords that are not only search engine-friendly but also target your audience. This way, you’ll be in a better position to generate organic traffic and get more people aware of your business and its operations.
Another way to get more people familiar with your business is through business events. In these setups, you’ll meet numerous entrepreneurs in different fields, which is essential for building a strong network. It may also be an excellent way to meet potential investors.
Also, take advantage of these opportunities to find out how other entrepreneurs build traction for their businesses and try to use the same approaches to build your own before approaching investors.
It’s also an excellent idea to attend conferences where you may have a chance to speak about your startup. In most cases, these types of setups have numerous people attending and large followings even on their social platforms.
It may, therefore, be a great way to raise your business’ awareness. And who knows, you may also start getting preorders for your product or service before you begin – something a potential investor wants to hear when they’re considering investing in your business.
Factor in Barriers of Entry and Number of Competitors
Another factor that will affect your valuation and investors’ willingness to invest is the competitive market forces. Is the industry saturated with direct competitors? Are you at the forefront or lagging behind your competitors?
This is the kind of information the investors will need. Therefore, ensure you have a competitive edge. If you’re leading the competition, you gain the “first mover” also known as “good will” advantage from the investors. Good will justify a couple of millions in valuation.
Assign Value to Your Intellectual Property
Factoring in the value of your intellectual property will also go a long way in justifying your valuation. When you file a patent for software or technique, it puts you several steps ahead of the competition and investors are more willing to give you funds.
In fact, every patent justifies a $1 million increase in valuation each. Therefore, if you have patents in place, play them to your advantage. You may end up getting way more money than you expected and only losing a small fraction of your business – every entrepreneur’s dream.
Consider All Your Physical Assets
Most startups focus too much on their sales when calculating valuation that they forget the value of their physical assets. However, your physical assets are your most concrete valuation approach. As a new business, you may not have a lot in terms of physical assets, but there are there.
Take the time to consider everything you own before you get into actual sales. You’ll notice a significant difference in the valuation. Besides, you’ll have concrete information to justify why you’re valuating your business at a certain value even when the sales are not very impressive or nonexistent.
Use the Earnings Multiple Approach
You can also justify your valuation by using the earnings multiple approach. It’s quite simple. All you need to do is to multiply your total earnings without including any deductions such as tax and depreciation by some multiple.
You can derive the multiple from scoring key factors of your business or using industry standards. If you don’t have enough data, consider using the 5x multiple as a rule of thumb. Because this is an approach that works in investments, you can use it to back up you valuation claims.
As you can see, there are many ways to determine valuation than simply coming up with a number at the top of your head. It takes research, a lot of evaluation, and understanding market trends to approach your investors with a reasonable valuation.
And when you have that valuation, you need to ensure you can justify it to your investors. Remember, these are people with vast experience in entrepreneurship. They know how to identify holes in your pitch. Therefore, prepare adequately and ensure you can hold your own in front of any investor. If you do so, you should be well on your way to getting that investment.