Any entrepreneur who’s had to raise funds to get their business up and running will tell you that getting the brilliant business idea is the easy part. If you don’t have the capital, you’ll have to think about selling a share of your business to get the funds you need. Selling your blood, sweat, and tears is not an easy feat. It’s even worse if you have no clue how to value your business.
With the wrong valuation, you may end up losing an incredible investor or losing a large chunk of your business for a not so significant 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.
Determining Pre-Money Valuation
Settling on a valuation for a business is probably one of the most challenging tasks for entrepreneurs. However, if you need funding to get your business off the ground, this step is inevitable. The first thing you need to do is to know how much your business is worth before the investment. This is known as pre-money valuation (PMV).
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.
Different startups use different approaches when determining their PMV. One common approach is using financial projections and using the discounted cash-flow method. This approach isn’t the best for startups because there’s a lot of guesswork involved, and the projections are inaccurate.
Some startups have no clue how to determine their PMV and go with the “give me an offer” approach. This is the worst approach because the investor can take advantage and give you money for a very large
The Best Way to Go About It
A simpler approach would be to deduct the total investment from your post-money valuation (the total value of your business after investment) i.e.
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.
However, if your business has not yet generated funds, the investors will calculate your PMV based on various factors. For starters, they may determine your valuation by comparing it with similar businesses’ revenue and market value.
Your track record in entrepreneurship and experience may also be considered when determining PMV. Founders and leaders with vast experience are more promising and more likely to get better terms of investments compared to individuals with little to no experience.
Justifying Startup Valuation to Investors
So, you’ve crunched the numbers, done your research and determined your PMV. You’re now ready to approach venture capitalists (VCs) and investors to get your much needed funds. Perfect! But do you know how to justify your valuation?
If one of the investors asks you how you arrived at the numbers your presenting, will you have an answer? Will you cower in fear and let them decide what they think your business is worth? You can’t afford to take the risk. Learn how to justify your startup valuation and stand your ground using these tips.
Decide How Much Money You Need
They say opportunities meet preparation. The adage holds water in landing investments. You can’t come up with a number out of nowhere and hope the investor will just give it to you. You need to understand why you need the money 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 in 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.
Figure Out What Percentage of Your Business You’re Willing to Sell
You’ve probably watched Shark Tank a million times and seen investors asking for up to 50% stake in the business. While this makes for good TV, it rarely happens like that in the real world. In real situations investors offer to invest for 10 to 20% stake in the business.
The reason for this valuation is the fact that they consider startups as high-risk, high potential ventures. They know they may not end up earning for a while but want a significant stake in the business so that they can have influence in decision making and other aspects of the business.
Therefore, if your potential investor is asking for up to 40% stake, think twice. In such a scenario, you’re probably asking for too much too soon or you’re not undervaluing your business. And if it’s impossible to get the money you need without giving up a large percentage, consider raising funds in small bits where you only give a small fraction of your business.
While you’ll take longer to get all the funds, you’ll not lose too much ownership of your business.
Source: Seed Legals
Rely on and Believe in 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.
If you believe you’re onto something and your product could really transform people’s lives, the investor will likely be willing to listen and disregard your pre-revenue status. However, you must leave no stone unturned in convincing them to invest.
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.