One of the most contentious issues in the startup space is putting a valuation on the startup at the time of fundraising and the problem is there really is no standard way of doing this. For established companies, we can use discounted cash flows (DCF) to estimate the value of the company by calculating the net present value of future cash flows. However, we can’t do this intelligently for a startup because most are pre-revenue, while others are just starting to gain traction. This is why no two people will ever agree on what the startup is worth.
The founder thinks of the future potential of his startup and his estimate of his worth is usually a lot more than what an investor is willing to give him. This is a sore area which often causes a lot of conflict and is one of those things over which they will spend hours negotiating.
Finally, it’s the founder who needs to decide how much stake of his company he’s willing to give up for how much money. There are standard rules of thumb and one of the commonest ones which people use is that of comparables. How much have other similar companies in the same space been valued at? Now, this is often flawed, because companies in the US are given far higher valuations than Indian companies – something which irritates Indian founders a lot, because they feel they are being treated as poor cousins.
The reason this is not a useful metric is because early-stage companies end up having very different trajectories and it’s hard to predict whether this particular startup will do well, or whether it’s a company which will go down to zero.
Related Article: Valuation For Startups – 9 Methods Explained
The reality is that equity in most startups is actually worth nothing, because 80% of them will crash and burn and most will not return money back to the investors.
Why Investors Value A Startup The Way They Do
Investors are very aware of this fact, because they have burned their fingers in the past. However, every founder feels that his company is the one which is going to be the exception, which is why he deserves a high evaluation. Models which use discounted cash flows will never work, because they are just Excel projections which are full of flaws and fantasies. Founders need to be realistic and a lot of it really is a question of whether you are in a strong position to negotiate.
This depends upon many factors, most of which are out of your control! These include: how much money do you require; how desperate are you; whether the area you’re in is hot or not; how much credibility you have; and how much investors are willing to give you. If you are able to setup a bidding war amongst investors, then your hand becomes much stronger. However, if there are other entrepreneurs in the same space who are desperate and are willing to settle for much less, this reduces your clout considerably. Obviously, a lot of these elements are determined by market forces, which are extremely dynamic.
For example, if there is a funding shortage because of a lack of liquidity, it can be extremely hard for even experienced entrepreneurs to raise money. On the other hand, when there is surplus liquidity, investors can be quite irrational about how much money they’re willing to give away.
At the end of the day, remember that the value of your startup depends on how much investors are willing to give you for it. There really is no standard metric anyone can use, and there is no right or wrong number.
However, a good investor will not try to beat you down on price, because he understands that it is not in his long term best interest to do so. He will not try to squeeze you, because while he might get away with it right now, he knows that this is something which you will resent in the long run, and that’s not good for the company.
Similarly, don’t get greedy and get lured by investors who offer you excessively rich valuations. This can come back to haunt you later when you try to raise your next round! It’s best to understand that the golden mean is the best path to follow, so you can create a win-win where everyone benefits.
One way of doing this is by asking for the funds to be released in tranches, based on milestones which you set which show that you are making progress. This allows you to course correct if things aren’t going to plan and adds discipline and rigor to governance, because you know you will need to report figures on a regular basis to your investors. You can also add a clawback clause, so that if you outperform, you get a sweetener in the form of a better valuation based on real life metrics!
[This post by Dr. Aniruddha Malpani first appeared on LinkedIn and has been reproduced with permission.]