In Part I of the article I had discussed how valuing a new business does not have a defined framework and there are endless list of factors that might affect a new company valuation. In this part we will see the essential determinants of valuation and furthermore how investors value a company.
What are the key factors that influence valuation?
Early-stage valuation is commonly described as “an art rather than a science,” which is, for the lack of a better word completely useless and a directionless statement. Let’s look in to the mechanics of what factors influence valuation.
Traction – In an ideal world, your business will be generating revenues and the trajectory of your growth will be something reminiscent of a space shuttle on takeoff. Out of all things that you could possibly show an investor, traction is the number one thing that will convince them. The point of a company’s existence is to get users (or consumers), and if the investor sees users – the proof is in the pudding. So, how many users is considered a good number? If all other things are not going in your favor, but you have 100,000 users, you have a good shot at raising $1M (that is assuming you got them within about 6-8 months). The faster you get them, the more you are worth.
Reputation – Entrepreneurs with prior successful exits in general tend to get higher valuations. But some people have received funding without traction and without significant prior success. One example that comes to mind is that of Kevin Systrom, founder of Instagram, who raised his first $500,000 in a seed round based on a prototype, at the time called Brnb. Kevin worked at Google for two years, but other than that he had no major entrepreneurial success. His VCs said they followed his intuition. As ambiguous a methodology as it may sound, my advice would be that if you can learn how to project the image of the person who gets things done, lack of traction and reputation will not prevent you from raising money at a high valuation.
Markets & Comparables – With nothing to go on but an idea, a team and possibly a product, the value of a business is based largely on what the market says its worth. If you are operating in a hot sector which is experiencing unparalleled growth and has seen numerous sizeable exits, that puts you at an advantage (as long as the market isn’t saturated) yet while an idea that could potentially change the world in a sector that has never been touched before can put you at disadvantage. Investors need something to base their potential return on so if you’re delving into segments of an industry that haven’t been explored then you need more firepower to convince the investor community.
One of the most popular methods to determine an entry and exit value for startups with limited financial history is the market and transaction comparable method. Comparables’ tell an investor how other companies in the market are being valued on some basis which in turn can be applied to your company as a proxy for your value today.
Related Article: How Startup Valuation Works – Measuring a Company’s Potential
Revenues: Revenues are more important for the B2B startups than consumer startups. Revenues make the company easier to value. For consumer startups having revenue might lower the valuation, even if temporarily. The reason being, if you are charging users, you are going to grow slower. Slow growth means less money over a longer period of time, hence lower valuation. This might seem counter-intuitive because the existence of revenue means the startup is closer to actually making money. But a startup is not only about making money, it is about growing fast while making money. If the growth is not fast, then we are looking at a traditional money-making business.
Does a startup necessarily need a higher valuation?
Well it is not necessarily true. When you get a high valuation for your seed round, for the next round you will need an even higher valuation. That means you need to grow a lot between the two rounds.
A rule a thumb would be that within 18 months you need to show that you grew ten times. If you don’t you either raise a “down round,” if someone wants to put more cash into a slow-growing business, usually at very unfavorable terms, or you run out of cash. It then comes down to two strategies.
One, go big or go home: Raise as much as possible at the highest valuation possible, spend all the money fast to grow as fast as possible. If it works you get a much higher valuation in the next round, so high in fact that your seed round can pay for itself. If a slower-growing startup will experience 55% dilution, the faster growing startup will only be diluted 30%. So you saved yourself the 25% that you spent in the seed round. Basically, you got free money and free investor advice.
Two, raise as you go: Raise only that which you absolutely need. Spend as little as possible. Aim for a steady growth rate. There is nothing wrong with steadily growing your startup, and thus your valuation raising steadily. It might not get you in the news, but you will raise your next round for sure.
How do investors carry-out valuation of a startup?
It is important to understand what the investor is thinking as you lay down on the table everything you have got.
The first point they will think is the exit – how much can this company sell for, several years from now. I say sell because IPOs are very rare and it is nearly impossible to predict which companies will. Let’s be very optimistic and say that the investor thinks that, like Instagram, your company will sell for $1 Billion. Next they will think how much total money it will take you to grow the company to the point that someone will buy it for $1 Billion. In Instagram’s case they received a total of $56 Million in funding. This helps us figure out how much the investor will make in the end. $1 Billion – $56Million = $ 940 Million, that is how much value the company created. Let’s assume that if there were any debts, they were already deducted, and the operational costs are taken out as well. So everyone involved in Instagram collectively made $940 Million on the day Facebook bought them.
Next, the investor will figure out what percentage of that she owns. If she funded Instagram at the seed stage, let’s say 20%. The investor that funded you early on does not want to get diluted too much by the VCs who will come in later round and buy 33% of your company. Let’s assume in the end, the angel gets diluted to 4% (4% of $940 Million is $37.6 Million). Let’s say this was our best case scenario. $37.6 Million is the most this investor thinks she can make on your startup. If you raised $3 Million in exchange for 4% – that would give the investor a 10X returns. Investors, especially VC firms are not interested if you can demonstrate an average return on their investment, you must show them a path to earn ten times their investment back!
A word to the wise
The best thing you can do is to arm yourself with what values are in the market before you speak to an investor. You can get that information by speaking to other startups like yours on the money they raised when they were at your stage. Also, read-up on start-up news as sometimes they’ll print information which can help you back track into the values. Also, nothing increases your company’s value than showing an investor that people out there want your product and are even willing to pay for it. Finally, DONOT get in to the trap of overvaluing your startup on misconceived assumptions, since an investor will take this as a sign that you don’t understand your market. And DONOT fight over the valuation it won’t get you anywhere. After all the idea is to start your new relationship with investor community on the right foot.
About The Author – Divya Sampath
Entrepreneurship is the last refuge of a trouble making individual. I consider myself a neophyte at entrepreneurship, someone who has had her tryst with the financial world and now is learning the ropes of business & management all in this lifetime.