Valuing your startup can be difficult and not an exact science. If you ask ten different funders to value the company, each one will, in all probability, come up with a different value. Following is a synopsis of factors to consider when calculating the Startup Valuation of your business, especially before any revenue is realised.
Startup Valuation 101
Business valuation matters to entrepreneurs because it determines the share of the company they have to give away to an investor in exchange for money. At the early stage, the company’s value is close to zero, but the company valuation has to be much higher.
Let’s say you are looking for a seed investment of around R1,000,000 in exchange for about 10% of your company. Typical deal. Your pre-money business valuation will be R10 million (R1,000,000 X 10). This, however, does not mean that your company is worth R10 million now. You probably could not sell it for that amount. Business valuation at the early stages is a lot about the growth potential of your business as opposed to the present value.
How Do You Calculate Your Startup Valuation at the Early Stages?
Figure out how much money you need to grow to a point where you will show significant growth and raise the next investment round. Let’s say that number is R10,000,000, to last you 18 months. Your investor does not have a lot of incentive to negotiate you down from this number.
Because you showed that this is the minimum amount you need to grow to the next stage. If you don’t get the money, you won’t grow – that is not in the investor’s interest. So let’s say the amount of the investment is set.
Now we need to figure out how much of the company to give to the investor. It could not be more than 50% because that will leave you, the founder, with little incentive to work hard. Also, it could not be 40% because that will leave very little equity for investors in your next round. 30% would be reasonable if you get a large chunk of seed money.
Where in that range will it be?
- That will depend on how other investors value similar companies and,
- How well you can convince the investor that you really will grow fast.
How to Determine Startup Valuation?
Early-stage startup valuation is commonly described as “an art rather than a science,” which is not helpful. Let’s make it more like a science. Let’s see what factors influence valuation.
Startup Valuation Factor #1 ― Traction.
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/customers, and if the investor sees users – the proof is in the pudding. So, how many users/customers? If all other things are not going in your favour, but you have 100,000 users, you have a good shot at raising R10 million (assuming you got them within about 6-8 months). The faster you get them, the more they are worth.
Startup Valuation Factor #2 ― Reputation.
There is the kind of reputation that someone like Warren Buffet has that would warrant a high company valuation no matter what his next idea is. In general, entrepreneurs with prior experience and exits also tend to get higher valuations. But some people received funding without traction and without significant prior success.
Two examples come to mind…
Kevin Systrom, the founder of Instagram, raised his first US$500,000 in a seed round based on a prototype, at the time called Burbn. Kevin worked at Google for two years, but he had no major entrepreneurial success.
Same story with Pinterest founder Ben Silbermann. In their cases, their respective VCs said they followed their intuition. As unhelpful a methodology is, if you can learn how to project the image of the person who gets it done, lack of traction and reputation will not prevent you from raising money at a high business valuation.
Startup Valuation Factor #3 ― Revenues.
Revenues are more important for business-to-business startups than consumer startups. Revenues make the company easier to value. For consumer startups, revenue might lower the business valuation, even temporarily. There is a good reason for it. If you are charging users, you are going to grow slower. Slow growth means less money over a longer period of time. Lower company valuation.
This might seem counter-intuitive because the existence of revenue means the startup is closer to 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, we are looking at a traditional money-making business. The last two will not give you an automatically high startup valuation, but they will help.
Startup Valuation Factor #4 ― Distribution Channel.
Even though your product might be in the very early stages, you might already have a distribution channel for it. For example, you might have sold air conditioners door-to-door in a neighbourhood where almost every resident works at a VC firm. Now you have a distribution channel targeting VCs. Or you might have run a Facebook page for women’s fashion with 14 million likes; now, that page might become a distribution channel for your new women’s shoes.
Startup Valuation Factor #5 ― ‘Hotness’of the Industry.
Investors travel in packs. If something is hot, they may pay a premium. It is important to understand what the investor thinks as you lay down on the table everything you have got. The first point they will think about is the exit; how much can this company sell for several years from now? Next, they will think about how much total money it will take to grow the company to the point that someone will buy it for a certain amount. Read more on industry market analysis in our article entitled Our Comprehensive 2023 Guide to Market Analysis for Business Plans.
Want to Prepare to Pitch to Investors? Here are some Questions to Determine your Startup Valuation.
As a rule of thumb, consider the following questions to determine the business valuation of your startup/early startup company:
Startup Valuation Question 1 ― My product or service is…
- An idea that I’ve been toying with for a while
- Currently under development, backed by solid market research and a business plan
- A working prototype being tested by potential customers
- Now generating revenues
Why is this important?
The more developed your concept is, the less risk there is of failure. The ultimate investment is a company generating revenues because it proves that you have a working product and that you have figured out how to get people to pay you for what you do.
Startup Valuation Question 2 ― My industry is…
- Something that has to do with selling to the general public (retail, food, entertainment, etc.) or to the government
- A field that nobody yet recognises as being an industry because my product is so cutting edge
- One in fashion among investors a few years ago (telecommunications, Internet, B2B, etc.)
- One currently in fashion among investors (medical devices, nanotechnology, Fingerprint Technology, Renewable Energy, security software, money-saving enterprise software, etc.)
Why is this important?
There is greater competition among investors to get into start-ups in ‘hot’ markets like Renewable Energy or e-commerce, and this competition can drive up company valuations. On the other hand, certain types of businesses, such as retail and food service, tend to generate much less interest. That doesn’t mean you won’t find an investor – your business valuation will be lower, and you will have to work much harder to find investors. Read more on market research.
Startup Valuation Question 3 ― My product or service will…
- Have some novelty value (i.e., there is only minor demand for the product in the marketplace)
- Make life a bit easier or more enjoyable for many people, but not solve any fundamental problems (i.e., a “nice to have” but not a “must have” for most buyers)
- Help a lot of people or companies do what they do a bit better, faster, and cheaper (i.e., the product addresses a fairly substantial need in the marketplace)
- Save lots of lives and/or money (i.e., the product is urgently needed in the marketplace)
Why is this important?
If your product or service addresses an urgent, widespread source of pain, you have a large and receptive market. That makes it more attractive to investors.
Startup Valuation Question 4 ― Global annual revenues in the sub-sector of the market I am competing in is…
- Under R100 million
- R100 million to R1 billion
- R1-3 billion
- More than R3 billion
Why is this important?
Investors make their money once your company has a ‘liquidity event’ or ‘exit’. This is typically an initial public offering (IPO) or acquisition by another company. All things being equal, the likelihood of a successful exit, whether by IPO or acquisition, increases with the market size. Furthermore, a large addressable market indicates strong demand and room in the market for more than a few major players.
Startup Valuation Question 5 ― My market is…
- Flat or shrinking
- Growing by under 10% per year
- Growing by 10-30% per year
- Growing by more than 30% per year
Why is this important?
A rapidly growing market suggests increasing demand and opportunities for your company to grow along with the market. In South Africa, e-commerce is growing by more than 20% per year. The growth rate of future cash flows is one of the most important factors in valuing an investment.
The valuation of startups is not an exact science. But you can prepare yourself before you enter the Shark Tank or Dragon’s Den 😨🤔😟💡