Valuing your Start-Up Company is a difficult exercise and not an exact science whatsoever; in fact, if you ask 10 different funders to value the company, each one of them will in all probability come up with a different value. Following is a synopsis of factors to consider when Valuing your Start-Up Company before any Revenue is Realised.
Why Does Start-Up Valuation Matter?
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 value of the company is close to zero, but the valuation has to be a lot higher than that.
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 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. 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 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 round of investment. 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. Why? 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 anything 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 are getting a large chunk of seed money.
Where in that range will it be?
- That will depend on how other investors value similar companies.
- How well you can convince the investor that you really will grow fast.
How to Determine Valuation?
Early-stage 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.
- 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 (that is assuming you got them within about 6-8 months). The faster you get them, the more they are worth.
- Reputation: There is the kind of reputation that someone like Warren Buffet has that would warrant a high valuation no matter what his next idea is. Entrepreneurs with prior experience and exits in general 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, founder of Instagram, raised his first $500,000 in a seed round based on a prototype, at the time called Burbn. Kevin worked at Google for two years, but other than that 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 as it 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 valuation.
- Revenues are more important for the business-to-business start-ups than consumer start-ups. Revenues make the company easier to value. For consumer start-ups having a revenue might lower the valuation, even if 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 valuation. This might seem counter-intuitive because the existence of revenue means the start-up is closer to actually making money. But start-up 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. The last two will not give you an automatically high valuation, but they will help.
- Distribution Channel: Even though your product might be in 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 of women’s fashion with 14 million likes; now that page might become a distribution channel for your new women’s shoes.
- ‘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 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. 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 a certain amount. As a rule of thumb, consider the following questions in order to determine the valuation of your start-up/early start-up company:
This Blog Article focuses on the first 5 questions of 25 critical questions. Kindly do check in with JTB Consulting in the coming weeks for the follow up Blog Articles to learn more
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 that is 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.
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 recognizes as being an industry, because my product is so cutting edge
One that was in fashion among investors a few years ago (telecommunications, Internet, B2B, etc.)
One that is 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 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 – it just means you valuation will be lower, and you will have to work much harder to find investors.
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.
Global annual revenues in the sub-sector of the market I am competing in is:
Under R100 million
R100 million to R1 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, regardless of whether it is by IPO or acquisition, increase with the size of the market. Furthermore, a large addressable market indicates strong demand and room in the market for more than a few major players.
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 suggest increasing demand, and opportunities for your company to grow along with the market. In South Africa, e-Commerce is growing at more than 30% per year. The growth rate of future cash flows is one of the most important factors in valuing an investment.