Deciding on a startup’s valuation is a key element in making an investment deal. Premature companies have very little to go on as to definitive metrics to gauge their value. So it’s often a challenge for both founders and investors to come up with a sum and agree on it.
Why is it so important to get it right? Well, the startup’s value also determines the price of equity an investor receives in return for their capital infusion. If the valuation is too high, it might not make sense for them to contribute as their returns will not justify the investment.
Founders must find common ground with their investors and make the valuation seem reasonable for both sides. In order to do that, they need to understand the fundamentals of startup valuation.
Pre-money vs post-money valuation: what are they?
Whenever there’s a conversation about valuations, you are bound to hear terms like pre-money and post-money. Just as the names suggest, pre-money valuation is how much a company is worth before investment and post-money valuation is its value after a round of fundraising.
The pre-money valuation is the one usually negotiated with investors as it determines how much capital the investor needs to infuse to get their desired amount of equity. It’s no rocket science but let’s break this down with an example:
For instance, say a founder and investor agree the company is worth $1.5 million prior to funding and the founder is asking for a $500,000 investment.
This means the pre-money valuation is $1.5 million, whereas the post-money valuation is:
Post-money = pre-money + investment = $1.5 million + $0.5 million = $2 million.
Then, the equity percentage owned by the investor will be:
Equity = investment / post-money = $0.5 million / $2 million = 25%.
Most VC investors will be looking for 20% - 30% of equity to justify their investment. If the valuation gives them any less, they might want to bring it down or secure themselves with predatory investment deal terms. Founders need to anticipate this and provide a fair deal for all.
Startup funding stages: understanding where you are
Go Global World harbors a strong relationship hub for startup founders and investors. One of our pitch programs is dedicated to getting founders fully prepared for pitch sessions with international investors. Quite often we see founders who have a vague idea of where they are in terms of their startup’s evolution and what they need to get to a particular funding stage.
This is very important as a company’s maturity determines how much capital a founder can expect from a potential investor, the types of investors interested in contributing to the startup, and the valuation range as well. Let’s take a closer look at what one needs to accomplish to qualify for the various stages in startup evolution.
Idea or bootstrapping stage: from product development to early sales
Sometimes founders overestimate and think of themselves as pre-seed or even seed companies when they are still in the idea stage. Unfortunately, if you still have no product, customers, or significant sales to show for, then this is where you are.
The bootstrapping stage basically means the company is more or less of just an idea (on paper or sometimes even a napkin). You are in the idea stage if you are still working on:
Building the core of your team (essential roles)
Working on the first prototype or MVP
Shaping your product based on customer insights.
Latter-stage idea startups closing in on the seed stage may even get to generating revenues, but most of the time, the money made goes entirely into further product and brand development.
Traditionally it is thought that the idea stage means you have to depend mostly on yourself and only get funding from friends and family aka FFF funding. But the business climate is getting warmer year by year. So now we have funds that actually invest in your vision, and not in products or traction.
Funds like RallyCry and Ann Arbor Spark aim specifically at idea-stage startups. Capboard, an equity management provider, lists a directory of investors that fund an idea or patent-stage companies.
When a company can only be judged based on an idea or vision, founders can expect a check of up to a few hundred thousand dollars, and be valued from $1 million to $5 million max based on how well you pitch. Your reputation helps a lot in this case, and founders with more pedigree are bound to have a more valued company.
Pre-seed stage: from MVP to product-market fit
At the pre-seed stage, you are still conceptualizing and working on your product’s core features and aiming to find your product-market fit. So obviously your customer base is limited at this point.
The tell-tale requisites of a pre-seed startup are:
Viable idea, vision, and set goals
Qualified and experienced team
Minimum viable product that actually works and sells
Early signs of traction and revenue growth.
At pre-seed, you have a little more room and opportunity to land an investment. This is when you can finally head to Y-Combinator to present your startup and use the incubator setup to nurture and grow your company. It’s also prime time to start applying for Go Global World’s Demo Days pitch program and GGW Sharks events.
Pre-seed is still an early stage for a company and investors are often reluctant to take chances on an idea without a proven track record or a strong customer base. Founders Go Here have a good list of VC funds that frequently invest in pre-seed startups.
In the first quarter of 2023, the valuation range for pre-seed startups according to AngelList’s report was from $6 million to $12.5 million.
Seed stage: product-market fit, real traction, and growth
The seed stage means you’ve charted beyond the MVP phase and created a product that sells with the early metrics to prove it. You may be still putting some final touches to it, but for the most part, you have a product that is in demand by your customer base.
To qualify for a seed-stage investment you need to have:
Proven product-market fit with the target audience
Fully established team with experts in key areas
Clear signs of traction leading to increased sales
Increasing growth in customers and revenue
Positive customer acquisition vs lifetime value
Enough revenue to support your operations.
Venture capitalists are more willing to engage with seed startups. This is where you start to get attention from big names in the investor space like Andreessen Horowitz and Greylock.
What can you expect in terms of valuation? Well, for the first quarter of 2023, the startup scene had seed valuations ranging from $12 million to $25 million.
Series A and beyond: from revenue to profits and expansion
When aiming for a Series A level investment you are closer to an established brand with a product that’s in demand and has loyal customers bringing you a significant monthly revenue. Showing the potential to scale at least 10x your current value is a great sign for investors since that’s the size of return the major venture capital firms expect.
Series A is strictly for the major leagues: venture capital firms and super angels. You are now able to source financing from top investors around the world.
Greater opportunity also means higher expectations. Not only do you need to meet Series A requirements, this is where your company will be diligenced and examined from head to toe: be prepared to show great financial metrics, exceptional management, and high growth potential.
AngelList’s report showed valuations for Series A in the first quarter of 2023 range from $40 million to $90 million. Going beyond Series A, you are expected to demonstrate serious growth, expansion, and product development. That’s when a startup becomes an established brand and is valued as such based on achievements and financial metrics.
Key factors for valuing early-stage startup companies
Founders need something to back the valuation they are suggesting. Investors have to look for signs of maturity in a startup.
The formula to catch investors' attention: “Present competing value proposition and then show traction as your proof” by Bill Reichert, General Partner at Pegasus Tech Ventures.
Here are the building blocks that add value to a company and may be used to gauge valuations:
Traction and growth
Having traction means the startup is showing signs of progress, being in customer demand that results in sales, or just having a successful PR & marketing campaign. It proves a founder is taking certain steps to develop and scale their business.
Growth is seeing real results that lead to expansion and development. It can be anything from increasing demand to a wider customer base to higher revenue and profits to market growth.
Customer base
A company without customers is worth nothing. We don't have to reach too far for examples. The recent failure of a unicorn social app for event organizing showed just that, when it had to shut down after revealing that 95% of its users were bots.
An expanding and diverse customer base is a very good sign for an early-stage startup. It may be also important to show a positive ratio of Lifetime Value (LTV) / Customer Acquisition Cost (CAC). Other customer success metrics like churn rate also play into the startup’s valuation.
Founders' skills and experience
As we’ve already mentioned, founders with more pedigree such as Ivy League graduates and founders with a track record of launching prodigious projects always have the upper hand.
What's more, a founder is helpless without a strong team of experts backing him, so team diversity is also an important factor. Having a stellar R&D team will get you nowhere without proper sales & marketing.
A founder with a strong belief in their vision and commitment can often top an Ivy League prospect. And some investors overlook previous track records favoring the stronger pitcher. So dedication, perseverance, and determination are all pieces of the puzzle.
Proof of Concept and MVP
A working model of the product displaces the startup from the initial ideation stage and raises the valuation in multiples. It’s a game-changing development and one of the major factors in valuing early-stage companies. If founders are still working on their MVP, it’s important to share the stage of development and how far they are from the launch date.
Market attractiveness
Launching into an overcrowded market is a risky endeavor and often tanks valuations from investors. Especially if the startup is a copycat in its essence. A rare patented idea, on the other hand, gives the founder more groundwork for a healthy valuation.
But that is just the tip of the iceberg. Prudent investors often glance deeper and try to evaluate the driving factors of the market such as consumer behavior, economic trends, technological developments, and regulations. All these factors play into market attractiveness.
Profit margins and projections
Obviously, low-profit margins will be less appealing to investors. Overall, we encourage founders to be more optimistic and reassure their investors by providing promising projections for future revenue and growth. That goes without saying, founders must strive to achieve the goals they set and avoid pitching a pipe dream.
It’s important to know that early-stage investors are often willing to overlook non-existing profits if founders deliver high revenue margins. High margins are always a great sign since it means a company has the resources to fuel its R&D processes, as well as marketing efforts which increase the potential for growth and scalability.
If you are a founder: How to maximize your valuation
The first piece of advice for founders: always push back a given valuation. It shows confidence and that you are a strong negotiator, which only earns you more respect. In valuing a startup, investors define a valuation range, and usually, their initial offer is the bottom margin.
Guy Kawasaki in his “The Art of the Start” suggests asking for a 25% higher valuation than the first offer. This tactic helps you get an average valuation that is reasonable for both sides.
What else can founders do to maximize valuations? Here are some basic guidelines:
Work on your pitch. Accentuate potential, traction, and growth. Prove that you have what it takes to become a unicorn and deliver a huge exit.
Find out what makes the investor offer a poor valuation. Identify your gaps and show what you are willing to do to close the risks. Let them know you are determined.
Demonstrate a plan to top your competitors. Explain why you’re worth more than the companies you are compared with and valuated against.
Be confident and imply that you expect better offers from other investors.
Common methods for startup valuation
Traditional corporate finance valuation is not good for pre-mature startup companies. Investors often try to make assumptions and compare the startup with other companies to figure out its worth. Founders need to be aware of these methods to be able to negotiate better deal terms.
Valuation by stage
Sometimes it’s easier to come up with a ballpark valuation based on the maturity of a startup. The farther along a startup is in its evolution, the lower the risks and the better the valuations.
AngelList provides real-time and current data on startup valuations for different stages of funding. For instance, a founder of a seed-stage startup can advocate for a median valuation of $20 million. The ballpark can provide a basis for other methods when applying additional metrics and risks.
Berkus method
The Berkus method assigns a financial valuation for each defining element that contributes to a startup’s success. Traditionally, the components are soundness of idea, prototype, quality management team, strategic relationships, and product sales. But you can add any other factor you think is relevant. So the final valuation is the sum of each factor (values given as an example):
Valuation = soundness of idea ($500,000) + prototype ($250,000) + quality management team ($100,000) + strategic relationships ($50,000) + product sales ($300,000) = $1.2 million.
Scorecard valuation method
The scorecard valuation method is similar to the Berkus method, judging a startup based on a number of success factors. The difference is you value the startup compared to other companies in the same funding stage. You can either take a competitor or use the ballpark value provided by the valuation-by-stage method.
With the scorecard method, you also assign a weighting percentage to each of the factors based on their relevance and multiply that percentage by the comparison percentage (100% being the same as similar companies) to get a score for each of the factors. The valuation is the total score multiplied by the ballpark value (values given as an example):
Total score = management strength (30% weight X 80% comparison) + size of opportunity (25% weight X 90% comparison) + product (15% weight X 120% comparison), competition (10% weight X 100% comparison) + marketing / sales / partnerships (10% weight X 150% comparison) + additional investment needs (5% weight X 50% comparison) = 0.92
Valuation = total score (0.92) X ballpark valuation ($20 million) = $18.4 million.
Comparables method
The comparables method determines the startup’s valuation based on recent exits and funding rounds of similar companies in the same market. The valuation is determined using a multiple.
You derive a multiple by dividing the exit value by a known metric’s value of the similar company (such as the number of registered customers or recurring revenue). You then calculate the startup’s valuation by using the multiple and the startup’s metric value.
Say we are talking about a social platform startup similar to Discord that supports communication among communities centered around various themes from gaming to arts.
In this case, for comparison purposes and as a basis for our valuation, we can take the recent funding round of Discord.
The company was valued at $15 billion and, reportedly, at the time it had 150 million monthly active users. We can use this user metric to derive the multiple here which is $15 billion / 150 million = 100.
Let’s presume our startup has 20,000 monthly active users. This means the valuation is:
Valuation = 100 X monthly active users (20,000) = $2 million.
Venture capital method
Venture capitalists often base their valuations on the exit value of similar companies and their desired amount of equity. The rationale behind it is that VCs usually aim at a best-case scenario where the return upon exit is 10 to 20 times their initial investment. So valuation basically determines the price of equity and the percentage of ownership the investor acquires.
For example, let’s take a startup in the BioTech industry located in the USA with a revolutionary new product. Suppose the investor learned from their network that several BioTech companies similar to the startup were recently acquired and the average price was around $125 million.
In this case, $125 million would be the anticipated exit value for our startup. Say the VC will own 15% of equity at the time of the startup’s exit. This means their return is:
ROI = owned equity (15%) X anticipated exit valuation ($50 million) = $7,500,000 million.
So If the VC invested $750,000 into the startup, they would make 10 times their investment.
Let’s also presume the VC initially receives 20% of equity for their $750,000 investment and then gets diluted to 15% upon exit after a few additional funding rounds. This means the post-money valuation is:
Post-money valuation = investment ($750,000) / received equity (20%) = $3,750,000.
From there you can easily derive the startup’s pre-money valuation which is:
Pre-money valuation = Post-money valuation ($3,750,000) - investment ($750,000) = $3 million.
This kind of backward engineering is what goes on in the investor’s heads when they decide upon a startup’s valuation. Being aware of this makes a founder more prepared for possible negotiation.
Discounted Cash Flow Method
For more established startups with a history of financials such as revenues, expenses, and profits, investors and founders may use the discounted cash flow method. The method involves creating something similar to an income statement with projections of future gross margins and expenses.
The key characteristic is that cash flows are discounted to reflect the time value of money (the idea that the value of money decreases with time) and the investment risk factor. Also, to consider various scenarios, it’s smart to create multiple discounted cash flow models.
Common practice is having models for the best, worst, and typical scenarios. Discounted cash flow modeling is not as trivial as other methods. Ernst & Young gives a great explanation of how to calculate a startup's value using the discounted cash flow method.
Conclusion
Valuing early-stage startups is something more of creative thinking rather than an exact science. There are plenty of waymarks both founders and investors can use, such as comparables, traction, potential growth, and sometimes even generated buzz.
But ultimately, the startup is worth what people are willing to pay for it. While founders and investors both want the startup to become a unicorn, their ulterior motives are to maximize their returns by crafting better deals.
Better deals come from expanding your network and the best way to do so is by joining a founder-investor relationship hub like Go Global World.
Our platform provides agility and grows your connections 10 times faster compared to traditional methods. Matchmaking, online pitch sessions, and automated deal flow is just a glimpse of the perks Go Global World offers to members.