Finding your startup’s valuation: 5 factors to consider

“What is your valuation?”

As an angel investor, this is one of my first questions when talking to founders for a potential investment. And often, I hear numbers that are either too low or very high.

For instance, a founder who had graduated from an elite business school recently told me his early-stage fintech firm was worth $50 million. The startup had two employees who were both in business school full time. There was no IP, no MVP and the founder had only a general idea of the go-to-market strategy. I ended the meeting soon afterward, because the factors they used to arrive at the valuation had no basis in reality.

Another CEO I spoke with had a game-changing product, sizable total available market (TAM), successful betas, some product sales, an impressive team and a well thought out go-to-market strategy. When this founder said the business was worth $500,000, I advised her to reconsider her valuation because it was extremely low.

Many investors would not offer this kind of advice to a founder they had just met, but because the startup had potential, I encouraged the founder to redo her homework.

What is “valuation”?

A startup’s valuation denotes what it is worth at a given point in time. Factors that make up the valuation include the development stage of the product or service; proof-of-concept in its market; the CEO and their team; valuations of peers or similar startups; existing strategic relationships and customers; and sales.

Entrepreneurs typically value their startup when raising capital, or while giving shares to their team, board members and advisers. Having an accurate valuation of your startup is critical, because if you overvalue it, investors likely won’t give you any money.

On the other hand, undervaluing your startup means you’re giving up a lot of equity for less money, or you’re undervaluing what you have built so far.

It’s more art than science

There isn’t a straightforward formula to follow when valuing your startup. Because most startups can’t really prove their commercial success at a large scale, valuations take into account the nature of the product or service, projections for the business and the TAM.

You may have heard that valuation is more of an art than a science, and it’s often true — startups often don’t have enough concrete data at the early stage and face a range of risk factors that could change the course of the business. Many traditional valuation methods, such as discounted cash flow, aren’t as useful for valuing early-stage startups. This means investors have to gauge other factors that aren’t so easily measured.

As a founder, your job is to showcase:

• The potential for value creation and how you’ll do it.
• The opportunity for an attractive return on investment.
• Your ability to mitigate risk factors.

The “art” of valuing a company often involves determining the qualitative value of certain factors. Primary among these are the nature of the product or service; TAM; evaluation of the team in terms of talent and fit; go-to-market strategies; projected forecasts; and potential exit opportunities.

The value of each factor will be different based on the industry and what a company does. For example, early-stage companies in life sciences may require four to five years to get to market as they have to get approvals, but SaaS companies can often go to market within a year. It’s crucial to balance your evaluation of the first few years’ forecast with the sector you operate in and what your product or service is.

Instead of trying to figure out all these factors by yourself, speak with experts, independent advisers, lawyers and investors who have experience performing valuations. The earliest valuation rounds are usually the most challenging. Later, you’ll be able to tap into the many stakeholders on your team for guidance.

The science involves math

Venture capitalist Dave Berkus has developed a formula, known as the Berkus Method, specifically for valuing pre-revenue startups. In this method, you take $2.5 million and assign $500,000 to each of five key success metrics: the idea, the prototype, the team, strategic relationships, and product/service rollout and sales.

VCs also frequently use the comparable transactions and venture capital methods to arrive at valuations. These are similar in that they both involve asking: “How much are companies like these acquired for?”

In the comparable transactions approach, you’ll consider deals involving companies in your industry that are similar in size to yours.

For example, let’s say a few artificial intelligence and machine learning companies have sold recently for 10x revenue. Knowing the past revenues of these companies and what they sold for can help you and investors value your business. So if an investor is expecting a 10x return in five years, and the company expects to achieve $100 million revenue in that period given the precedent set by similar companies, a valuation of $10 million would fit with the expected return.

When researching your market, you should look for the revenue multiples or EBITDA multiples of similar companies in your sector.

In the venture capital method, you calculate your startup’s exit value by determining the anticipated return, such as 10x, and plug everything in to find your post-money valuation. After you arrive at a number, subtract the investment amount you’re asking for to get your pre-money valuation.

Now focus on your exit multiple, which is the anticipated exit value of your company divided by the amount invested. To get your exit multiple, divide the total cash drawn from the investment by the total amount of the investment. So if an investor put in $10 million into your company and received $100 million back, your exit multiple is 10x.

Timing is everything

Despite all the math involved, your valuation has drivers you have no control over, such as market conditions, where your investors are located and the value of comparable startups.

Often, a company will get a higher valuation when the economy is booming than it would during a severe recession. Ultimately, you finalize your startup’s valuation by negotiating with investors.

Investors want to be your partners

Investors want to work with you. They want you and your team to be extremely motivated, as this ensures everyone gets an attractive return. If investors own 90% of your company, you won’t be happy with your share of the returns. Conversely, if you don’t give up some equity, you’ll have a hard time raising funds.

Be transparent and realistic about future funding rounds and communicate all information to your investors. Your current round is likely part of several funding rounds, in which each valuation you get will be progressively higher.

Remember, what your business is worth today is based on the potential value you’ll generate at exit. Early-stage investors balance the high risk of failure with your company’s potential to provide an attractive exit. This means your exit value could be more than 10 times your value at the moment they invest.

Investors play the long game

Investors carefully consider the balance of risk and reward for each prospective investment opportunity. They need good returns and successes to make up for the investments that will inevitably fail. An investor’s portfolio often looks like this: two companies are outstanding (they may return 10 times or more), three could do fairly well (three to four times the investment), two may return the amount invested and three might fail.

Investors want to know what their investment will look like in five to seven years if you achieve your goals. An investor’s returns will be diluted by the rounds you raise in the future, so they factor these projected lower returns into their assessment of the numbers you give them.

While there is no exact science for figuring out how much money you’ll need down the road, certain sectors and industries have patterns you can look for. Life science investments typically rely on multiple fundraises, as the returns you get in this sector can be outsized even after accounting for dilution. However, the risk is also higher, as the final product may require approvals from the FDA and from other countries.

The likelihood of a successful exit depends on your ability to show your company’s potential for creating future value and how you’ll mitigate the risk of failure. Investors are more likely to accept your proposed valuation if you do the research and build a practical argument based on industry-accepted practices with sensible metrics from sample exits in your industry.