During an economic downturn, investors with money in financial vehicles such as mutual funds and ETFs may have a portfolio that has substantially declined in value. So since they have less money overall, their motivation to invest in risky assets takes a hit.
From an investor’s perspective, valuations are most reasonable when it’s harder for startups to raise money. For example, a company I knew in the beverage space had a valuation of $45 million when valuations were sky high. A year later, when the economy was quieter, its valuation was at $10 million.
Another company I spoke with in the diagnostics space de-risked their offerings by demonstrating great progress and more favorable data. But because the economy had softened, their valuation still fell from $35 million to $20 million.
Angel investors will often assess valuations both by themselves and as part of an angel investment group. This results in a collective due diligence process that aims to arrive at fair valuations via both group management and angels with diverse backgrounds. The benefit to founders is that if one angel refers you to their group, other angels in the group will often invest as well.
Understand the market
When you look for investments, ensure your valuation is realistic for the type of innovation and market segment, and is aligned with the state of the economy.
While assessing prospective investments, I ensure it’s a product or service that I care deeply about and educate myself about the company’s market. I want to see a fair valuation of the business and a well-defined market worth at least $100 million. I also assess whether the product or service has a significant advantage versus the competition.
To determine your valuation, you need to understand your market.
If your company has a minimum market threshold of $100 million in a large total addressable market (TAM), clearly explain how your company’s innovation solves a huge problem in a space that has no solutions or is substantially better than existing products and whether it can scale rapidly.
Determine your company’s valuation
When I’m considering an investment, “What’s your valuation?” is one of the first questions I ask.
Valuation has two primary concepts: pre-money and post-money.
Pre-money valuation is the value of the company prior to an investment, and post-money valuation denotes what it’s worth after investment.
So if I want to invest $1 million in a company that’s currently valued at $10 million, that will be its pre-money valuation at the time I invest. After my investment of $1 million, the company’s valuation will be $11 million — its post-money valuation.
Investors will often receive shares of your company’s stock in return for their investment. To calculate the value of each share of your company’s stock, take your pre-money valuation (the price the investor is willing to pay for each share) and divide it by the total number of shares outstanding.
So if I want to invest $1 million in a startup that has a pre-money valuation of $10 million and 1 million shares of stock outstanding, I will have to pay: $10 million / 1 million shares = $10 per share.
A pre-money valuation that’s too high without good reason may disqualify your company from being considered as a fair investment.
A founder who graduated from an elite business school recently told me his early-stage fintech firm was worth $50 million pre-money. The startup had two employees who were in business school full-time; it didn’t have any intellectual property, no minimum viable product, and the founder had only a general idea of its go-to-market strategy. I ended the meeting shortly after it began because the factors the founder used to establish the valuation were unrealistic.
The Berkus Method
Venture capitalist Dave Berkus has developed a formula known as the Berkus Method for valuing pre-revenue startups. Try it to help determine your company’s valuation.
Using Berkus’s specific example, begin with $2.5 million and assign $500,000 to each of five key success metrics: idea, prototype, team, strategic relationships, and product/service rollout, including sales.
Although intended for VCs, Berkus’ formula is equally valid for angel investors, which is why I mention it.
VCs and angels also use the comparable transactions approach, where you consider other transactions in the same sector involving companies of similar size to arrive at a fair value for the startup in question.
Let’s say you have an AI or ML startup and your research shows several similar companies in the sector recently selling for 10 times revenue. Knowing past revenues and what these companies sold for can help an angel investor determine the potential value of their investment in your company.
These methods share a similar trait in that they each ask: “How much are comparable companies within a sector acquired for?”
Be an informed founder
The startup ecosystem is a fascinating world to be a part of. You and your founding team have an exciting breakthrough product. When you look for investments, ensure your valuation is realistic for the type of innovation and market segment and is aligned to the state of the economy.
A fair valuation that feels good to both founder and investor will lead to a partnership in which both sides win.