Startup Valuation: A Brief Introduction
Updated: Apr 15
Startup valuation is complicated. You will have heard that it’s an art, not a science and it’s true—there is little concrete data and many risk factors that could change the course of your business.
This means your startup’s financial projections can quickly become obsolete. So how do investors look at valuing your startup, and how should you think about your negotiation?
Many of the traditional valuation methods are problematic when it comes to valuing your startup. Discounted cash flow valuation and comparable company valuation are imperfect, which is not to say that you can’t use them as you construct your negotiating position with an investor. Making sure you have done all the work that a potential investor will do is a great starting point.
Ultimately, startup valuation results from a negotiation between you, the startup founder, and the angel or VC investor. Valuation is driven by the strength of your value creation potential, the opportunity for an attractive return on investment, and your ability to mitigate the risk factors by proving your value as a team.
The Problem With Valuing Your Startup
Calculating the value of your startup is not straightforward. Most startups have limited proven commercial success, so valuations look at future projections. And future projections are notoriously inaccurate. Investors will often take the view that everything will take twice as long and cost twice as much as you initially thought.
In addition, there’s the interesting dynamic between an ambitious entrepreneur with a cast-iron belief in their business and a battle-worn angel or VC investor who has seen it all before and will look at your financial projections with scepticism.
With limited hard facts to fall back on, we are in a world of guidelines, rules of thumb, and plain old-fashioned negotiation. Successful outcomes depend on creating competition between investors, sales prowess, and process management.
Let’s explore the fundamental principles that drive startup valuation.
Key Principles of Startup Valuation
To understand how startup valuation works, let’s look at some fundamental principles. Scroll down if you’re looking for tips on venture capitalists or angel investors.
The Golden Rule: Whoever has the gold makes the rules. It is the investor’s capital, so they make the rules. They will decide if the valuation is attractive enough for them to part with their cash.
It's not Dragons Den: Reasonable investors don’t try to steal your business from you. If your potential angel or venture capital investor takes the view that it’s a battle for ownership between you and them, be wary. Savvy investors want a correct valuation, not the cheapest one. That’s because it’s important that the founder and team are motivated and, if the investor takes 90% of the business and leaves the scraps to the team which is driving the company, they are less likely to see a return on their investment.
A small percentage of something vs a large percentage of nothing: Often founders get hung up on equity percentages early on or on how much their business will be worth in the future. In reality, your equity isn’t worth a lot if you cannot raise the funding you need to execute your vision. Don’t sacrifice the smaller piece of the big future pie for a big piece of the currently small pie.
Think about future rounds: Be realistic about additional future capital requirements, and communicate that to potential investors. You’re likely to raise funds again in the future, so this round is part of several valuation steps. The biggest valuation today isn’t always the best solution if it puts your next fundraise at risk. Valuing your startup realistically in the first place is critical, as is being confident that you can increase that value next time.
Future value potential drives pricing today: What your startup is worth today is mainly based on the potential future value of the company when there is an exit event. Your valuation is unlikely to be driven by applying a multiple to current revenues or valuing your current IP or other assets. Make sure that your financial projections demonstrate your value creation potential and ambition. Why be conservative if the resulting projections don’t offer attractive value potential which meets investors’ expectations?
Valuation is about balancing risk and reward for investors: Investors in growth startups seek to balance the high risk of failure with the potential for significant returns on investments that do well. They want to see evidence that their investment has the potential to yield a serious return on investment - a 10x return is a rule of thumb.
Get Into the Mind of an Angel or Venture Capital Investor
To understand how investors are likely to value your startup, we need to know how they look at the balance of risk and reward. Let’s start by making some assumptions about the performance of an investor’s portfolio:
For every ten investments, let’s say two will be highly successful, three will fail, and five will do OK. And let’s assume that “OK” means a return on investment of 2x. How much do the successful deals need to return to produce a decent overall return to the investor?
The five deals that do OK achieve 2x: The investor gets their money back.
If the two successful deals return 5x: The overall portfolio return is 2x or 19% annual return over five years. That’s OK, but not a great return if you consider the risks of investing in startups.
If the successful deals return 10x: The overall portfolio return is 3x or a 32% annual return. That’s a bit more like it.
Investors need high returns because the statistics are sobering. 90% of startups fail. Even if an investor has a portfolio of 10 startups as above to spread the risk, statistically they still have about a 30% chance of losing their entire investment.
Taking 10x as the target return on investment, let’s look at valuations now and in the future. If your business achieves its goals, what will it be worth in 5 years? What could you sell the business for?
Let’s say that you can demonstrate that your business in 5 years could be worth £50 million. By the way, investors will use various techniques to estimate future value, such as looking at comparable companies and discounted cash flow analysis, but that’s for another time.
A realistic valuation today would be 1/10th of £50 million or £5 million.
Assuming you’re raising £1,000,000 now, the pre-money valuation would be £4 million.
The investor’s returns are going to be diluted by any future fundraisings. Imagine you need to raise a further £10 million at a valuation of £20 million to achieve your £50 million valuation. That would reduce the investor’s share in that future value by half, so a 10x return becomes a 5x return.
Nobody can be sure about how much additional funding your business will need, but expect your investor to take a more conservative view than you, and therefore potentially reach a different valuation conclusion.
General Rules of Thumb
We’ve looked at the maths, talked about risk/reward, and identified the problems around different valuation methods. Let’s tie it all together. Of course, every situation is different. Keep that in mind. Here are some rules of thumb.
Investors want to see a significant potential value increase - say 10x their investment. Make sure that your business plan and financial forecasts show that it is achievable.
Visibility of exit potential is important for some but not all investors. It is worth assuming an exit in around 5 years to ensure you can demonstrate your value creation potential.
Most pre-revenue early-stage growth companies in the UK will struggle to justify a pre-money valuation of greater than £2 million.
Once there is evidence of consistent and growing revenue, pre-money valuations can rise to £5 million or more. Consistent revenue will validate your startup financial model and reduce investor risk, so valuations increase.
Often, if you are raising an appropriate amount of funding for your stage of development as a business, you sell between 15% and 25% of your business. This tends to hold true through the seed stage and into Series A.
Putting It All Together: Startup Valuation
Valuing your startup is much more a matter of negotiation with your investor than a mathematical exercise. A successful outcome depends upon highlighting your value creation potential and your ability to mitigate the risks of potential failure. If you research and build a sensible valuation argument based on industry-accepted rules of thumb, all should be well, and valuation will not be a sticking point.
Remember the bigger picture. Your funding round gives you the resources to build value for you and your investors; without it, you may not have that opportunity. Stick within industry boundaries, and expect the same from your angel or VC.
Where Can I Learn More?
Capital Pilot is here to help founders value their startup. For more information, check out all our Startup FAQs here. Or, if you are ready to get your investability assessment and rating, click here.