Startup Valuation: A Brief Introduction
Valuing a startup with precision is impossible. Smart investors will want to reach a fair valuation so you stay motivated and aligned.
Startup valuation is an art, not a science. It is impossible to calculate the value of a private, early-stage business accurately, especially one that is yet to start generating revenue. However, it is a necessary part of the equity-raising process. You will have to decide how much of your business you are willing to sell at what price.
To understand how startup valuation works, we’ll begin by sharing some fundamental principles and then help you get into the mind of a venture capitalist or angel investor.
Some Key Principles Around Startup Valuation
As a business looking to raise funds, they are some key principles to familiarise yourself with.
1. The Golden Rule
Whoever has the gold makes the rules. It is the investor’s capital. The valuation will need to work for them to invest.
2. Don’t be deceived by Dragons Den
A reasonable investor isn’t out to screw you or extract as much from the negotiation as they can. If your potential investor has some zero-sum view of business, be wary. Savvy investors want the right valuation, not the cheapest one. The reason for this is to keep you motivated. If they take 90% of the business and leave the scraps to the entrepreneurs who will be the difference between success and failure, then they should realise they are less likely to see a return on that investment.
3. A small percentage of something vs a large percentage of nothing
Often founders get hung up on equity percentages early on. In reality, they aren’t worth a whole lot if you aren’t able to raise the funds you need from strategic investors to execute on your vision. Don’t sacrifice 50% ownership of a £1bn company for 80% ownership of a £10mn company.
4. Think about future rounds
Be realistic about additional future capital requirements, and communicate that to potential investors. For this reason, bigger isn’t always better. You don’t want to have a down round, where the valuation at your seed raise is higher than your series A for example. So valuing your startup realistically in the first place is critical, as is being sure that you can increase that value by the next time you are raising capital. We see this happen quite often in crowdfunding rounds, where startups tend to get favourable valuations for an early fundraise, which makes the next round much more difficult.
5. Future value creation expectations drive valuation
It is driven not by what the business is intrinsically worth today, but by the value of the company in the future when the investor gets their money out via an exit event.
6. It’s all about balance for investors
Investors in growth start-ups are looking to balance the high risk of failure with the potential for huge returns on investments that do well. They want to see that their investment has the potential to yield at least a 10x return.
Going Into the Mind of a Venture Capitalist or Angel Investor
To understand portfolio balance, think from the perspective of a VC or angel investor.
For every ten investments, let’s say two will be highly successful, three will fail, and five will do OK, i.e. generating 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 mean the investor gets their money back.
If the successful deals return 5x, the overall portfolio return is 2x – 19% annual return over five years. That’s OK if you don't consider the risk.
If the successful deals return 10x, then the overall portfolio return is 3x – a 32% annual return. That’s a bit more like it.
Target: 10x return
So let’s take 10x as the target return. If your business achieves its goals, what will it be worth in 5 years? What could you sell the business for?
Say £25 million for this example...
So the realistic valuation today is 1/10th of £25 million or £2.5 million post-money. That’s the value of the business INCLUDING the invested funds that will be required to enable it to achieve its targets.
You’re raising £500,000 now, so the pre-money valuation is £2.0 million.
... That pre-money valuation is going to get adjusted by any expected future fundraisings. Imagine you need to raise a further £5 million at a valuation of £10 million to achieve your £25 million valuation. That would reduce the investor’s share in that future value by half, so a 10x return becomes a 5x return.
The amount of future fundraising required will only ever be an estimate. Nonetheless, an investor will want to take it into account and will reduce the valuation accordingly.
This all leads us to a massively caveated, generalised and not-to-be-relied-upon rule of thumb (because every situation is different):
If you are putting a pre-money valuation on your pre-revenue business of greater than £2 million, be ready for some push-back. Unless you are on the West Coast of the US, where you might be able to double the valuation.
If your pre-money valuation is £1 million, you are probably on more solid ground.