How does a technology startup determine its valuation? Is it an art, a science or a combination of the two? Does a startup’s valuation increase if it has a slick pitch deck and a clever company name? Should a startup use a Ouija board to determine its valuation?
There are myriad theories and myths about valuing startups, and no one method is used universally by investors and founders in valuing startups. It is safe to state that valuing startups is more an art than a science and is a subjective undertaking in all cases. Do, however, save your pocket change and pass on the Ouija board (unless you want one for non-valuation purposes).
The secret in valuing a startup is that a startup is worth as much as the market will pay. This may not seem like much of a secret. If bona fide investors are willing to invest in your startup at a $20M pre-financing valuation, then your startup is worth $20M. You might think your startup is worth more than the market will pay. I have represented pure raw startups that have raised seed capital at valuations equal to three times a typical Series A valuation because of their rock star founders (serial entrepreneurs with stellar track records who are well-known in the investment community).
How do angels and VCs value their potential startup portfolio companies? Many angels and VCs value startups based on the percentage of the startups such investors want or need to own to meet their firms’ internal investment criteria. For example, many VCs want to own at least 20% of their startup portfolio companies. If such a VC is willing to invest $2M in a startup, then it is willing to invest at a pre-financing valuation equal to $8M (i.e., $2M investment divided by a $10M post-financing valuation is equal to 20% ownership).
The most common method used in valuing startups could be market comparables, and I recommend that you use market comparables in your negotiations with potential investors. A number of service providers (accounting firms, law firms, 409A valuation firms, data statistic firms) publish startup valuation data. The data varies from service provider to service provider and industry to industry (mobile, gaming, healthcare, etc.). Find data that supports a higher valuation for your startup and use such data in your negotiations with potential investors.
If a startup has revenue and profits, there are many mathematical methods, such as discounted cash flows, that could be used in valuing the startup. For a pure raw startup, projections for revenue and profits are speculative at best and are not helpful in determining valuations. MBA students aspiring to land positions with Goldman Sachs and Morgan Stanley crunch numbers in Excel spreadsheets to determine valuations. Angels and VCs scribble numbers on napkins and notepads in booths at Buck’s in Woodside to determine valuations. If your potential startup investor is valuing your startup with complicated Excel spreadsheets, he or she is probably not the right investor for your startup. Walk away quickly. See our Founder Tips for insight on how to select the right investor.
Assuming that you have gathered startup valuation data for your industry, how do you increase your startup’s valuation relative to comparable startups? One of the better methods to increase valuation is through competition. Raising capital is a numbers game and a juggling exercise at the same time. Do not limit your outreach to one potential investor. Keep as many potential investor balls in the air as possible when raising capital. With just one potential investor, you do not have much leverage with such investor and your next best funding option may be your own pockets. You have a better chance of increasing your valuation by being able to tell a VC, “I like you and your firm, but your valuation is below other VCs’ valuations.” If a VC really wants to date you, it will increase its valuation in response to competition from other VCs. Another way is to focus on your startup’s future in your pitch. If you can convince an investor that your startup could be the next Facebook, Craigslist or Amazon, you will have a much better chance of increasing your current valuation, even if you are a pure raw startup.
Good luck and remember that raising capital is a numbers game.
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