Valuation

I just helped a client establish a valuation for his startup, and thought I’d discuss the topic a bit here. He hadn’t raised capital before, and his instinct was to value the startup based projections of future cash flows (i.e. Net Present Value analysis). That can work for a going concern, but startup valuations are typically driven by comparables, meaning recent valuations of other startups being financed.

At the time of this post, most seed-stage round valuations are between $500K and $2MM. Factors that determine where a startup falls along this spectrum include:

  • Quality of the team. Have they founded successful businesses before, and made money for investors?
  • Stage of development. Is this an entrepreneur with a business plan and nothing more? Does she have a prototype developed? Paying customers?
  • Size of the opportunity. Is this a company that could, in theory, become a $10MM business or $100MM business?

After considering these issues, we came up with a valuation. To be more specific, a pre-money valuation, or the value of his company today. Our number was $1.5MM. His goal is to raise $500K. So how much do his investors get? The math is pretty simple. Take the value of the company before the investment ($1.5MM), add the amount of the investment ($500K), and you have a post-money valuation ($2MM). The investors get $500K divided by $2MM, or 25% of the equity.

Like any good entrepreneur, he was concerned about giving away too much equity, and thought he should try for a $3MM pre-money valuation. It took a bit of discussion, but I convinced him otherwise. Of course, I want the best for my clients. But if he walked into a meeting with a sophisticated angel investor with a valuation that’s out of line with what’s happening in the market, he could lose credibility, and blow the deal. If he were to convince an unsophisticated investor (e.g. a family member) to take the higher valuation, he could have a different problem… Down the road, if he took money from a venture capital firm, they might strike a tougher bargain, in which case (depending on terms) the unsophisticated investor could suffer significant dilution.

Have thoughts on valuations of early stage companies? Please share them below.

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One Response to Valuation

  1. Halley says:

    Great post!

    Another place to check in for up to the minute deal flows over the last 12 months can be found here:
    http://angelsoft.net/industry/index.seam (a company I work with who has leveraged the angelsoft platform was pointed to these statistics when we were trying to get more traction on our project).

    Another interesting consideration when making the valuation decision, can sometimes come in the form of asking yourself the hard questions like “if you really ‘sucked it up’ would you be able to do this without investment dollars? Or at least get it to the next level of a business – where it may start generating modest revenue?” If the answer to that questions is yes, I’d be inclined to say “do it” and leave your valuation where it is.

    If on the other hand, your answer is “no” and those angel dollars are the difference between your idea staying an idea, and your idea being a business – then you ought to set your valuation at a more appealing price-point for an investor to take interest, because at that point the question is moodt. You’re deciding between less of 100% over more of 0% which is just illogical.

    Thanks again for the great reading material.

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