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.