Putting the correct valuation on your startup business when you’re ready to woo investors could be one of the biggest commercial decisions you ever have to make.
Fundraising is a delicate balancing act. You need to attract capital in order to grow, but you don’t want to undersell your business. You can expect to give away 10%-20% equity in your company in a seed funding round, so you need to tread carefully when it comes to valuation. Overvaluing your business comes with its own set of problems in terms of meeting investors’ expectations down the line. You need to convince investors that your business is a safe bet, and get them on board at the right price. But how can you work out what that is?
Mature companies that make profits and generate cash are easier to value than startups, as their past financial performance offers a guide to future profitability. Price to earnings ratios (comparing earnings per share to the current market price) are commonly used to work out the value of well established, publicly traded companies. But new companies are unlikely to have steady earning streams and may not yet be making a profit. For this reason, startups are more likely to be valued using revenue multiples, or, in the case of very early stage companies, simply according to their perceived potential, measured by things like user base, for example. This is why valuing startups is often described as an art rather than a science – investors may be relying on gut feeling more than hard numbers on a spreadsheet.
High risk, high returns?
Early stage investing is inherently a risky space, with the failure rate for startup businesses as high as 90%, according to some estimates. To persuade investors to back your funding round, it’s a good idea to try to understand how they will look at your company.
The price they are willing to pay, along with their investment horizon and how much involvement they want in your business decisions may change depending on whether they are angel investors (typically smaller-scale individual investors), venture capitalists (investing on a larger scale through a firm) or investors sourced through peer-to-peer platforms, for example. (Not sure who to target? An accountant or business adviser can help.)
Venture capitalists have historically preferred more established emerging companies rather than offering seed funding to very early stage startups. VC investors will think about your company valuation in terms of the return they expect. They will usually plan to exit a company within three to seven years, so they will estimate the exit price and how much equity they should hold in order to meet their targeted return on investment in future. They then work backwards and discount to the present value to figure out what price they should pay now, noting the risks they will face over the course of the investment. Because of these risks, they will probably be aiming for returns of 10 times their initial outlay, or more. They will research what entry and exit prices companies similar to yours have achieved – this is called the comparables method. You can try to work out where to pitch your business using this same method, looking at the fundraising history of your closest competitors and seeing how your company stacks up in terms of revenues.
Starting from scratch
Another valuation method is entry cost, which looks at how much it would cost to set up a similar business to yours from scratch, taking into account staffing costs, research and development, buying assets and looking at ways to cut costs. Potential investors would compare this ballpark figure to your suggested valuation to see if it’s realistic. But this method doesn’t really take into account your company’s growth potential.
There are online calculators you can use to gauge your company’s value, which will be affected by different factors such as:
Physical assets like equipment and infrastructure
Intangible assets like brand value
Liabilities like money owed to suppliers
Developmental milestones it has met like product launches or strategic partnerships.
Other factors to consider which could also influence the price you set are:
The backdrop to your industry or sector and its long-term prospects
Supply of capital
Demand from other startup businesses
Investors’ appetite for risk
How much cash you need to raise and how badly you need it.
But, in large part, setting a valuation is really a case of understanding what the market will bear, that is, what investors are willing to pay for exposure to a business like yours.