Let’s start with a caveat that I’m not advocating anyone make a startup investment based on a valuation you’d do in only 10 seconds. Not for one second! But you might be able ascertain whether the valuation a startup is pitching you is in the right ballpark that fast.
There are so many different factors that will influence a startup’s valuation such as how loose investor money is at the time, competition from other startups and investors, how much runway the startup still has (i.e. how desperate they are for your check!), the valuation of comparable startups and liquidity events and so on. These are all supply and demand factors.
However, paying a high price, for example, just because others are willing to (now or in the future) is an exercise that many naive startup investors engage in. I’ll pass on that thank you.
An investment is only a good investment if the startup is awesome AND it’s well priced. The rise in down rounds that we’re seeing is testament to this fact. Check out Forbes, Economist and Fenwick for more information if you’re interested!
The valuation of a financial asset is the discounted value of its future cash flows.
Unfortunately, predicting future cash flows of a startup can be more crystal ball than dependable forecasting. Often this exercise is somewhat academic. The results are also very sensitive to input assumptions. The more mature the business the more accurate and useful this model becomes.
So we’re largely back at square one. Supply and demand is misleading and can’t really be trusted as supply and demand dynamics can fluctuate significantly over the 5-10 year lifespan of a startup investment and discounted cash flow methods (which of course you should do anyway) are not exactly dependable either.
Ironically, the wonderfully simple, yet powerful, Pareto principle applies here. Pareto discovered the 80-20 Rule whereby roughly 80% of the effects come from 20% of the causes. In this case with 20% of the effort (or 10 seconds work) you should be able to get 80% of the answer you’re after.
Here are a few methods we use. They are commonly referred to as Rule of Thumb methods. It’s worth noting that the accuracy increases when you can get several valuation methods to come out to similar answers, reinforcing each other.
There are several rule of thumb valuation methods. Here are our four favourites:
1. Value a Startup by Stage Method
This is probably the easiest of the Rule of Thumb methods and simply values a startup by the stage of it’s development. The further a startup has progressed along the development pathway, the lower the startup’s risk and the higher its value. A valuation-by-stage model might look something like this (you’ll need to adjust this by country):
|Estimated Company Value||Stage of Development|
|$250k to $500k||Exciting business idea, plan or presentation|
|$500k to $1 million||Prototype, MVP and key management|
|$1 million to $2 million||Live product/service and initial revenue|
|$2 million to $5 million||Growing revenue and some key partnership|
|$5 million plus||High revenue growth over a period and clear path to profitability|
2. Future Valuation Method
This method works on the basic assumption that investors are looking for a 5-10x return on their investment over a 5-year period. The investor asks:
How much could this company sell for 5 years from now?
Let’s say $100 million. You can determine this via comparables or sales multiples etc. Any decent startup pitch should have some comparable exit analysis to get you started.
How much is the entrepreneur valuing it today (post money)?
Let’s say $10m. So you might assume that this matches your 10 times criteria, taking the valuation (and your investment) from $10m to $100m. However, that ignores dilution.
How much do you think your investment will be diluted by follow-on rounds?
Remember there will likely be more investors looking for a slice of the payday diluting your holding. Let’s say you get diluted 50%. You could of course have topped up on subsequent rounds to maintain your percentage, but then you would be investing at higher prices. Therefore the proportion of your payout at a $100m after dilution will actually be half. So in order to get the 10x the return on your shares the exit valuation actually needs to reach $200m.
3. Raise Restricted Range Valuation
This valuation works on the basic assumption that the amount of money you need and the equity that is allocated determines your valuation range. Going outside this range starts to impact the commercials of the investment.
- How much does the Startup need? Let’s say they need $500k to give themself an 18-month runway and achieve strong traction. Investors should have little incentive to negotiate this lower as it would constrict the business (and increase the risk of failure and loss of the investment).
- How much do investors receive? Giving investors 50% would leave founders with too little equity and incentive to work hard. Standard ranges are between 10% and 30%.
- So $500k and 10% to 30% are fixed. Therefore, your post-money valuation is somewhere between $1.667m (giving away 30%) and $5m (giving away 10%). So between $1.17m and $4.5m pre-money.
Where the startup lands in the range will depend on other valuation methods such as comparables.
4. Berkus Approach
Created by Dave Berkus, applies to pre-revenue businesses and basically adds value based on the development of the business. The maximum valuation is $2m (or post rollout value of up to $2.5m). You simply add $1/2 million for each additional stage the startup has achieved.
|If it Exists||Add to Company Value up to|
|Sound Idea (basic value, product risk)||$1/2 million|
|Prototype (reducing technology risk)||$1/2 million|
|Quality Management Team (reducing execution risk)||$1/2 million|
|Strategic relationships (reducing market risk and competitive risk)||$1/2 million|
|Product Rollout or Sales (reducing financial or production risk)||$1/2 million|
Valuing a business at any stage of it’s lifecycle is difficult, but early stage is particularly problematic. These rule of thumb models help give founders and investors a sanity guide of realistic range of sensible valuations.
There are exceptions. But they are exactly that…exceptions. Some “exceptions” are justified and some aren’t. It can be easy to get caught up in a great story. It’s a founder’s job to sell the vision and the sizzle.
But valuation is not the only variable when it comes to investing. Investor protection terms are often used to offset high valuations, such as liquidation preferences (at 1 or more and even participating style), pro-rata rights, pre-money options pool for staff, lock in periods, Board seats and so on. These can be far more expensive for founders in the long run than agreeing to a lower valuation now.
There are many things to consider when investing in a startup. So what should an investor do if they aren’t sure or they are new to the startup investor scene? Follow a great lead investor. Then the question of valuation becomes a binary one. They set the price and terms.
The only question is “Are you in?”