I talk a lot about getting in early. The earlier, the better (here’s why).
But it can be tricky to figure out just how much cash a brand-new business needs… let alone what it deserves.
Often, a company seeking seed funding has no assets, customers, or revenue.
Some don’t even have a prototype developed.
When a business is nothing more than two guys, a big idea, and a laptop, how do you know what you’re buying?
The fact is, nailing down an exact valuation for an early-stage startup is close to impossible.
There are dozens of accepted methods out there… none of which are perfect.
That’s why I suggest working through the three best methods, comparing their results, and landing somewhere near the average.
First, let’s go over the basics. Bear with me – I’m going to give you more information than you probably need. As you know, I like to be comprehensive in my coverage.
In practice, when you’re first starting out, you shouldn’t need to worry too much about the valuation. Most startups have already established their valuation with “lead angels” by the time they’re bringing on additional investors – and the best advice I can give you is to ride on those angels’ coattails. More on that here.
What is a valuation?
Simply put, a startup’s valuation is the amount of money it’s worth in its entirety – team members, assets, intellectual property, and all.
If you’re investing in Company X, the first step is to agree on the pre-money valuation; i.e., what the startup is worth before your investment goes in.
Say that you agree the business is worth $750,000 as is (the pre-money valuation). You’re prepared to invest another $250,000.
Here’s how that math plays out:
If you make that investment, you end up with a 25 percent stake in the company, because your investment comprises one quarter of the startup’s post-money valuation.
That’s why getting the valuation right is so important – it directly affects the amount of equity you end up with.
It’s not an exact science, so every valuation formula has its weak points.
Instead of choosing one and dealing with the consequences, you’re going to calculate three different ones – then meet somewhere in the middle.
Here are the three best ways to determine a startup’s valuation.
1) The Risk Factor Summation Method
In this method, you’ll evaluate a startup based on 12 risk factors. Less risk, more value. You will add or subtract up to $500,000 from the bottom line based on those scores.
For example, a company run by a fabulous team of entrepreneurs, all of whom have built successful businesses in the past, has very low management risk. That factor adds $500,000 to the bottom line.
On the other hand, if a startup has one major competitor who holds a portion of the market, that’s a high risk factor (but not disastrous). As such, it will detract $250,000 from the valuation.
Here’s an example:
In our example, the pre-money valuation of Company X is $1.75 million.
2) The Scorecard Method
The scorecard method also considers value in terms of risk mitigation. But this time, we’re getting a little more mathematical.
First, we’ll score each risk factor from 0 to 100. Zero indicates a terrible, crushing risk. One zero is a deal breaker, if you ask me – I don’t like to see any values under 60 or 70.
A score of 100 indicates that the startup more or less matches the norm. Qualities that give the startup an exceptional advantage may be scored above 100; 125 is a typical “bonus” score.
Here’s an example:
From here, you’ll do the math to get a multiplier value. Math below:
One you have a rough idea of what the startup would be worth, use this multiplier to adjust your estimate.
Let’s say you’ve agreed the startup is worth somewhere around $2 million.
Your multiplier (0.9925) adjusts the pre-money valuation down to 1,985,000, to account for the startups’ shortcomings in addressing the risks ahead.
3) The VC Method
In this method, we’ll work our way backwards, based on the ROI we hope to get.
For example, say that we believe Company X could be acquired for $20 million in a few years. We would like to receive a 10x return on our investment.
Here’s how that plays out:
In this case, the pre-money valuation is $1,750,000. That was easy!
Now you have 3 different valuations to work with:
The Risk Factor Summation Method: $1,750,000
The Scorecard Method: $1,985,000
The VC Method: $1,750,000
Looks like a pretty good ballpark. From here, you’ll either settle somewhere around $1.8 million, or use these figures as guidelines while you negotiate further.
There’s a little give and take here. The lower the valuation, the more equity an investment dollar will buy.
The key is to find a balance between founders, who benefit from a high valuation, and investors, who know that a lower valuation entitles them to a bigger piece of the pie.
At the end of the day, though, the business is worth what everyone agrees it’s worth.
So do your homework. Come to the negotiating table prepared.
But always stay flexible. After all, this is just as much an art as it is a science.
Until next time,