How does an early-stage investor value a startup?

thedrawingboard.me

Startup valuation, as frustrating as this may be for anyone looking for a definitive answer, is, in fact, a relative science, and not an exact one. For those of you that want to cut to the summary of this post (which is somewhat self-evident when you read it) here it is:

The biggest determinant of your startup’s value are the market forces of the industry & sector in which it plays, which include the balance (or imbalance) between demand and supply of money, the recency and size of recent exits, the willingness for an investor to pay a premium to get into a deal, and the level of desperation of the entrepreneur looking for money.

Some of the valuation methods you may have heard about include:

  • The DCF (Discounted Cash Flow)
  • The First Chicago method
  • Market & Transaction Comparables
  • Asset-Based Valuations such as the Book Value or the Liquidation value

Knowing what the exit price will be, or having an idea of what it will be, means that an investor can calculate what their returns will be on any valuation relative to the amount of money they put in, or alternatively what their percentage will be in an exit (money they put in, divided by the post-money valuation of your company = their percentage). Before we proceed, just a quick glossary:

  • Pre-Money = the value of your company now
  • Post-Money = the value of your company after the investor put the money in
  • Cash on Cash Multiple = the multiple of money returned to an investor on exit divided by the amount they put in throughout the lifetime of the company

An investor is willing to pay more for your company if:

  • It is in a hot sector: investors that come late into a sector may also be willing to pay more as one sees in public stock markets of later entrants into a hot stock.
  • If your management team is shit hot: serial entrepreneurs can command a better valuation (read my post of what an investor looks for in a management team). A good team gives investors faith that you can execute.
  • You have a functioning product (more for early stage companies)
  • You have traction: nothing shows value like customers telling the investor you have value.

An investor is less likely to pay a premium over the average for your company (or may even pass on the investment) if:

  • It is in a sector that has shown poor performance.
  • It is in a sector that is highly commoditized, with little margins to be made.
  • It is in a sector that has a large set of competitors and with little differentiation between them (picking a winner is hard in this case).
  • Your management team has no track record and/or may be missing key people for you to execute the plan (and you have no one lined up). Take a look at my post on ‘do I need a technical founder?‘.
  • Your product is not working and/or you have no customer validation.
  • You are going to shortly run out of cash

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