How to evaluate startups?
Both investors and entrepreneurs who want to review early-stage and seed companies must understand the impact of the valuation. To scale fast, the most successful starts must be able to acquire the necessary capital.
If a startup can’t execute on marketing initiatives, hire the right people, or develop the products with its current funding strategy, it may not survive.
Hence, that is why establishing the right valuation for a pre-seed and seed-stage startup is a key factor. Let’s discuss in detail valuation, its importance, and how to evaluate a start-up you’re considering an investment in.
What is Valuation?
Valuation is the process of determining the current or projected worth of a company. This process uses objective measures and evaluates all aspects of the business to calculate its value.
There are different tools that are used to determine a company’s valuation. These tools vary between different businesses, industries, and evaluators.
Reviewing financial statements, cash flow models, and other types of company comparisons are common approaches that are used during this business valuation. Pre-seed companies are typically more difficult to establish their valuation.
Venture analyst at Plug and Play, there is “No formula to establish a valuation for pre-seed companies because revenue multiple and techniques that are used to evaluate public companies are not applicable.”
Understanding Divergence
In addition to a company’s valuation, another important aspect when evaluating a startup is its divergence. This is the difference between the growth rate of the company’s valuation and the valuation the investor receives as shares as a result of dilution.
Factors such as dilution by subsequent investors lead to this. Divergences are typically found to be around 3x and 5x even with successful ventures.
Let’s say that an investor funds a $2 million post-money valuation and receives shares that are valued at $1.After five years, the company is sold for $20 million dollars which is a 10x increase in the company’s valuation.
However, because of dilution, the investor’s shares are not likely to experience this 10x increase in value. So instead of those shares being 10x to $1, or $10 per share, they might increase by a factor of 5x. That would be 5x to $1 equals a value of $5 per share.
This example would take the increased valuation of 10x and divide it by the actual increase in the investor’s share of 5x. That equates to a 2x divergence.
Why is Valuation Important to Investors?
For entrepreneurs, valuation is important because it helps them determine how much equity to give an investor in exchange for funds. Consequently, investors find the valuation as being important because they want to know how much of the company’s share they will receive for the funds that have been invested in this stage.
Startup valuations typically will be what either make the deal or breaks them. Founders who do not have adequate knowledge about how the process of startup valuation works should be looked at with pause.
For example, if an extremely high figure is quoted, the expectations will be very high, regardless of whether the startup generates revenue currently. For a startup that fails to meet these high expectations, the next round of funds must be calculated at a lower valuation.
Why is Valuation Important to Investors?
For investors who gained equity in the first round, they have yet to see a return on their investment, which creates higher risks.
As you can see, the valuation is the key determining factor of the return for an investor. Successful investors are dependent on having a solid understanding of valuation. However, the most misunderstood aspect of the investing process is the valuation.
It is often the subject that leads to entrepreneur’s and investor’s relationships off on the wrong feet as a result of contentious negotiations. Considerations for evaluating a startup can vary by the stage of funding it is seeking investment.
Startup Funding Stages
Most startups will need to acquire external funding rounds to firmly get established in their business. The funding stage that a startup is in will have an impact on the valuation and help an investor evaluate whether to invest or not. Here are the startup funding stages and considerations to associate with each round discussed below.
Pre-Seed Funding Stage
This is the first startup funding stage and is often not considered even a stage in funding. That is because this stage is typically the time period where a startup is working on getting operationally prepared. Also referred to as bootstrapping, the pre-seed funding stage is often when entrepreneurs are using their existing resources to scale-up.
Since this is the development stage of the startup, it’s common for entrepreneurs to put in long hours and get another job to provide additional funding to build their startup. Investors may not make an investment for equity in the startup during this stage.
A startup in this stage may stay here for a while or they may consider pre-series funding to move faster. Legal issues such as partnership agreements and copyrights should be worked out during this stage by the entrepreneur. Investors should avoid investing in startups that have legal issues before their launch.
The seed funding stage is considered the first step in startup funding. You can think of this stage as an analogy to planting a flower. When the startup is given the appropriate amount of water, it will be able to grow and eventually become a flower. Startups at the seed funding stage will typically provide equity to investors in this phase.
Seed Funding Stage
Investors who provide monetary support at this stage are taking much more risk. There is no guarantee that its business model will be successful. Costs that are funded in the seed funding stage include those associated with the product launch. This includes marketing, hiring the right staff, and funding additional market research. This funding stage is critical for startups that are trying to get their business off the ground.
Series A Funding Stage
Venture capital financing begins at this stage. The startup now has a product that’s developed and a consistent revenue flow. To optimize their offerings and scale to different markets, a Series A funding round is the ideal opportunity for entrepreneurs.
Startups should have a plan to generate long-term profits to attract investors at this stage. You’re not looking for a company that has “great ideas”, but ones that have a business strategy that results in a successful, revenue-generating business.
Series B Funding Stage
By this stage, the startup has acquired a solid user base and has consistent revenue. Investors should see that the business can achieve more success by scaling. Funding for market reach activities to increase their market share may include marketing, business development, and customer success initiatives.
Series C Funding Stage
When a startup reaches this stage, it should be on a growth path. Funding from investors should help them reach new markets, build new products, and even the potential to purchase other startups.
Investors seeking to fund a startup at this stage should see a successful business that is well-established, have stable revenue startup streams, a history of growth, and a strong customer base.
Series D Funding Stage
This stage is not very common among startups. Entrepreneurs will use the Series D Funding Stage to raise money for a specific purpose. For example, if a startup wants to merge with another company.
Additionally, a startup that was unable to achieve its growth goals during Series C may consider this stage to acquire more funding.
How to Calculate Startup Valuation
There are many aspects to valuation. It’s common for investors to talk about pre-money or post-money valuation with discussing a company they are investing in. The valuation calculation is straightforward when the only thing you get is a specified percent of the common stock for your investment.
How to Calculate Startup Valuation
However, it is becoming more commonplace for investors to negotiate for preferred stock instead. Additionally, other negotiation points often include other financing terms like controls, dividends, controls, and board seats.
Seed Stage Startup Valuation Factors to Consider
Having the right valuation leads to a deal maker for startups. When calculating the startup valuation, the factors that influence the company’s valuation includes the following:
Traction – Is there quantitative proof that customer demand is rising? A company that shows traction is indicative of a company that is starting to take off. Traction indicates there are growth and development which are key indicators for an investor to consider. After all, you would not want to invest money into a company that isn’t clearly showing they are poised for future growth.
Prototype – A prototype is typically not the end-product for a startup but it demonstrates the product or service in action. Investors should review the prototype and ask follow-up questions to determine if there is viability in the use-cases during the pitch.
Reputation – Does your company and its founders have a positive image in the market? An investor should be keen to understand whether the founder’s image and capability is sound. Oftentimes with startups at this stage, you’re investing as much in the people as you are in the company itself.
Distribution Channel – The product or service at this initial stage is likely to be in the preliminary stages as well. As a result, investors should note the distribution channel to be used. There is a direct connection to the startup’s valuation and distribution channel.
Pre-valuation revenues – Revenue figures make it easier for investors to determine a company’s valuation. If you’re considering a startup that has already been in the market and generating revenue, this could help determine whether an investment would be the right move or not.
Business sector – The industry itself that the startup belongs to will provide insight into how they may perform. For example, if the industry is growing substantially, an investor has a higher likelihood of getting a return on their investment. Keep in mind that this also typically indicates that you may have to pay a premium for the opportunity.
Quantitative Approaches to Startup Valuation
Determining the valuation of your startup, particularly one that’s in the early stages can be very subjective. Investors will often base their investment on their impression of the founders and their own gut feelings.
Still, there are some methods that investors can use during their due diligence to help determine a startup’s valuation. Here are some of the most commonly used startup valuation methods explained below.
Venture Capital Valuation Method
This method is typically used during the Seed and Series A funding stages. Startups in their first year of operations are not usually profitable. So the venture capital valuation methods look at the predicted cost of a startup when the investor leaves the company.
There are two indicators used in this method: The first is the pre-money valuation which assesses the company before it has received investment money. The second indicator is the post-money valuation which then takes into account the investment the startup receives and the time frame from when the investor leaves the project.
This matter of methodology uses the following two equations:
ROI = Terminal Value/Post-Money Valuation
Post-Money Valuation = Terminal Value/ Anticipated ROI
The terminal value is the selling price for the company at a certain point in the future. It can be estimated by using reasonable expectations for revenues in the year of sale. Those revenues are used as a baseline to estimate earnings.
The anticipated ROI is the amount of return an investor expects on their investment. Most investors expect to get a 10-40x return when investing in an early-stage startup.
Scorecard Valuation Method
Using a comparison of the target startup with companies that are in the same industry or similar is the basis of the scorecard valuation method. This method is commonly used during the pre-stage round of funding.
Multiple risk factors and the average valuation of companies in the industry that were recently funded are taken into consideration. These comparisons can only be applied to startups that are in the same industry and development stage for pre-money valuation.
Multiple factors are weighted and scored to obtain the full valuation. The score range used is from -3 (worst) to +3 (best) to weigh each factor. Then this score is multiped by the comparison factor range that gives each section a weight, then totaled and multiped against the average pre-money valuation for the industry of the startup. Here is an example below:
Comparison Range Target Company Factor
Strength of Management team 25% Score =RxT
Size of Opportunity 20% Score =RxT
Product/Service 15% Score =RxT
Sales Channel 10% Score =RxT
Stage of Business 10% Score =RxT
Size of Investment round 5% Score =RxT
Need for additional funding 5% Score =RxT
Business Plan & Presentation 5% Score =RxT
Business location 2.5% Score =RxT
Business Type 2.5% Score =RxT