If you ever wondered how investors, venture capitalist or seed fund managers decide on early-stage company valuation, we have an answer! One of the most common questions that arise on the Investor panel is: “How do investors value a startup?”. Startup valuation is, in fact, a relative science, and not an exact one. In other words, there is no defined formula that you can follow and draw a conclusion.
The valuation methods to value the early-stage company
Some of the valuation methods you may have heard are the following:
The market forces in the industry are mostly the deciding factor for early-stage company valuation. Specifically, the current value is based on market forces today and on what the future will bring.
Berkus method can be easily explained if we take a box for example. The Berkus Method is a simple and convenient rule of thumb to estimate the value of your box. According to Medium, the starting point is: do you believe that the box can reach $20M in revenue by the fifth year of business?
If the answer is yes then you can look to go against these criteria for building boxes. The criteria you need to consider are sound idea, prototype, and quality management, team. Also, you should consider your go-to-market strategy and last but not least your product rollout.
Risk factor method is based on a pre-money valuation. Pre-money valuation varies with the economy and with the competitive environment for startup ventures within a region.
Scorecard Method is to compare the target company to your perception of similar deals done in your region, considering 6 criteria: Management (30%), Size of opportunity (25%), Product or Service (10%), Sales channels (10%), Stage of business (10%) and Other factors (15%).
We’ve provided you with the links to additional information on each of these valuation methods. Therefore, you can learn more details about these methods.
When an early-stage investor is trying to determine whether to make an investment in a company he estimates what the likely exit size will be for a company of your type and within the industry in which it plays.
Moreover, investors decide how much return on investment he will need to achieve relative to the amount of money he put into the company throughout the company’s lifetime.
This can be a very hard decision when you don’t know how long it will take a company to exit. Also, how many rounds of cash it will need, and how much equity the founders will let you have in order to meet your goals.
Effectively, VCs, in addition to having a pulse of what is going on in the market, have financial models which, like any other financial analyst trying to predict the future within the context of a portfolio. Based on the assumptions investors will decide how much cash they need now.
Find a 10x multiple for cash-on-cash returns is what every investor wants from an early stage venture deal, but of course, the reality is more complex as different levels of risk.
Investors need to incorporate assumptions about how much more money your company will require, and thus how much dilution they will take provided.
We’ve established how market and industry trends can dictate the value fo your company. However, there are some key factors you should consider as well. An investor is willing to pay more for your company if you are in the hot sector. If your management team are professionals in this industry. Lastly, a huge asset to your company is your product and you have traction from customers. The most convincing story you can share with an investor is your customer testimonial.
Early-stage company tips
Gather information from startups in your sector about what similar deals are being priced at. Also, consider the amounts of recent exits that can affect the company valuation. However, this process is not an easy task for your early-stage company. Consider talking to an advisor in private equity and venture capital to help you get easier through this process.