Startup valuation basics

Any founder or CEO should know that the valuation of your company is a powerful predictor of future financial success. Here are three main reasons why:  

1. Capital

The amount you can raise from investors will be driven by the valuation assigned to your startup. If they set a low valuation, then it follows that you will have less access to the capital you need to grow your business. Conversely, if the investors assign a high valuation, you may have access to more money than you anticipated.

2. Future Earnings

The current valuation of your company will determine how much money you can expect to make in the future once your startup has begun generating revenue. If the market value exceeds what you are projecting for the future, you can expect to see higher profits.

3. Valuation Upon Exit

If a company or another investor acquires your startup, the price at which it is sold will be driven by the current valuation of your company. The greater the value that has been assigned to your business, the more money investors stand to make once it is sold.

How Do You Put a Valuation On a Startup Company?

Valuing a startup can be tricky. There hasn’t been enough time to generate actual financial results, so you need to rely on best-effort projections to determine your company’s value. Also, startup companies are often valued relative to similar businesses rather than based on a set formula.

There are no hard and fast rules when it comes to valuing a startup or growing business; however, you can use several methods to assess the value of a company, which we’ll discuss below.

What Is The Right Valuation For Your Company?

Startups have different phases they go through as they grow and develop. At the seed stage, where the product has just been designed and is unproven, the valuation will be lower than if you are a fully-fledged business with revenues. Things become more manageable if your startup is in the growth stage of development.

The correct valuation for your company should be fair market value, which is what an investor would reasonably pay to purchase 100% of your company.

The easiest and most common way for investors to determine the proper valuation is by using a multiplier on projected yearly revenue or EBITDA (earnings before interest, taxes, depreciation, and amortization). This method works well if you are at an early stage of business growth and have little to no revenue.

Pre-Money or Post-Money Valuation?

Before you determine the right valuation for your startup, it is important to understand what pre-money and post-money mean. These terms are used to describe how much equity an investor will receive in exchange for their investment. The actual calculations can get complex, but you mostly need to be concerned about which term applies to your company:

Pre-Money:

Pre-money valuation refers to the startup valuation before fundraising. No money has been invented yet. 

Post-Money:

Post-money refers to the pre-money valuation plus the amount of investment capital that is raised.

For example, let’s say your pre-money valuation is $1 million, and you are raising $300,000. This means that your post-money valuation is $1.3 million ($1 million + $300,000).

Different Valuation Methods

There are three different types of valuation methods you can use when determining the proper pre-money valuation for your company:

1) Multiples

With this method, an investor calculates what their investment in the company is worth as a percentage of the overall business.

It is important to note that it is a percentage of the pre-money valuation when you calculate your multiple. For example, let’s say you want to acquire 100% of a company and you are willing to pay a 20x multiple on the pre-money valuation. This means that if your pre-money valuation is $1 million, then you will pay $20 million ($1 million x 20) for the entire company. You multiply the pre-money valuation by the multiple, which will tell you how much your investment grows to after an acquisition or new round of financing.

2) Comparables

To use comparables to determine your company’s valuation, you will need to find similar companies that have been recently acquired or raised a round of financing. You take the post-money valuation of those comparable companies and divide the size of your expected investment by it.

3) Discounted Cash Flow

This method calculates the present value of future cash flows using two main components:

1. a) The discount rate, which is the investor’s expected return on their investment 
2. b) A terminal value, which represents what the startup will be worth at some point in time after the projection period.

The main benefit of the discounted cash flow method is that it accounts for future growth and earnings.

4) Cost-To-Duplicate

With the cost-to-duplicate method, an investor calculates how much it will cost to duplicate your product or service. This approach is a combination of price and profitability. For example, if you are selling a new social media platform that will require $50 million in an up-front investment to develop and then $25 million per year in expenses, then the cost of duplication is $75 million ($50m + $25m).

If you ask for more than that, the investor is better off spending the money to build their own competitor. On the other hand, if you set your asking price at a lower rate than that amount, they will probably be willing to pay that for your company and thus make an offer.

Why Valuation Is Not Everything

Valuation is essential when pitching investors, but it should not be the only deciding factor. If you can show that your startup has the potential to be a market leader or disrupt an industry, then valuation should not matter quite as much. When it comes to startups, realistic growth potential is just as significant.

Valuing a company is crucial when talking to investors, and it can be difficult to choose what valuation to use for your startup company.