Posted by Early Growth
January 18, 2013 | 5-minute read (964 words)
I’ve already addressed formal valuation for startups in previous posts: Generating Your 409A Valuation and Calculating Your Equity Valuation. Now I’d like to look at how a potential investor determines your company valuation. In other words, how can you figure out how much an investor will be willing to pay for your company?
Of course, value, like beauty, is in the eye of the beholder, so it’s kind of tricky to pin down a definitive number. In reality, your company valuation is whatever investors would be willing to pay. It’s a pretty simple equation, in some ways: If there is a demand and your company satisfies the demand, your valuation will be high.
But, of course, it’s much more complicated than that. Investors take into account a wide variety of factors in their process of pinning a price on your company.
In my experience, I’ve seen that there are seven main factors that investors consider in determining valuation:
1. The Market. This is the big one, of course: market is the most practical determinant of valuation. If your company is in a hot market, lucky you! If your company is in a depressed industry, then you may not be so lucky, no matter how much promise your startup shows otherwise, or how successful you’ve already been. Potential investors look at current trends in your market, identify similar companies, and then gauge your potential valuation against what your competitors are receiving in valuation.
2. Market Size. VCs like to make bets on companies that are in a very large market. This is no surprise: they most value those companies that have the potential to go really big. Investors will give much thought to your potential growth curve, that is, how quickly you will be able to capture the market. Certain types of business grow more slowly based on market potential and their ability to quickly reach their market. Investors like companies that have already laid down a foundation for quick growth, such as establishing essential partner relationships. The higher the growth projection, the better.
Contact Early Growth Financial Services for help with financial projections.
3. Founding Team. If some of your founding team members already have a proven track record (particularly in your existing line of business), your company valuation will likely be much higher, based on the promise of a repeated success. Serial entrepreneurs with impressive track records in any industry are likely to be well-known and respected by the the investment community, and garner higher valuations accordingly.
4. Competition. While investors are busy assessing the market, and measuring the valuation of your competitors, they are getting a broad view of the competitive landscape. This information is used to assess how many direct competitors you have, how tough your competition will be, and any barriers of entry. Basically, they are assessing whether or not you will be able to measure up and beat the competition. If you have “first mover” advantage, with a potential lead on your competition, you should make sure investors are aware of this.
5. Funding Size. Investors are very interested in how much money will be required. We have seen a trend wherein VCs are looking for companies with smaller and smaller capitalization needs. This is yet another argument for milestone funding. Instead of trying to secure a large amount of funding, consider milestone raises: raising the amount you need (plus a little cushion) to achieve a milestone and get you to the next one.
6. Timing. Timing, like economic conditions, is somewhat out of your control, but it plays an important role in valuation. As the cliche goes, you want to strike while the iron is hot. There are advantages and disadvantages to being early to market. Do your due diligence of the market place and try to time accordingly.
In terms of “timing,” investors also look at time to exit. When a potential investor is determining valuation, he gauges your likely exit size, based on your industry and company type. Then he uses this assessment to determine how much equity he needs to achieve his ROI goal.
7. Current Capitalization. Funding is a cycle. That is, how well-funded your company is from the start factors into its future valuation determination. Once you have funding (and a solid business plan to execute on), a higher valuation is justified. This can be a bit frustrating—“so I need to have funding to get funding?” Yes. But, it’s important to note that there are things you can do to get in the game. Maybe you can get a seed round from family and friends before seeking out a larger VC round. Or, depending on your concept, crowdfunding might get your foot in the door.
Without a doubt, market forces beyond your control have a great impact on your valuation. But rather than obsess over these factors, take matters into your own hands. Ultimately, the best thing you can do to increase your valuation is to create a stellar product/service that satisfies customer needs. If you have something that people want and will pay for, your valuation will naturally increase and investors will be more than happy to fund your vision.
Questions about valuation? Let us know in comments below or contact Early Growth Financial Services.
David Ehrenberg is the founder and CEO of Early Growth Financial Services, a financial services firm providing a complete suite of financial and accounting services to companies at every stage of the development process. He's a financial expert and startup mentor, whose passion is helping businesses focus on what they do best. Follow David @EarlyGrowthFS.