Ahh startup valuations. It’s a topic that causes lots of angst, raises tons of questions, and definitely gets the emotions blazing. But let’s take a step back. Why are valuations even important? Besides determining things such as the amount of equity you give up for funding and how much value you are able to extract from your company in the long-term, valuations are important for demonstrating how attractive your business is to investors and in showing how you compare with your industry peers.
EGFS Founder and CEO David Ehrenberg and Molly Otter, Chief Investment Officer for Lighter Capital, led a session on How to Increase Your Startup Valuation. Below are some of the key takeaways:
There are 3 main types of valuation:
- 1. Business valuations are based on company price as calculated by cash flows, physical assets, and market sentiment.
- 2. 409a valuations are required by law if your company is privately held and you give employees stock options. While they take into account multiple elements, in practice, they are set by extrapolating the implied value of your company based on any outside funding rounds you’ve raised.
- 3. Startup valuations are what an investor, acquirer, or the public (in an IPO) is willing to pay for your business. They are based on intangibles such as the quality of your founding team, the size of your market opportunity, and how hot the space you are focused on is.
For more details on each of these, read David’s recent piece on the different types of valuations.
Components of Valuation
VCs are looking to make home runs with their investments. Out of ten investments a VC makes:
- five will fail
- two will break even
- one to two will be home runs.
Because of that, VCs place a lot of value on the size of the opportunity.
Here’s another tip: very few VCs are visionaries. Most VCs are “fast followers” who move in herds. That means when it comes to your valuation timing, whether your sector is in or out of favor, really matters.
- Having a previous successful exit will increase your chances not only of getting funding but also of raising it at a higher valuation.
- Select your team carefully. You should always hire deliberately, but if you know you plan to raise equity funding, choose your hires especially carefully. Pick people who don’t just have an area of expertise, but who are also leaders in their chosen field.
- Milestone financing, provided you hit your milestones, increases your startup valuation with each funding round. Pick milestones that matter. They could be around technical development (beta versions or prototypes of your product), customer traction, or team goals but they they should be specific to your business.
- However you define your key milestones, make sure you are thoughtful about setting them. You’ll lose credibility by choosing ones that you can’t hit. Once you’ve identified them, build your budget based on your expected costs to achieve them. That will determine the size of your ask. Always include a 25% fudge factor to account for unexpected speed bumps or delays.
- While traction means different things to different people, investors will always look at your burn rate versus your growth rate. Lighter Capital for instance, looks for burn rates longer than 6 months when it considers extending revenue-based funding to startups.
- Fundraising is a negotiation—the more interested parties you have, the higher your valuation will be. As part of your negotiating strategy, let VCs come up with numbers first; then play investors off each other. Don’t commit to anything until all the information is out there and you know how high a valuation you can get.
The whole concept of dilution—the more you raise, the more equity you give up—means you want to have as high a valuation as possible, but—you need to balance it with your future funding plans so that you don’t arrive at a price that can’t be supported by the market. For good intel on valuation statistics and information, check TechCrunch and Strictly VC.
Do you have questions or advice to share on startup valuations? Share them in the comments section below or contact Early Growth Financial Services for a free 30-minute financial consultation.
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.