Startups all, struggle with a question of what’s called, “valuation.” What is the company worth? To put together a pitch deck, negotiate terms with investors, or just to share with potential team members and advisors what you’re doing, people will want to know what it’s worth now.
Before you take money from a venture capital firm, you’ll agree to a valuation and that valuation will also affect how much of your company you continue to own, depending on how you part with shares of the company in order to raise that capital. Being prepared to discuss your valuation, appreciating what is considered, and understanding how it works, is more important that figuring out a precise value, so let’s explore an easy way to think about valuations.
Cutting to a chase… valuation is in many respects more art than science.
Particularly early, it’s a matter of perspective and opinion. There are some patterns and norms that have emerged over the years, and as founders seek to learn how to make sure they’re at least in the right neighborhood, how do we make sure we’re roughly right?
Accounting for Revenue
That vaunted of startup metrics!
Everyone talks about revenue as if it’s the most important thing in the world. Here’s the trick, a new business, with a known business model, can certainly argue that it should have revenue whereas a “startup” without a known model, frankly can’t. All this talk of revenue is misleading and you should be empowered to reply confidently to an advisor/investor who asks about revenue, “WTF do you mean revenue??“
Here’s how and why.
Revenue actually isn’t typically factored heavily into “startup” valuations because startup means you don’t know the business model yet (you’re still figuring it out); revenue is just an indicator that you can sell something of value… not necessarily create a fundable company.
That is, for example, service based businesses start all the time and drive revenue, heck, place a phone call and you may be able to “start” something right now that has revenue.
That neither a “startup” nor fundable company makes
That fact, is reasonably well conveyed in appreciating innovation vs. service, and then thinking about that difference by stage of your new venture: A pure innovation with no revenue (brand new) is worth what it costs someone else to build it. An invention or a patent. A pure service oriented business, with $20,000 in revenue, years in the making of the business, is worth a slight multiple of that much because people would buying the book of business. An agency, for example. Follow? If all you’ve done is start a service business OR invent something / have an idea, it’s essentially worth *that*
$10k for someone else to build it? It’s worth $10k, no matter what it cost you to get develop the same thing
With revenue, in a pure innovation, clearly that invention is worth something more; what it costs build or license it, TIMES 2.
$10k for someone else to build it… you have $20k in revenue per year = $50k
This is why patents really aren’t worth anything at an early stage… just because you have revenue on the thing, doesn’t mean it’s worth much more than what it is. Revenue x2 OR what it costs to build.
A pure service based business (that agency or development firm) is generally considered to be worth 2-4x revenue. What people would be buying is really only the people and book of business you have… and people (employees) leave so…
$20k in revenue with no innovation = $60k
Tech enabled service businesses can creep that a little higher – 3-5x revenue (presuming the tech and skills in place are worth more in actually growing the business and not being dependent on that team of people). Innovation with service oriented skills (e.g. marketing & sales) is where we start seeing far higher valuations – further varied from that estimation, given the team and market.
Great, so… How do I value a “startup”? Essentially, it’s this…
Tech Enabled Service??
A technology company is an organization that wouldn’t (indeed, couldn’t) exist if it weren’t for technology.
A tech enabled service uses existing tools, platforms, libraries, and frameworks to make a company or a solution it provides more efficient or effective.
Given the above, let’s say have a great team of engineers and marketers and you’ve build something that ticks up into that 3-5x range.
$100k in revenue… it’s worth $500k
But you’re likely in a situation where you don’t really have revenue yet. Apply a matrix such as this.
|Strength of entrepreneur and team||30% weight|
|Product / Tech||15% weight|
|Exit scenarios||10% weight|
|Size of opportunity||10% weight|
|Growth rate||10% weight|
|Marketing & Partnerships||10% weight|
|Need additional investment||5% weight|
|Other (i.e. customer sentiment)||5% weight|
Perhaps you’re seeing that the team, innovation, and marketing related considerations are most important? That’s because they are.
The weighting of each of those considerations provides a means of calculating an estimation of value derived from what you actually have now.
To do that, we add to the matrix a 100% estimation of each. A lower % being bad for you and a higher % being good for you. How do you know what to put? Recall my statement above, “valuation is in many respects more art than science” and how I’ve just referred to it as an estimation.
Be thoughtful, pragmatic, and honest.
What you’re trying to derive is a reasonable and defendable number. This methodology and matrix gives you means of understanding how valuation tends to be worked out, while also arming you with explanations to defend or debate your point of view.
Lacking team that capable team? Call it 80% then, or worse.
Incredibly ideal and experienced team? Maybe score yourself higher and overweight at 110%.
Get the idea? If bad, use a lower % and if good for you, higher. Is Competition stiff? That’s not good. Need additional investment….but that’s a good thing for you? Great, lean in that direction on the %. If it’s bad that you *need* capital and you can’t be successful without…
Let’s update the matrix
|Strength of entrepreneur and team||30% weight||70%|
|Product / Tech||15% weight||90%|
|Exit scenarios||10% weight||110%|
|Size of opportunity||10% weight||100%|
|Growth rate||10% weight||20%|
|Marketing & Partnerships||10% weight||50%|
|Need additional investment||5% weight||80%|
|Other (i.e. customer sentiment)||5% weight||90%|
My third column is our assessment of our startup. To help make the logic clearer, notice, as our example, I’m estimating based one known companies that want to acquire us and that it’s a big opportunity (high scores) but that our growth rate is pretty terrible and our marketing is lacking, evident in both Marketing & Partnership and a softening of the team score.
Our WEIGHTS add up to 100% so if everything is 100%, the impact on our valuation is just that: (see above) what it costs to make, and our revenue (more or less) = what it’s worth right now. But below or above 100% overall, adjusts our value so as to account for other things that matter.
The outcome of my scenario here is 77% (weight * estimation added all together).
Let’s take our $500k estimation from above and now we have $385,000
Yuck. Not happy about that? Think you’re worth more??
See why you’re not? You invested money to build something and you have some revenue, great. But our estimations roll out that you likely can’t compete, aren’t growing, and really aren’t the ideal team, so are you actually worth just what’s on paper OR is someone investing/acquiring you going to have to fix some of those things?
Look at it instead through a more positive estimation to see why it works
|Strength of entrepreneur and team||30% weight||110%|
|Product / Tech||15% weight||90%|
|Exit scenarios||10% weight||120%|
|Size of opportunity||10% weight||140%|
|Growth rate||10% weight||170%|
|Marketing & Partnerships||10% weight||110%|
|Need additional investment||5% weight||90%|
|Other (i.e. customer sentiment)||5% weight||130%|
Great team, lot’s of growth, bigger opportunity, and we know how to develop that, people love it…. 118% impact and our $500k simple estimation is closer to $600k
Keep in mind, this entire point of view and article is largely based on PRE funding (and likely pre revenue); so if the numbers still feel small to you, that’s because they are at that point.
You’re seeking your seed round from here and let’s say that will put $2,000,000 of raw capital into the company. That’s direct value so our basis is now $2,500,000 given the original $500k estimation and $2M in.
The venture capital industry uses terms like pre-money valuation and post-money valuation (I’m not going to get into those here so as to not distract you from the basics to appreciate how it works – you can learn more here if you’d like)
Now, with more capital or value as your basis, obviously a multiplier means a lot more. Armed with some perspective, you can justify that all that you do is worth more than the obvious, even with the capital investment; 118% estimation turns $2.5M “post-money valuation,” into a company arguably heading toward $3,000,000 and more as you go.
There are countless and very involved modeling sheets, basic ways to think about it, and every advisor or investor out there has their opinion of the factors and importance of each. End of the day, the estimations are roughly the same, and what matters most is that you, the founder, are prepared to talk about it. What ends up being debatable is the % assessment of each of the considerations – You say the team is stellar and 120%… they say, “eh… 70%.”
Now you have something to talk about.
Lost in the Weeds
- The Comparable Pricing Method.
- The Scorecard Method.
- The Discounted Cash Flow Method.
- The “Cost to Duplicate” Method.
- The Risk Factor Summation Method.
It’s art as much as science. Or rather, there are norms and reasonable ranges more than precision. Focus on how we think about it, bury in your brain the intentions and considerations behind that, and you’re in great shape to capably talk about startup valuation.