The art and science of valuing your start-up

Key Takeaways

• Comparing the value of similar early-stage businesses is the most basic valuation method.
• Missing the milestones that justify an inflated valuation can have dire consequences.
• There’s no single solution to determine the value of a start-up, so it’s best to consider various methods.

The art and science of valuing your start-up

How do founders work out what their business could be worth?

For established business, it’s a case of crunching the numbers around revenue, cash flow, and growth rate, along with a handful of other financial metrics.

But for start-ups, the valuation process is a little more complex. New businesses at the forefront of the innovation economy may not have any revenue figures, or even a working prototype.

Thankfully, there are a few techniques that can help founders value their business in preparation for negotiations with potential investors.

Valuation techniques: Comparison vs cash

Comparison is the most basic valuation method for start-ups.

The goal is to find a similar business, ideally in the same sector and location, with comparable market size, and use that to estimate what your business might be worth. These comparisons are easy to find: reports that detail the criteria for Seed A, B and up to E level funding are freely available online.

That’s why investors often turn to another key method for valuations – cash.

They reverse engineer a start-up’s post-money valuation based on the amount of cash the founders are looking for, and the ownership stake the investors need to warrant their time and money.

For example, if a founder asks for $4 million, and investors need a 25% ownership stake to justify their involvement, then on paper the company is worth $16 million.

Potential pay out – a key consideration

The potential pay out on offer is also a crucial factor for investors trying to set valuations for early-stage businesses.

Although it’s impossible to accurately predict the value of a business at IPO or on acquisition, investors will sometimes make back-of-the-envelope estimates to calculate what a business could be worth at exit. This potential value is then used to calculate present value based on the investors desired rate of return.

Naturally, these calculations are heavily influenced by the mood in public markets. If a company with a huge valuation fails on their first day of trading, forecasts take a hit.

High valuation, great expectations

It makes sense for founders to try and maximise the value of their business, because it means that investors may be willing to pay more for a slice of it – but this is a double-edged sword.

High valuations come with even higher expectations, and failure to meet the milestones that come with an inflated valuation can have dire consequences.

There are two alternatives. Founders can either choose to postpone valuation decisions until they have real numbers or use an investment contract known as a SAFE.

A SAFE, which stands for Simple Agreement for Future Equity, allows a company to raise money from friends, family or angel investors without making a decision on their valuation. Instead, the SAFE converts to equity at key milestones – like the company successfully raising a round or being sold; points at which there is enough information to calculate an accurate, fair valuation.

Valuation is not an exact science

There’s no one-size-fits-all solution for the valuation of start-ups.

Indicative figures calculated using the methods above can help ease founder and investor uncertainty, but sometimes an educated guess that factors in market conditions is as good as it gets.