Startup valuations are not always intuitive. They're full of nuances and based on elements that aren't seen in other markets. Simply having a better plan can improve your valuations and help you build a better startup.
When you apply the linear logic of markets to startups, it simply breaks down. There are many ways to express the apparent lack of rhyme or reason, but here are two startup valuation examples:
Startup A has two founders, no product and no revenue. They raise money on a $10 million valuation. Startup B, on the other hand, has a product, traction, and $1 million revenue. They raise money on a $5 million valuation. This sounds like nonsense and you might be wondering how to value a startup with no revenue like Startup A.
Valuing a pre-revenue startup can be challenging. Mathematically, you only need two things to determine valuation: (1) the amount of money you’re taking in, and (2) the amount of equity you’re giving away.
If you double the amount you’re taking in, you should double the amount you’re giving up, right? Wrong.
What is a good valuation for a startup?
Determining a good valuation for a startup is complex. It depends on a number of factors, such as the industry, the startup's growth potential, the caliber of its founding team, its competitive landscape, and the amount of funding it raises. Startup valuations can vary widely, even within the same industry or sector.
Ultimately, a good valuation accurately reflects the startup's potential for success and fairly compensates both founders and investors. It is necessary to work with experienced investors and advisors to establish a fair and appropriate valuation for your startup.
The rhyme and reason behind startup valuations
There are several things to know about both the opportunity of startups, and the investors who fund them, for these mind-bending valuation examples to start making sense.
1. Tech startup valuations are based on a secret
The entire private tech startup market is premised on opportunities that other people aren't able to see. None of the normal questions for determining valuation of a startup—market, revenue, comparables—are relevant to startups because a private tech startup is based on a secret. Only founders, employees, customers, and investors are privy to this info.
2. Opportunities are more valuable to some than others
Opportunities are not created equal and do not have a static value. It’s a foundational premise of the industry that many people miss when they scoff at acquisition prices.
Consider this example of startup acquisition valuation. Facebook bought WhatsApp for $17 billion when the latter had no revenue. On the surface, this is insanity. But dig deeper into the value to three parties:
To a retiree that wants a dividend on revenue, WhatsApp is nearly worthless to them.
If McDonald's bought WhatsApp, they could at least do something with it. Maybe use the technology to send messages to everyone when the orders are ready. If they’re lucky, it drives a 1% uptick in sales. It’s not worth very much to them.
Facebook, however, can do a lot more with WhatsApp. Facebook is expanding its messaging capabilities and trying to drive usage among younger generations. They have a 10-digit number of users and a sophisticated ad network that could be deployed at any time. They also have a future to protect, and that future requires continued ownership of communication channels. Protecting their ecosystem is very valuable to them.
Another example is Amazon's acquisition of Twitch. Amazon ended up rolling the streaming company into a cross-sell of its Amazon Prime offering.
In tech, there are opportunities to solve problems that are really valuable to certain people. Remember, secrets may only be visible to a small number of stakeholders who have been exposed to them. Don’t mistake that for lack of value.
3. Any startup worth venture capital will likely raise a lot of money
Startups that are onto a special opportunity almost always need cash to capture that opportunity. For a non-tech example, let’s say you open a shop with a breakthrough sandwich that no one has ever seen. Everyone loves it.
You open your shop and sell out instantly. That’s well and good, but you feel constrained. You can only sell 100 sandwiches. You earn $100 net profit, which you plow back into the business. If you continue to scale this way, you can grow without funding, but it’s slow and incremental growth.
The problem is that maybe you can sell sandwiches all day long: not just 100 in 10 minutes, but thousands in a few hours. Knowing this, you’re not going to wait to get that cash. You want it upfront, to grow all at once. Let’s buy the next month’s worth of sandwich materials and grow this thing.
That is the situation of every successful tech startup. If you’ve found a truly great opportunity, then demand is so high you can barely keep up. Those are the startups investors want.
If you can grow a startup from your own profits, you probably either don’t have a venture capital-scale opportunity or are leaving serious opportunities on the table by limiting your growth, and exposing yourself to competitors who can grab early market share.
How to calculate valuation of a startup?
The following are the common startup valuation methods:
- The Berkus Method: To determine valuations specifically for pre-revenue startups.
- Comparable transactions method: To analyze the prices paid for similar companies in similar industries.
- Scorecard valuation method: To assign a score to various factors that impact a startup’s success, including the size of the market opportunity and the experience of the management team.
- Cost-to-duplicate approach: To evaluate how much it would cost to recreate the startup from scratch.
- Risk factor summation method: To assess different risk factors associated with a startup, such as competition and regulatory risk.
- Discounted cash flow method: To calculate the future cash flows of a startup and discounting them back to their present value.
- Venture capital method: To estimate the expected return on investment for a venture capitalist investing in a startup.
- Book value method: To measure the net worth of the startup by subtracting its liabilities from its assets.
How to calculate valuation based on investment?
If an investor offers $1 million for 25% of a business, this means:
- 25% of the business is worth $1 million
- $1 million x 4 = $4 million post-money valuation
- $4 million - $1 million = $3 million pre-money valuation
But if you want that investor to double their investment, the formula collapses. Maybe they really like your startup and want to invest $2-$3 million. Not only will they not ask for 50% or 75% of your startup, but they also shouldn’t even accept it.
There are two variables in startup investing: investment capital and equity. And there are two broad categorizations of investors: angels and venture capitalists.
Angel investors vs venture capitalists
Angel investors are using their own money to write smaller checks. If you’re raising $1 million, an angel may or may not have it. They may not be overly flexible here. But the other side of the coin, equity, is where they can be flexible. They might only have $50,000 or $100,000, but they can be flexible in the amount of equity they take because they’re not accountable to anyone.
If they believe in you and it makes sense to them, you may be able to negotiate it down. Granted, some angels are committed to a specific equity strategy and won’t budge. But it’s worth finding out. The takeaway: Angel investors can be flexible on equity, but have limited capital.
Venture capitalists are a different story. They are investing other people’s money; namely that of their limited partners, who may be insurance companies, endowments or retirement plans. VCs are responsible and accountable to their limited partners. They have a business model they must stick to; if they deviate, limited partners won’t trust them and the fund dries up.
Because of this, VCs are not generally as flexible on equity. In a Series A round, they will usually ask for 15-30%. You will not get them to budge too far outside this range, but you can ask for more money. The takeaway: VCs aren’t very flexible on equity, but they can give you a lot more money.
VCs ask for 15-30% because they are searching for opportunities that will skyrocket. Knowing that, there are a few underlying assumptions that drive their business model.
How do venture capital value startups?
The term "venture model" equates to grow, fast. If you don’t have a formula that you can pour money on to grow rapidly, VC may not be right for you. Since the secrets of startups are hard to interpret, VCs place a lot of bets, including many that fail. The power laws of startup investment mean that they don’t want you to grow solidly, or even really well. It needs to be explosive growth.
VCs also know they’ll get diluted. Since high-growth companies need capital to scale, this round won’t be the last. You might raise one, two, three or more times. This is how dilution works in venture capital. For this opportunity to be worth their time, projecting for dilution, it’s often hard for them to accept less than about 15%.
VCs also need you to stay motivated. For a startup to overcome the competition, successfully iterate its product, and grow, you need a motivated founder. Most successful founders are driven by an internal fire and the passion to solve a problem, but VCs want to ensure that founders also have sufficient financial light at the end of the proverbial tunnel. They don’t want to make a significant investment in a startup where the founder gets diluted out of being motivated.
What to do about it? Dream bigger.
Valuations are based on opportunities no one else sees, which are more valuable to some than others. A startup’s value is not linear, nor is the investment-to-equity ratio. Angels are constrained by cash, VCs are constrained by equity requirements. What do you do with all this? Have a bigger plan.
If they can write a $5 million check, the VC can probably write a $10 million check. $10 million could be $20 million. When you’re networking and talking to investors about what you’d do with $1 million, also have a plan of what you’d do with $10 million.
Not only can VCs write a bigger check—they want to. Think about it from their perspective. It’s really hard for VCs to find a company that can take $5 million and turn it into $100 million. When a VC does find it, it’s hard for them to get in on the action because a lot of VCs are competing to make the investment.
As a VC, once you do find that startup with the ideal growth potential, you want to deploy as much capital as possible. Your limited partners are expecting you to take $X and turn it into $Y. The last thing you want to do is write a small check and start that process all over again.
Increase startup valuation by thinking more ambitiously
If the investor’s already talking to you about cutting a $5 million check, keep in mind that they are more than capable of giving you $10 million. That difference almost doubles your startup valuation. Instead of $5 million for 20%, you can probably raise $10 million for 25% or even 30%, but they’re not going to ask for 50%. Just remember, you need a great plan that shows you can deploy the capital effectively in about an 18-month period.
The value of an ambitious venture capital business plan
Plans are valuable. A great venture capital business plan can already put you in a better position to dethrone or outpace the competition.
Think again in terms of the VC. They’re wondering how much money you can deploy effectively and to essentially double the valuation in 18 months. A bigger, better plan shows the opportunity for greater ambitions and bigger growth — and that’s what VCs are interested in.
“At the very beginning of Y Combinator, we encourage more ambition,” Sam Altman has noted. “The potential of a big, bold impact is critical to attracting people to your mission down the road. If you start a company that people won’t get passionate about if it’s successful, you’ll run into problems scaling.”
Once you can create a solid business plan to be able to execute on higher ambitions, you can get VCs—and talent—more excited. Venture-funded startups are chasing huge opportunities where time and cash are the biggest constraints. When you find an opportunity, prove an initial model, and need funds to grow, don’t be afraid to plan for more capital. This means a bigger round and higher valuation for your startup.
No matter how much money you raise in your Series A, your post-valuation is usually going to be about five times that. If you raise $20 million, it will likely be close to a pre-money $80 million and post-money $100 million valuation. When you’re preparing for your Series A, have an ambitious plan, but also be ready with an extra-audacious plan that could change the fortunes of your startup.
LTSE Equity is a fully-featured cap table management tool that helps startups manage and plan equity.
Disclaimer: LTSE is neither a law firm nor a provider of legal advice. Before making decisions on matters covered by this post, readers should consult their legal adviser.