The majority of entrepreneurs do not know what to start with when setting the company valuation. Often the value of the company appears to be too high because entrepreneurs are too optimistic about the future of their startup. However, setting a very high valuation of your business, can make it extremely hard for you to raise funds and to deliver on expectations.
For very young companies valuation is not a definite answer, but a matter of assumptions and negotiations. It is also a relative analysis, which requires weighing multiple quantitative and qualitative, tangible and intangible factors, such as:
- stage of development;
- team composition;
- market size;
- industry values;
- startup ecosystem;
- tangible and intangible assets;
- future financing;
- the state of economy;
- terms of investment;
- traction and growth rates;
- financial forecast: revenue and profit;
- unit economics.
At the end, your company is worth the amount the market is ready to pay. That is why considering the factors above may help you estimate an approximate demand on your shares and assess your attractiveness in the eyes of investors.
Stage of development: if you have recently started the company, no matter how great your business idea is, the market will be ready to pay less for your company than for a business with existing customers, sales and well-established partnerships.
To identify your company's stage of development, ask yourself the following questions:
Do you have a business idea in mind, a tested prototype or a product/service in the market? Do you have any existing customers or you have only a clear understanding of your target users? How many employees do you have? Do you have a well-defined business model and well-developed supply/distribution channels? Are there any revenues in place and/or a positive cash flow?
Team composition: a great team is nearly the most important factor in the company valuation. The team members with relevant competences and a positive track record will be more likely to build a successful company. The most important fact to consider is whether you have a complete team.
The more complete and qualitative your team is, the higher valuation you can set. It is also considered that a strong management team combined with a weaker business plan is better that the opposite.
Mainly, you should have at least two complementary competences in place: people that can build and people that can sell. If you have both kinds of competences, you will be able to adjust your business model to any situation despite of how dynamic your market is.
The valuation is also adjusted to such factors as the relevance of education acquired by the team members, the level of degree and the reputation of the educational institution, relevance of the work experience, the vast track record of relevant accomplishments and the size of the network of professionals and potential investors relevant for the industry where the company operates.
Market size: If you operate in a large market, on average, the probability to generate a return on investments in a shorter amount of time is higher.
To determine the size of your market decide on who your target customers are and how many of them are in your market segment. Then make a realistic assumption on the share of potential customers who might actually purchase your product or service at least once (a so-called, penetration rate). Finally, multiply the above factors on the average price of your product/service.
Market size = Penetration rate x Target customers x Average price
Pay attention to the penetration rate as it might be higher if you have any legal allowances and lower if the business is limited by the relevant legislation and faces high competition. Therefore, the bigger the market is, the higher is the potential valuation of your company and vice versa.
* Do not think broad at once, start with the market segment, which you pursue at the moment of funding and in the nearest time period after that.
Industry values: valuation of your company is to a large extent dependent on the market forces of the industry or sector you operate in. Consider the relationships between supply and demand in your sector. Figure out how often company exits take place and how big they are. How many successful investment rounds took place in your industry lately, whether investors are starving to become shareholders in your industry, whether they are willing to pay a premium for the opportunity to invest.
Obviously, if your industry is “hot”, like Fintech or Biotechnology, investors are likely to agree on a higher valuation for your company. A company with similar characteristics and metrics but in a less attractive industry will often be worth less.
On the other hand, if you operate in a depressed market with low future potential, but still are able to reassure investors in your ability to positively shift the current trends, you can account for a higher valuation.
Startup ecosystem: Startup ecosystems are formed by people (entrepreneurs, mentors, advisors, investors, researches and entrepreneurial-minded people), different types of companies (any other startups, competitors, distributors and supplies) and organizations ( incubators, accelerators, universities, coworking spaces, funding providers, media, network spaces, event organizers). If your company is founded in a well-established startup eco-system, you are more likely to set a higher valuation.
*Coming from a Silicon valley area would make a difference. However, London, Berlin, Singapore and Paris are also included in the 20 most developed startup ecosystems worldwide. You can even compare ecosystems locally in the borders of your country.
Comparables: check out similar companies. In particular, you might find a company similar to yours that have also run a crowdfunding project. In this case, check how much money it raised, who were the investors, how high was their valuation, what percentage of shares they offer for sale, what stage of development the company is in and what were its past deals.
You may also try to dig into more tangible information and check the sales of similar companies. Similarity or comparability may be assessed either industry-wise or geographically.
Exit: the closer you are to exit, the higher is the industry’s exit value and its growth, and the higher valuation of your company can be. To account for the exit factor in your valuation, find information on the typical form and size of exit in your industry and the value of exit growth in your industry. In relation to your company, you might want to consider whether you have a well-defined exit strategy and the number of years left to exit.
Tangible and intangible assets: what equipment do you own? What technology? What inventory?Is your business idea scalable enough? Do you have the right competences around you? Are there any established partnerships? Have you received any patents, awards?
Everything can come to a value. The more tangible and intangible assets you have, the higher your valuation will be.
Future Financing: consider how many funding rounds you are likely to run in future. The more funding rounds you are going to run, the less equity you should sell in the beginning and the lower valuation you should set. Nothing is worth than running a down round next time, meaning, setting a lower valuation in the consequent rounds.
The general economy: your company valuation is inevitably related to the market forces and the general state of the economy. In particular, investment activities tend to be lower during the recession periods. Consequently, it will result in a lower company valuation compared to the valuation in the periods of economic booms.
Terms of investment: there is more to a financing round then just the valuation. The deal terms are equally important. You may be able to raise money at a higher valuation but if the deal terms are not good (i.e. liquidation preference shares at a high multiple ahead of you), you will be better off taking the investment at a lower valuation.
The value of your company is adjusted not only to the current state of your business but also by future projections.
Traction and Growth rates: if you are experiencing high traction and high growth rates in the number of users, customers or sales, you may aim at a higher valuation. Positive growth projections inevitably signal that your business might have a big potential and might generate a substantial return on investment.
Financial forecasts - Revenue: Even though it is very difficult to make revenue projects, it is necessary for justifying your valuation. For example, if you're running a food store, your valuation and financial projections will likely be lower than if you're running a firm in biotechnology industry.
You can also calculate multiples in your industry and form valuation by multiplying the multiples on revenue. You can use plenty of multiples like enterprise value/sales, enterprise value/number of clicks, enterprise value/number of users and etc. Try to find the relevant one for you particular business and multiply it by your revenue. It will give a rough indication of your company valuation.
Financial forecasts - Profit: being profitable is a clear advantage for you company valuation. If a startup does not have a profit yet, the trick in estimating the valuation is to focus on future. First, determine how many years it will take to be profitable. A business with a long road to profitability will usually be worth less than the one with a quick path to profitability. Next, determine at how much the comparable companies have been valued when they reached profitability.
However, do not forget to adjust your expectation of profitability to the likelihood of success, the time frame to exit and the quality of the management team relevant for your company.
You can also make projections for your future profits times multiple used in the industry you operate in. However, keep in mind that the profit will vary depending on the changing price strategy, competition and market conditions.
Unit economics: a good way to justify your future profitability and motivate the chosen valuation is to provide the projections of unit economics. These metrics show your revenues and costs on a per unit basis. Interesting metrics to look at are revenue per user, revenue generated by a user during the entire usage of the product/service (Life-time value, LTV), and the costs of acquiring the user (Cost per aquisition, CPA).
For the matter of valuation, it might be interesting to calculate the difference between LTV and CPA and to estimate the number of years until their break-even. So far LTV exceeds CPA the business is viable. If you can find new ways to increase the amount of money spent by each user, increase your user retention or decrease CPA (by, for example, a more active online advertising and other marketing tools), you valuation might be higher than the valuation of comparable companies.
To summarise, despite of your financials, the value of a startup will always be adjusted upwards or downwards by such factors as the strength of the management team, location of the business, the state of industry, market and economy.