Startup valuation is a recurring subject among entrepreneurs willing to raise capital funds from investors. That’s of course comprehensible, because entrepreneurs work hard to build great businesses, so they don’t really want to drop too much of their equity (or at least not much than necessary).
However, for a lot of startups, raising private equity is a necessity to fund their beginning and growth. That means “losing capital” is also a requirement to build and share a great venture … and maybe great profits at the end.
A small stake of a large cake may be greater than a large stake of a small cake.
When raising capital, remember that somehow entrepreneurs and investors are both buying and selling :
- An entrepreneur sell a part of his equity as an opportunity for investors to make a potential great return on investment
- An entrepreneurs also buy capital funds with his equity from investors to build and grow his startup
This ambivalent relation is central in startup valuation, because in the end this is the old “supply-demand balance” that will really define the value of any startup. If a lot of investors are willing to invest in one startup, its value may increase. Inversely, if no investor are interested in investing in a startup, its value is close to 0. Hence, it’s always better for a startup to have more than one investor inclined to invest. Yet, remember that investors are meeting many entrepreneurs with great startups project every day, so they will generally prefer to miss an investment opportunity rather than paying a valuation that they would consider as too high.
Now, let’s get deeper into how investors value startups!
Valuation comes after a whole startup project analysis
First, it’s really important to remind that investors won’t start their analysis on a startup by the valuation issue. Investors will consider the valuation point, only if they are really interested in investing in the project. Hence, investors will always work on their due diligence before. They want to be convinced of the startup potential to meet success before going further in the deal bargaining. So, it’s not necessary to show an arbitrary valuation that you have calculated during the first meetings with investors.
Sorry, we won’t get into the whole process of an investor due diligence here, because it’s not the topic of this post (this is a good subject for a next post, though!).
If investors are interested in a startup, they will then start to discuss the valuation and the whole deal structuring.
Investors expect huge return on investment to pay risk
Investing in startups is really risky because most startups fail to succeed (either they crash or they just survive without reaching their early high expectations).
Investors are looking for high return on investment when they invest in startups because they need to pay the risk they take. An early-stage investor usually expect to have 1 to 3 great successes for about 10 investments, while the 7 to 9 other startups funded won’t pay back him much… That’s why investors are expecting a return on investment around 5 to 10 times for their investments in each startup : if they invest 1M€, they want to gain a potential 10M€ return (or more) in a 5 to 7 years period. Investors select only startups that are able to generate sufficient growth and profits. Otherwise, they won’t invest.
So, investors will value startups according to such a return on investment they expect.
Startups value depend on future potential profits
Startup don’t value much in the beginning with conventional financial formulas (assets valuation, discounted cash flows, multiples …), because their financial results are usually really poor (no or low revenues, high losses, …).
Instead, startups may value something because of their potential revenues and profits they may generate in few years. That’s what investors will look at. Indeed, they will try to estimate the potential value of the startup in a next future (5 to 7 years) by using convential financial formulas with future financial performances forecasted. Investors are likely to use a middle case scenario for these financial forecasts, so they may challenge numbers given by the entrepreneur. For startup valuation, investors will generally use a “Multiple formula” to estimate the future valuation, because it’s the simplest method. It’s not necessary to use more complicated formula like the “Discounted Cash Flow” because financial forecasts of startups are not sufficiently accurate. So, it’s rather better to stay simple… The Mulitple formula is simply based on a multiple of a financial perfomance as revenues, EBITDA or profits. The multiple and the financial ratio used by investors highly depend on the sector and are usually based on the lastest valuations from other recent deals. If you want to calculate the potential future value of your startup, try to find the common multiple and ratio used in your sector recently.
When investors have calculated the future potential valuation of the startup, they simply divide it by the multiple of return on investment they expect to get the current “post-money” valuation they are willing to pay. This “post-money” valuation is the value of the startup after fundraising. Investors will then deduct funds they are investing to get the “pre-money” valuation (the startup value before investing).
Startup value = (Startup value in 5/7 years) / (Multiple of return on investment by investors) – Funds invested
Example for a SaaS startup : Let’s say, an entrepreneur wants to raise a 0.5M$ and expects a forecast of 10M$ revenues for a 3M$ of EBITDA in 5 years for his startup. Let’s say investors agree on these hypotheses. If they use a 2x multiple of revenues, it will give a potential future valuation of 20M€. If they use a 8x multiple of EBITDA, it will give a potential future valuation of 24M€. So, investors may accept an average and hypothetical valuation of 22M€ in 5 years. Because they expect a 10 time return on investment, they will then value today the startup 2.2M€ post-money. This means that the “pre-money” valuation would be 1.7M€. Investors may take around 22.7% of the startup equity.
Case of multiple funding rounds
If a startup plan to raise multiple funding rounds, investors are likely to take into account the dilution from the next rounds to value the current “pre-money”. Indeed, early-stage investors will be diluted by these next rounds, so if they want to reach their potential 5 to 10 times return on investment, they need to take a higher stake of equity for the same amount invested.
In our previous example, let’s say that the entrepreneur finally forecasted another 3M€ round to reach his financial hypotheses in 5 to 7 years. Investors will then probably ask for a lower “pre-money” valuation. Hence, if next investors take a 30% of the equity, historical investors will be diluted to 17.5% of the equity. That means that if the startup is valuated 22M€ in 5 years, early-stage investors may retrieve “only” a 7.7 multiple (instead of 10). So, investors may value the startup less, to get enough equity (32.4%) on the first round to absorb the dilution on the next round so they can have a their 22.7% of equity in 5 years to make their 10 times return on investments.
In this case, the valuation of the startup in 5 to 7 years need also to take into account the positive impact of successive rounds in the financial forecast (more money should help to reach better objectives).
Keep the founders team motivated
Investors need also to make sure that the “founders team” remain super motivated, even after multiple rounds dilution. Indeed, a startup is a small business relying a lot on the founders hard work, knowledge and experience. Without this team the cash of investors is not sufficient to meet success. This is the founders team that creates the value with the help of investors cash. Hence, a good investor will always be careful in negociating a win-win deal with the founders team, instead of trying to crush them. A founder team motivated with the potential long term value of the startup will always be a better defender of investors interests than a top management only motivated with high salaries…
So, beyond hard calculation to value a startup, investors make a strong case of soft parameters when negociating a deal.
Valuation is a small part of a fundraising deal
Finally, it’s important to underline the fact that the valuation issue is a small part of a fundraising negociation. It’s of course important to try to find a fair value that is accepted by both investors and founders. However, this is only the visible part of the iceberg… A fundraising will usually also include many other really important clauses : Full/Average Ratchet, Liquidity preference, Tag/drag along, Bad/Good leavers, relution terms, …
Especially, some of these clauses can modify the initial valuation :
- Relution of investors (Ratchet, Liquidity preference, …)
- Relution of founders (Stock options, share of investors super profit, …)
To conclude, the valuation of a startup is estimated from the potential of the startup before closing a deal, but important clauses will ajust the value along the stakeholding of investors depending on the real business perfomance compared to the original forecast.
As you just see in this article, the financial forecast take a central place in calculating a startup valuation. This why it’s really important to build a steady and relevant financial plan when fundraising from early-stage investors. If you want to build a great financial plan, have a look to our other articles :
- 2 complementary ways to create a financial plan
- How to forecast startup revenue and growth ?
- Startup cash & treasury management with financial planning
- 80/20, a golden rule in financial planning for startup
Good luck with your fundraising!