Putting on a price on your business at its early stage is one of the trickiest things you can do as a business owner, but it is possible. Reece Chowdhry and Frederik Lyng Pedersen at RLC Ventures explain the different ways you can value your business.
As an entrepreneur, it can be hard to put a value on your new startup, especially if the business is at pre-revenue seed stage. At this stage, it can be argued that your business can either progress and become successful or simply die. Hence, to move the business forward you will need to sell something; either the product to your identified customers, the business idea to investors, or both. The valuation process has been widely identified as being a frequent source of friction in investment negotiations and arguably is the root cause of most investment failures. This article focuses on portraying a justifiable valuation to maximise your chances of investment.
Why is the valuation so important?
The first valuation process is an important one, as it’s one of the first signs of success and sets the bar for future investment rounds. If it is too high, investors will think you are greedy and out of touch with the risk associated with investing. Also, an overestimated valuation may result in high expectations for future operations and rounds, eventually resulting in future investment rounds at a lower valuation – a “down-round:. On the other hand, if the first valuation is too low, you can be subject to significant dilution in equity, losing control of your company in succeeding rounds. Therefore, it’s vital to generate a justifiable valuation from the get-go.
‘…Startup valuation is an art rather than a science…’
The challenge, due to the nature of an early-stage startup, is that valuation is often an art rather than an exact science. This is another reason why you should have a realistic valuation from the outset, so to reduce chances of conflict with investors during negotiations. Ultimately, generating alternative scenarios to triangulate a result will help in the long run. Hence, when you are making a valuation, it can be beneficial to use different methods to give credibility to the justification.
The valuation methods…
It can be argued there are two different approaches to valuing a startup: the quantitative corporate financials approach and the qualitative entrepreneurial approach, each highlighting different characteristics.
The quantitative corporate finance valuation methods include: ‘Discounted Cash Flow method’, ‘Multiplier Valuation method’, ‘Venture Capital method’, ‘Net Asset method’, and the ‘Real Options method’. These traditional quantitative valuation methods attempt to value an investment by allocating the present value of future forecasted cash flows. This makes valuing companies quite tricky as there is a general lack of accurate information about any company. The problem is amplified when trying to value a startup as the lack of accurate historical information results in weak assumptions about discount rates, rate of return, growth rates etc. Thus, a combination of quantitative and qualitative analysis is required.
The qualitative entrepreneurial valuation methods include: ‘The Berkus method’, ‘Scorecard Valuation method’, and the ‘Risk Factor Summation method’. The entrepreneurial valuation methods attempt to incorporate non-financial factors which add depth to the existing financial information and outcomes of quantitative methods. Qualitative methods of valuation suggest that instead of using outputs (i.e. cash flows), it would be more effective to base a valuation on inputs (i.e. past experience). Therefore, qualitative methods consider these inputs to value startups which are readily available and are based on the risks that may incur.
Regardless of the approach, however, it is important to remember that there is no universally accepted analytical method. The best process is one that uses multiple valuation methods to determine the value of a startup. Hence, using a multitude of methods with distinguishable strengths is more appropriate as each valuation will focus on a slightly different aspect of the business.
What to consider when valuing your startup?
But what key factors do investors consider when investing in early-stage startups? As investors’ perspectives are different, one should think they invest in different ways too. However, by large there are a few themes which emerge repeatedly:
– Founder / Entrepreneur / Team
– Market / Industry
– Product / Technology
These main themes can be broken down into different factors which are then divided into attributes to describe the different nuances of each theme. This dilution helps to understand how a potential product works and fits in the market as well as testing the suitability of the team. Ultimately, attributes of your startup, (i.e. experience of the co-founders, maturity of industry, stage of product development, early user experience and scalability) should dictate the company’s valuation.
‘…Price is what you pay, value is what you get…’ – Warren Buffet
Once you have made your valuations, it is still important to differentiate between value and price. The price someone is willing to pay might be higher or lower than the actual value of the company. For an investor, this difference might be influenced by investment risk, growth opportunity and time to exit. However, for entrepreneurs psychological bias can emphasise a higher valuation compared to the actual price. As such, the price of a company can be seen as an outcome of negotiations concerning its valuation. The better and more accurate the valuation, the shorter the price negotiation – allowing you to do what an entrepreneur should be doing – running and building your company.
Find out more: RLC Ventures