How will you evaluate a company’s value? Especially an organization, which you have kick-started a month, back. Start-up valuation is an art which you need to perform if you are expecting money from investors. This strategy helps to take your business to the next level. It is no rocket science. Adopting some simple steps helps you to easily assess the value of your start-up.
Why start-up valuation is so important?
As an entrepreneur giving significance to start-up valuation will help you to determine how much of your company‘s shares you would be giving to the investors in exchange for their capital. The valuation factors depend on the seed capital or the initial investment you get. In the starting stages, your company’s value would be near zero; however the investment has to be a lot more than that.
Before going ahead, a sneak-peak into some of the glossaries & formulas as it will help you to understand things in a much better manner.
Pre-Money = the value of your start-up (company) as of now
Post-Money = the value of your start-up (company) once your investors put their money in
1. Pre-money valuation
Take for instance if you are seeking a seed investment of $100,000 by giving 10% of your company’s shares, then your start-up’s pre-money valuation would be $1 million. This does not signify that you are at present worth $1 million. In early stages, the valuation does not display your company’s true value it is all about how much the investor will get by investing in your company. For convenience, let us assume a 10x multiple for cash on cash return is what each investor expect from an early stage venture deal.
2. Decide on your investment
If you plan to seek a seed capital of $100,000 to run your business for the next 18 months, your investors will not have reasons to negotiate on this number, as you will clearly indicate that this the minimum investment you need to run the business. You will not be able to perform, if you are not getting the required amount, and your investors do not want that to happen. Hence let’s assume $100,000 as the amount set for investment.
3. Giving your company equity
Now you need to work out how much percentage of company shares you plan to give to the investors. If you are seeking $100,000 then it is relatively a small amount, based on your evaluation, you would be possibly offering 5-20%. If you intend to get a huge seed capital, then offering 30% of the company would be a reasonable one. Giving more than 30% of, company shares will leave you with only less equity for the investors, when you plan to go for the next round of investment. Higher the investment, the more you need to give your company’s shares.
When $100,000 is set as the seed investment, the initial equities would be 5% to 20%. This places pre-money valuation around $0.5 to $2 million, if you intend to give 5% to 20% of your company’s shares respectively.
4. Factors determining the range
The following 2 parameters decide the equity range.
- The equity range is based on the investors assessing companies, similar to yours.
- How smart you would be able to influence your investors.
Others factors that determines valuation
Traction is a significant factor that decides your start-up valuation. Having a good number of users serves as a tangible proof for your investors. Getting as much as 100,000 users, in a short span of 6 to 8 months of your start-up launch, helps you get an effortless investment of up to $1 million. The quicker you grow, the worthier you are.
Entrepreneur having reputation are capable of having a good influence over the investors. These individuals without any traction or any prior success are able to receive investments. Two instances help you to understand the scenario in a better way. Instagram founder, Kevin Systrom was able to mobilize 500k in a seed funding for his prototype known as Brnb, during that time. The only experience Kevin had was a 2 year stint with Google as employee, and not any other previous entrepreneurial success. The same goes with Ben Silbermann, Pinterest founder. In these 2 entrepreneur cases, their individual VCs said that they pursued their instincts.
Revenue is another factor that helps the investors to value your start-up. A customer start-up valuation decreases, if it generates revenue. This is because when you charge your customer, your growth rate slows down. Slow growth signifies less revenue in the longer run, hence low valuation.
8. Distribution channels
Although your product may be in the initial stages, you may have a distribution channel already. For instance you may have sold some floor mats in a locality where almost each resident would be an employee of a VC firm. Likewise you may have run a facebook page for dog photos and may have likes, in millions. Now your face book page can serve as a distribution channel for your pet care business.
It is vital to comprehend what the investors will be thinking, when you put your business across the table.
9. Selling factor
The first factor, your investor will consider is exit, how much your start-up will sell for many years down the line. Since IPOs are very uncommon, it is difficult to forecast which company will perform. To be on a positive note, let’s say your start-up will do business for $1 billion.
The next step the investors will consider is how much investment is required for a startup to grow to a stage, when somebody can purchase it for $1billion. In the case of Instagram, the founder received 56 million as funding. This will assist you to know how much amount the investors will get in the end. $ 1billion- 56 million =$940 million. This is the value that instagram produced. If there is any debts and operational costs involved that will also be taken into account and deducted. Hence on the day Facebook bought Instragram, people who were involved in it together made $940 million.
10. Option pool
Option pool is stocks that are kept aside for your future workers. Option pool serves as sufficient motive to pull talent. In general, you can set your option pool somewhere in between 10% to 20%. The larger the option pool, the lesser will be your start-up valuation. Since option pool is your future employees’ value, something which you do not possess yet. The option pool’s value is subtracted from your start-up valuation.
This is how it is calculated. Let us assume $4m as your pre-money valuation and $1m is your new funding. So you now have $5m as post money valuation. Your VC in his “term sheet”, will say that he desires a completely diluted 15% option pool from your pre-valuation money. This indicates that you need to take off 15% from $5million (post money valuation), and that comes to $750,000. This amount should be subtracted from your pre-money valuation i.e., $4m-$750000 =$3.25 million. Hence $3.25 million would be your start-up’s true valuation.
- Know the amount of your seed investment
- How much equity to be given to the investors
- Have a strong Traction
- Building a good Reputation
- Have a distribution channel
- Understanding your investor’s perception
- Know your Option pool
The above mentioned Startup valuation steps help you to efficiently steer your business and take it to the next progressive stag.