Ever watched Dragons’ Den and seen the Dragons baulk at the value of a startup company? It happens all the time. And not just on TV, but in day-to-day business life, too. It’s not unusual for the startup’s valuation and the potential investor’s valuation to vary considerably.
If a startup begins to gain traction, it can be easy for the team behind it to start making wild valuations. In some cases, if the potential investor believes the hype as much as the startup’s owner, they may agree with this valuation. It could be that the investor has a heavy dose of FOMO (fear of missing out) and wants to be the first on board.
This kind of scenario sends valuations skyrocketing – but these situations often end in disappointment.
After all, being a paper millionaire doesn’t count for much.
To clear things up, this article will explain what investors look for in a startup, how a startup valuation works, and average startup valuations for different stages.
What do investors value?
Before making an offer, a would-be investor looks at the following:
A strong business idea
Is the product or service something the investor believes in, and does it interest them? It’s hard for angel investors to get excited about products that don’t stir their passions. For VC funds, it has to fit their investment thesis.
To an investor, the team behind the product is every bit as important as the product itself. Before making a decision, an investor is going to ask critical questions around the teams:
- Expertise (domain, startup, growth and technical)
- Mission and backstory
Is the startup pre-product, pre-revenue, or post-revenue? Does the company have a minimal viable product? An MVP shows just enough to make an investor want to part with their money, even if it’s not quite ready for market.
UK and European investors are more concerned with seeing revenue than their US counterparts. Just 8% of VC investors in the UK know what it’s like to work at a startup. For comparison, in the USA it’s 60%. Because the UK VC industry was schooled in banks and consultancies they have been wired to rely on data to make decisions. Therefore, securing a pre-revenue investment in the UK is notoriously difficult.
Intellectual property and technology
One of the most common questions investors ask themselves is how easy the product is to copy. If the startup can’t guard their product or some part of the process with intellectual property (IP) protection, this will reduce its attractiveness to the investor.
If a product is simple to copy, the market could easily become swamped with similar (and cheaper) versions.
When VCs assess a startup they are considering whether it can generate $100M+ in revenue and $1B+ in enterprise value reasonably quickly. VCs need investments to meet these levels in order to generate fund level returns.
To support this, a market size at a minimum of $1bn and preferably greater than $3bn is required.
What’s the competition like from other products or services? Intense competition and a difficult-to-break-into market will give an investor pause for thought. They don’t want to invest vast amounts of money into something only to see it fail to make a dent in the market.
But on the other hand, intense competition can be the sign of a growing market.
The product or service may well have high demand, but that doesn’t mean it’s profitable. In which case, even with significant financial investments, it could fail long term if profit margins are tight.
How much money does the startup need initially, and will it need further cash injections along the way?
The business model
Are there similar models the investor can compare the startup to, and how well have they performed over the years? What’s the market value of similar startups? And what was their value at exit, or when the company filed an initial public offering (IPO)?
While these are all important considerations, there is one factor that is more essential than any other: market forces. That means analysing factors such as:
- Whether there is a demand and supply
- Recent market exits
- Current market conditions.
How a startup’s equity is valued
Investors use several different methods to calculate valuation. The main being:
- Scorecard method
- Discounted cash flow with long-term growth
- Venture capital method
- Checklist method.
Scorecard valuation method
This is sometimes referred to as the Bill Payne valuation method, after the developer who published it in 2011. However, it was used by angel investors long before that.
This is one of the most popular methods used by investors to value early startup and seed investments. Investors with niche expertise favour this approach because of their industry knowledge.
Investors divide this method into two steps:
- Calculation of average pre-money valuation for pre-revenue startups. There are many sources for this data, including AngelList and Crunchbase.
- Comparison of the startup to similar companies. This step is complicated and time-consuming, and includes consideration of:
- Management teams
- Market size
- Whether the investment needs future financing
- Marketing capabilities
- Additional assets.
Discounted cash flow analysis
This method uses future cash flow forecasts to estimate potential returns (very hard to do in an early stage startup). The calculation provides a measure to decide whether investing now would give a worthwhile return in the future.
To estimate future cash flows, an investor will analyse the balance sheet from previous years, in order to arrive at a projected growth rate. In a startup there is often little historical data, and even if there is it bears little relevance to the future. Therefore valuations need to be based on forecasts that are hard to predict.
Investors then apply a discount rate (weighted average cost of capital, or WACC) to reflect the time value of money, and risk factors.
Of course, there are no guarantees with this method, as numerous factors outside of an investor’s control could impact the company’s long-term growth rate.
Venture capital method
Investors use the venture capital method primarily to value pre-revenue early-stage companies. To make the calculation, it dismisses any immediate cash flow and instead estimates the exit value.
As Equidam explains, an investor will estimate the exit value using the earnings before interest, taxes, depreciation, and amortisation (EBITDA) of the last projected years and applying the multiple.
Though the venture capital approach is efficient, it makes multiple assumptions, meaning that provides no certainty (but no valuations at this stage really provide much certainty).
Checklist or Berkus method
Used for pre-revenue startups, the checklist method is more widely known as the Berkus method. It takes its name from well-known angel investor Dave Berkus, who’s been using this model since the mid-nineties.
The checklist method values intangible assets. It begins by placing a fixed maximum price on the startup, based on its location, then applies a score for each of the five criteria set out in the method.
It uses the most significant risk factors that each startup faces:
The startup can then award itself $500,000 for reducing those risks, plus the startup automatically gets $500,000 for the idea itself. If it earns a perfect score, its valuation tops out at $2.5 million.
Typical valuations by stage
Naturally, a company’s value will vary depending on its stage. So, as a startup, what can you expect typical valuations to be? This will depend on region, competition, and long-term potential, as well as other factors.
- Funding range: from £50k to £150k in the UK/EU, and up to $0.5m in the US
- Valuation: from £0.5m to £1m (UK/EU), and $1m to $2m (US)
- Equity and runway: Expect to sell 10% to 20% of your startup to fund 9-12 months of runway
- Funding range: from £250k to £500k in the UK/EU, and up to $1m in the US
- Valuation: from £1m to £2m (UK/EU), and $3m to $5m (US)
- Equity and runway: Expect to sell 20% to 30% of your startup to fund 12 months of runway
- Funding range: from £750k to £1.5m in the UK/EU, and $2m-$3m in the US.
- Valuation: from £4m to £6m (UK/EU) and $6m to $10m (US)
- Equity and runway: Expect to sell 15% to 25% of your startup to fund 18 months of runway
- Funding range: from £3m to £10m (usually in the £4m to £6m range) in the UK/EU, and $5m-$10m in the US.
- Valuation: from £10m to £15m (UK/EU) and $20m to $25m (US)
- Equity and runway: Expect to sell 15% to 20% of your startup to fund 18-24 months of runway
Ultimately though, any startup valuation depends on how much an investor is willing to pay for it. Investors are not always the most logical of people and therefore a little FOMO and a sense of urgency and you can see valuation swinging wildly from the averages.
Pre-money and post-money valuation
Pre-money valuation is the value of a startup before it receives cash from a round of financing.
Post-money is the market valuation of a startup immediately after a round of financing.
Post-money valuation includes all the recent cash injections and outside financing from venture capitalists and angel investors.
Here are two simple equations to help you understand:
Post-Money Valuation = Pre-Money Valuation + Investment Amount
Equity sold = Investment Amount / Post-Money Valuation
With so many factors to consider, valuing a startup takes skill and understanding. Both investors and startups will look at their startup from entirely different angles, making it easy to see why a startup and potential investors may disagree along the way.
There are many factors that influence how an investor will value a startup, including the market size, profitability, and the team behind the investment. Beyond this, an investor will often turn to one of the many tried and tested methods of valuing a startup.
However, ultimately, at the end of the day, it’s the amount an investor is willing to invest that is important and the potential they see in an investment