Tips and tricks on startup valuation
BY: ANA BARJASIC
Company valuation is always a challenge, particularly when it comes to young companies, because their future performance is uncertain. There are many formal ways to value a company but the question is whether investors will accept the valuation as well as the performance projections affecting it.
Entrepreneurs often outsource valuation reports to analysts or even online valuation calculators, but later have troubles justifying them if they do not understand the valuation methods used. It is critical for every entrepreneur to master the basic principles of valuation. This is not only important in order to be well prepared for investor meetings, but also for the overall financing and investment strategy of the company and future implications of early valuation decisions.
Valuation combines aspects of future profit and investment risk. The less uncertainty related to future profit, higher the valuation. Valuation of a company before the investment is called pre- money valuation. Post-money valuation refers to company worth after the investment. Example: 1 Million investment for 20% equity means the post-money valuation is 5 Million (1M/20%=5M). Pre-money valuation in this case is 4 Million (5M-1M=4M).
Investors will try to keep the valuation as low as possible before the investment, while entrepreneurs try to get the valuation as high as possible because it means more shares for them. In order to postpone the valuation issue, convertible note can be used. Convertible note is a loan for a period of usually two years, which is later converted into equity under special conditions for the investor. This type of financing is interesting for entrepreneurs, but not so much for the investors since it usually limits the profit.
Entrepreneurs have a tendency of inflating numbers in order to impress investors and get better valuations. Professional investors often walk away from unrealistic valuations. However, sometimes valuation disagreement can also come from interest in profit or control of the company, which can be solved with different types of shares.
Startup valuation is a highly speculative process, but here are some highlights to be taken in consideration.
1. Business plans can focus on expectations such as market share but should also focus on real commitments from clients. The ultimate goal is not getting investment, but creating a sustainable and profitable business.
2. Valuation should be linked with the future real performance of the company. If the sales in year X are Y, agreed valuation is Z.
3. If an investor insists on a low valuation, a possible solution is to agree on an option to buy back investor’s shares at a fixed price.
4. Different valuations should be offered to different types of investors. Crowdfunding investor is different from a business angel, an active investor is different from someone who does not contribute to the business.
5. High valuations can be glamurous, but can also be a trap for entrepreneurs, because at some point entrepreneurs will be asked to deliver their promises.
The most important message is – focus on execution. The more likely you are to execute the business plan, higher the valuation, which is ultimately good for both entrepreneurs and investors.
