February 12, 2008
Many of you have written asking how you should value your startup during the fund raising process. There is no easy answer. I will start by telling you how your startup is NOT valued. To the disappointment of finance types, valuations of startups are not done via net present value of future cash flows. From a theoretical sense that should be the valuation, but the future cash flows are really completely unknown. From my experience, financial models you write before your business has launched are not worth the paper they are written on in the startup world. They might be helpful to you to understand your gross and net margins and the scalability of the business, but beyond that their revenue and profit predictability is so low that you cannot base your valuation on them.
However, there are a number of elements that will come into play:
- Market size:
The larger the potential market size, the easier it is for VCs to justify a higher valuation.
- Capital requirements:
From a purely theoretical perspective capital requirements should not come into play, but in reality the more cash you need, the higher pre-money valuation you are able to ask for. Note that this is true of cash you need (to build the product) much more than cash you want (which would be nice to have to grow the business faster).
- Team track record:
Especially for the early stages before the product has taken off, the team’s track record will have a disproportionally large impact on the valuation. This abates as the company actually starts to show results.
- Team ambition:
If you are looking to build a multi-billion dollar company, it will be a lot easier for a VC to commit to a higher valuation than if you would be happy to sell your company for $20-100 million. If it’s your first startup, this compounds with the lack of track record to lead to a lower valuation because the expectation is that you should be more willing to sell in order to put money away. Once you have made it, you should be more willing to swing for the fences.
In the very early stages you will be evaluated on your progress to date. Have you been able to get the product out of the door with minimal cash before raising money? If the answer is yes, you took away a large component of execution risk and should be able to get a higher valuation than you otherwise would have. I would actually recommend starting to raise money only AFTER the initial product is out of the door and you have a few customers. You can build sites for extremely little in this day and age! Beyond this very early stage, you will be evaluated on your performance. Note that that evaluation might very well be non-financial in the first few years: traffic, customers signed, etc. It all depends on the expectations you set. Make sure you set realistic expectations, not to set yourself up for failure at the next round!
- Supply and demand:
Fundamentally, your valuation is going to depend on the attractiveness of your project on the market. If you are the only team with this type of project and many VCs are fighting over it, your valuation is going to be a lot higher that if multiple teams are going after the same market and you are able to garner the interest of only one or two investors.
Remember to try to anchor the price you want early in the discussion such that the negotiation is around that price, but be realistic (if on the upper bound of the realistic range) and remember that VCs like to own at least 15% of the companies they invest in.