Valuation matters to entrepreneurs because it determines the share of the company they have to give away to an investor in exchange for money. However, many entrepreneurs stumble at this question, losing the deal or most of their ownership, by having no answer, or quoting an exorbitant and indefensible number that convinces the investor that they don’t understand basic economics. Indeed, if you’ve ever watched Dragons’ Den on TV, you will have seen that valuation matters are common deal-breakers.
At the early stage the value of the company is close to zero, but the valuation is a lot higher than that. How is that achieved? Early-stage valuation is commonly described as ‘an art rather than a science’. While many techniques have evolved to assist in assessing the value of early stage, ‘seed’ companies, the value of a start-up company can often be summed up as follows:
The biggest determinant of your start-up’s value are the market forces of the industry & sector in which it plays, which include the balance (or imbalance) between demand and supply of money, the size of recent exits, the willingness for an investor to pay a premium to get into a deal, and the level of desperation of the entrepreneur looking for money.
If you’ve ever watched Dragons’ Den, you will have seen that valuation matters are common deal-breakers.
We will now look at some of the factors that influence the valuation in more detail:
Market Forces: A start-up company’s value, as mentioned earlier, is largely dictated by the market forces in the industry in which it operates. Specifically, the current value is dictated by the market forces in play today and today’s perception of what the future will bring. Effectively this means, on the downside, that if your company is operating in a space where the market for your industry is depressed and the outlook for the future isn’t any good either (regardless of what you are doing), then clearly what an investor is willing to pay for the company’s equity is going to be substantially reduced in spite of whatever successes the company is currently having (or will have) unless the investor is either privy to information about a potential market shift in the future, or is just willing to take the risk that the company will be able to shift the market.
Traction: Traction is perhaps the most significant factor that can affect an investor’s decision to invest. The mission of every company is to get users (not necessarily customers!) and if the investor sees users then it means the business case is proved. The faster you get users, the more they are worth. How many users? Well that depends off-course on the sector or target market the start-up is aiming at; a biotechnology start-up may only need a handful of hospitals to implement its technology to become successful, while an online service may need several thousand users to demonstrate economic feasibility.
Track Record: Entrepreneurs with prior exits in general tend to get higher valuations. The value of your start-up will be affected by yours and your team’s experience, track record and specialist skills.
Distribution Channel: Even though your product might be in very early stages, if you already found a distribution channel for it, your valuation may be much higher. For example, securing a contract with a big supermarket chain to distribute a product, once its development is completed, is often highly valuable for investors.
The faster you get users, the more they are worth.
Revenues: While the existence of revenues makes it easier to value a company, they don’t automatically translate into a higher valuation. In fact, in some cases, particularly in internet B2C start-ups, charging users may actually result in a lower valuation as it slows down growth. Would Facebook been able to reach over 1 billion user accounts if it was charging users from the start? If you are charging users, you are going to grow slower. Slow growth means less money over a longer period of time, resulting in a Lower valuation. This might seem counter-intuitive because the existence of revenue means the start-up is closer to actually making money. But start-ups are not only about making money, it is about growing fast while making money. If the growth is not fast, then we are looking at a traditional money-making business.
Is a high valuation desirable?
Very few start-ups have succeeded in growing into a mature business after having only one round of seed funding. An important tip is to treat your initial funding round as a stepping stone to more significant funding when you really want to ramp up growth. The money you raise during the seed round helps you to develop the technology and test the model, but once that is done, in order to really expand, build out the features and market extensively (and hire all the people to do these jobs), you may need to ask for several millions of pounds. Thus, when you get a high valuation for your seed round, for the next round you need a higher valuation. That means you need to grow a lot between the two rounds. A rule a thumb would be that within 18 months you need to show that you grew 10 times. If you don’t you either raise a ‘down round’, if someone wants to put more cash into a slow-growing business, usually at very unfavourable terms, or you run out of cash. In other words, an entrepreneur has two options:
1. Go for Big – Raise as much as possible at the highest valuation possible, spend all the money fast to grow as fast as possible. If it works you get a much higher valuation in the next round, so high in fact, that your seed round can pay for itself. If a slower-growing start-up will experience 55% dilution, the faster growing start-up will only be diluted 30%. So you saved yourself the 25% that you spent in the seed round. Basically, you got free money and free investor advice.
2. Raise as you Grow – Raise only that which you absolutely need. Spend as little as possible. Aim for a steady growth rate. There is nothing wrong with steadily growing your start-up, and thus your valuation raising steadily.
In conclusion, current market forces greatly affect the value of your company. These market forces are both what similar deals are being priced at (bottom-up) and the amounts of recent exits (top-down) which can affect the value of a company in your specific sector. Our Valuation Services provide entrepreneurs with the right tools and information to deal with investors and with tips to extract the optimal valuation for the business.