I often get this question from early stage entrepreneurs: “How do I calculate the valuation of my startup?”
The valuation of a startup is the value of the company at the moment when the first round of venture capital is raised. Valuation should not be the focus of the early stage entrepreneur. For more on that, please read on.
Am I ready to talk to a VC?
If VC’s are willing to talk to you, go ahead and talk to them. But the conversation will have tangible consequences only if your startup is at the stage of development for a VC capital investment.
You are ready to raise VC funding when at least one of the following conditions are satisfied:
- Users – Your B2C service has millions of users and that number is growing exponentially through social propagation. The target audience is everyone in the world. There is no business model, but who cares? You are the next Instagram.
- Traction – Your project has a significant number of users (hundreds of thousand for B2C, several customers for B2B) and at least one business model for monetization has been validated (advertisement, commission, subscription, sales, etc.). Your startup is not a website, it is a business.
- Innovation – Your project includes Innovation with uppercase “I”, that is applicable to the solution of a high-value concrete problem. The innovation is either protected by patent or is very difficult to replicate. You’ve invented teleporting.
- Resume – You have a well-formed project and a team that has previously created other companies that were successful and generated return to investors. Those investors are willing to offer capital even before the previous criteria are satisfied.
The details of the criteria above might vary slightly from a VC to another, but there is no magic. Note that VCs are professional investors investing capital from a fund that received money from other investors. The VC investor does not own the money and can only invest if they can model it based on the goals of the fund.
If none of the criteria above is satisfied, the valuation of your startup has no valuation.
But that should not be cause for alarm. It is the case of the vast majority of the startups. It doesn’t mean the project is wrong or has no future. It only means you need to execute further before its value creates a valuation.
If you need capital to execute before there is a valuation, you will need seed money, normally a smaller amount enough to run the company for a few months, provided by an Angel Investor.
While it is fun to guess numbers, there is usually no need to define a valuation to raise seed money. The angel investor usually receives convertible notes in exchange for the investment. Simply put, a convertible note is a loan denominated in dollars (often including interest and discount clauses) that is converted in equity participation if and when there is a first round of venture capital investment (when a more concrete valuation is defined by a professional investor).
Ok, got it. But what if I still want to guess what valuation I can get for my company?
The definition of a valuation at the raising of venture capital will take in account the structure of ownership (how many founders, how many key people) and the amount to be raised (which is a function of the money needed to execute as well as the preferences of the fund).
The investor must believe in the project and the team, so it has vested interest in keeping the team committed and motivated. There is no incentive to squeeze the entrepreneurs by defining valuation that is too low. So the actual valuation is based on real market perceptions, but ends up being a number that makes the round viable and a win for all parties involved.
Now, if after all this discussion, you really want to estimate a possible valuation, you can try at least three different approaches:
- Financial – If you have a solid business plan, valuation can be calculated based on the execution risk and the projections of revenue and profit and a possible sale or IPO. Because execution risks in early stage are very high, it is virtually impossible to achieve much confidence in a number. Normally, the investors try to model this, not the entrepreneur.
- Market – VC investments usually become public information. You can estimate your valuation based on the valuation of similar companies in similar stages of execution that are receiving professional investment.
- Opportunity Cost – Calculate the amount of the time and effort applied to the project and estimate what would be its value if that effort was applied in a well established business. This is the cost of opportunity of your project. This number is irrelevant to the investor, but can be useful for the entrepreneur to continuously monitor the viability of the project (the cost of opportunity must be always below the valuation one hopes to achieve in the future).