Perhaps the most frequently asked question by my clients: how do I establish a company valuation for my startup?
So, you have been working on an idea, you think you have problem-solution fit. Even perhaps product-market fit. After considering different options to fund your start-up, you have concluded that giving away some equity is the best way forward. You might be even considering equity crowdfunding…
In certain circumstances, you can avoid this thorny issue by raising money through a convertible round. In case that’s your chosen route, I wrote an in-depth article with the different types of convertible rounds and how to use them.
But there will be a point where you won’t be able to avoid it any more… and that’s why I created this quick guide to value your start-up (even if you’re not doing an equity crowdfunding round).
Let’s start from the beginning. What does a good deal look like?
The key here is willing buyer, willing seller.
The buyer, i.e. the investor is taking a big risk on an unproven business. He knows that and therefore will be looking for big returns in case the bet is successful. We’re talking that in 5 or 7 years he’ll want his investment back multiplied by a range of 3x to 12x, depending on the industry.
The seller, aka entrepreneur, wants to get enough money to execute their business plan while keeping control of the business (giving away too much would make them un-investable in future rounds). There are also other practical and emotional factors in play (like wanting to get ‘smart’ money or avoiding someone they don’t like in their cap table) but we’ll leave them aside for the moment…
There is a tension here… both parties will need to meet in the middle somewhere.
Why is it so difficult to agree on a company valuation for a start-up?
Well, for a start, there are no set rules for start-ups. And the typical ways of valuing an established company don’t work. Let’s take a quick look at them:
- Multiples of revenue or EBITDA: depending on the industry, a mature company will be valued at, for example, 3x their revenue or 10x their EBITDA. But a startup will have very volatile revenue (if any) and, most likely, negative EBITDA… next!
- Discounted cash flow: this assumes that past performance (in terms of positive cashflow) predicts future performance. Not a great idea for a nascent company with huge potential.
- Net assets basis: a potential buyer of a company looks at tangible (equipment, buildings…) and intangible (brands, IP…) assets and assigns a value to the company. But it’s quite unlikely that a startup has any of those…
3 methods to reach a company valuation for your start-up
So we need to get creative and look at alternative methods to value our company. And here are three:
- Rules of thumb: different industries (even different investors) have different rules of thumb to value a young start-up. For example, an app at the idea stage isn’t likely to be valued at over £250k. If you have an MVP, you could raise the valuation to the £500-£750k region. Only if you have recurrent revenue you’ll be able to go over the £1m mark. It’s something you’ll only find out by talking to several business angels or VCs.
- Finding comparable transactions: you could look at startups that have publicly fundraised through Crowdcube (link to the search function for funded companies), or Seedrs. There are clear outliers in both sites, so make sure you’re excluding them. Also, you could use tools like TechCrunch or Beauhurst.
- Working backwards from an exit: the last but probably most robust method. First of all, you’ll need to produce a business plan that covers 5 to 7 years, when a ‘liquidity event’ or exit is possible. Make sure you’re baking in the most sensible assumptions about growth, innovation roadmap, new markets, etc. After 5 or 7 years, it will be more reasonable to apply the method ‘multiples of revenue or EBITDA’ discussed in the previous section. You’ll be able to assign a company valuation at exit. Then divide this valuation by the expected return for your investors (remember, a multiple between 7 and 15 depending on your industry) and you will have a valuation at the present day.
My recommendation here would be to combine the three methods to reach a valuation that works for you and you feel comfortable defending. Run it through several people for a check – or even if you’re crowdfunding, the platform of your choice can give you a sense check so you’re not too far off the mark.
But the most important method…
… is to have validation from a cornerstone investor. Ideally a big name from the industry that believes in you and your business and is ready to put a significant chunk of the money.
Once you have a cornerstone investor, discussions with further investors in the same round will be hugely simplified. After all, you’ve already sold part of the company at a price. This cornerstone investor should, ideally, come from your network. It is surprising to see who your contacts in LinkedIn know… but if you’re unlucky, you can always do a bit of research and cold-email some players in your industry.
Wrapping it up
Getting to a company valuation is not a trivial matter for a start-up. As discussed, the two keys are getting to a ‘willing seller, willing buyer’ situation and find a cornerstone investor that’s happy to bet on you. If you need help with your company valuation or finding investors, please don’t hesitate to contact me.