Introduction to Startup Valuations
You’ve found a potential investor after many months of searching. He appears to like your project and sees the potential for everyone to make some serious money on the deal. You discuss your technology, marketing strategy, operational plan, and financing needs. You see eye-to-eye on practically everything. Then finally, when you are both feeling comfortable with one another, the question of valuation is finally broached. How much of your company are you willing to surrender in exchange for his investment?
That’s when the “you know what” hits the fan–every time. In your best estimation, his money is worth 20% of your company at best. In his estimation it’s worth 51%.
In many cases, the discussion grinds to a halt at this point. No negotiating item between entrepreneur and investor creates a wider gulf than this one. The two parties may agree on every other point but will have diametrically opposing views on what the company is worth and how much equity the investor should receive in exchange for his capital.
To put it bluntly, placing a credible valuation on a startup is impossible. Privately held companies on the sales block are typically valued at a multiple of their historical ODCF (Owner’s Discretionary Cash Flow). ODCF is the cash that can go into the owner’s pocket after all operating costs are covered for the year. Obviously, since a startup lacks any historical ODCF, which is the basis for an objective valuation, any opinions expressed on startup’s valuation by the entrepreneur will be little more than wishful thinking. I have been involved with buying and selling companies going back to 1991 and find startup valuations on par with arguing over how how many angels can dance on the head of pin.
It’s all made up but a number is required for entrepreneur and investors to come together.
As a rule of thumb, this is what invariably happens when a startup is seeking seed capital. The entrepreneurs convince themselves, based on discounting future cash flows, that the company is worth today, say, $5 million. So, since they are looking to raise only $500,000 the investor providing that sum should be happy to settle for 10% of the equity. Then when they start talking with a serious investor, they discover that he expects 50 or 51% of the equity for his money. That’s the magic number for most investors these days. Fifty one percent, no matter what the required sum is. It can be $50,000, or $500,000, or $5,000,000, the investor always wants 51% to insure that he has control should things head south.
Here’s some cocktail party trivia. During the dotcom madness it was reported that many venture capital firms, which were funding startup back then, automatically placed a pre-money valuation of $5 million on startups so as to avoid the tedious ordeal of arguing over it. And we all know how well that worked out.
Read more on negotiations here.
Important Terms to Know
Every capital seeker needs to understand these two terms.
Pre-money valuation: venture capital terminology for the valuation given to a company by a venture capital firm before it puts money into it. For example, a start-up is valued on a pre-money basis at $4 million. After $1 million is invested the company has a post-money valuation of $5 million with the venture capital firm owning 20%.
Post-money valuation: valuation placed on a firm immediately after receiving a round of funding.
More Resources on Startup Valuations
Do you set a valuation before talks begin with your investor? Find out how not to turn off potential investors.
What are the three best ways to maximize your startup’s valuation?
Online resources for startup valuations.
The Best Way to Maximize Your Startup’s Valuation
Startups that consist of nothing more than a business plan get the lowest valuations from all investors. You can dramatically boost your valuation and power in negotiations by doing what successful entrepreneurs do: creating traction first. Decide how you want to go to meetings with investors. As a player or as a beggar?