I hate paying more for milk or gas than I have to. It bothers me. At the same time, I pay way too much for a small decaf latte hand-brewed by a local barista. One of the hardest things to do in life is to know how much to pay for something. The converse is also true. Selling milk on sale must anger my grocer. When the stakes go up, so do the emotions. Buy or sell your home in Silicon Valley during a tech bubble and you’ll witness serious anguish. The bottom line is that the only true value is what the buyer and seller agree upon. Everything else is conjecture. Startups are no different. Fortunately, there are ways we can approach the bottom line, which is what I’ll discuss here.
You wouldn’t pick a price for selling your home without looking at the comps, would you? Startups are no different. Find the closest startup to yours and start digging through the company’s digital history. Odds are that you can find some press release describing that company’s funding rounds. Crunchbase has tons of historic data to sift through. Of course each startup is a unique snowflake. That is why one should pick several startups in a similar rollout model or market and repeat this process. Look at the max and min valuation at each stage. Each of those data points is a grounding point. From there, you’ll have to wave your hands and say, we’re comparable because …
The Average Angel Round:
The angel round is challenging. Early-stage startups often don’t have revenue. They typically don’t have real traction. If the leadership team is good, they’ve validated the hell out of their startup with customer interviews, surveys and signups. But the value of a company is all about implementation opportunity. If the team fails, the company fails. One approach is to assume that your startup is average. Fortunately, angel.co has some awesome angel funding stats for you to play with (https://angel.co/valuations). You can find the average valuation for startups in Austin Texas or for mobile commerce. Of course, those include later stage companies, so you should pair those back by about half.
Snowflake Risk Factor:
Every entrepreneur thinks, “My startup is unique.” And they’re right. That uniqueness is both a pro and a con. The pro is that their uniqueness can help the team dominate a market opportunity. The con is that their unique team/solution hasn’t proven itself. Every risk factor is increased by the fact that a startup is a unique snowflake. Each risk decreases the value. Risk of team failure. Risk of stealth competition. Risk of the tech bubble bursting. The way you can de-risk your startup is to identify snowflake patterns. This snowflake’s rollout strategy follows this successful model. This snowflake’s CEO uses that successful leadership style. If you’re risk in each category drops by 50% in each of 5 categories, your valuation goes up 32 times. This is why valuation can rise from near zero at formation to something huge in such a short time.
Keep the Lights On:
If you need $500k in operating costs and you’re only willing to give up 20% of your company in this round, the post valuation is $2.5M (minimum valuation = operation costs/percent sold). The question is, “How did you get to your $500k operating costs?” Let’s assume you spent weeks fretting over an elaborate business plan, with projected inflection points, assumed salaries, overhead, marketing, services, capital expenses, taxes and more. If you’ve done this all before revenue, you can stop fretting. Your model will be wrong. This doesn’t negate the need for a valid projected burn rate. It just means that you need to understand what it costs. Every dollar spent on your startup is a dollar that could be spent on another. Go lean, but make sure you have enough to keep the lights on.
The Risk Reduction Model:
Startup studios invest in their spin offs from the problem identification stage all the way through launch and often for each investment round thereafter. Thinking back to the snowflake risk factors above, each incremental step taken by a startup decreases the risk thereby increasing its valuation. Valuation is much higher after validation than before. It’s higher after team forming than before.
If you think of a startup’s value as $2M at formation, you can roughly estimate the valuation at all other stages by assuming 60% reduced risk for each.
Risk Reduction Valuation
|Startup Stage||Odds of Success||Valuation|
|Traction (Angel Round)||32%||$5,000,000|
|Revenue (Series A)||80%||$12,500,000|
While it seems pretty simplistic to assume 60% risk reduction at each stage, this table illustrates a clear point; for each risk reduction stage you skip, you decrease your startup’s valuation a lot. Founders who skip one of these steps may drastically overestimate their startup’s value.
Team, Team and Team:
As I stated, the value of an early stage startup is based on the implementation opportunity. The leadership team is ultimately responsible for making sure that an astronomical number of startup goals are achieved. So, one way to valuate the company is just to evaluate the team. Do you have three experienced rock stars, or one part-time newcomer looking for a technical partner? Logic dictates that experience is worth a lot. A highly functioning team is worth more. Unfortunately, it is hard to be objectively and quantifiably evaluate a team’s likelihood to kick butt. Google tried and only came up with a loose guideline; teams that feel safe to communicate have better group IQs.
Identifying an excellent problem is worth a lot. It takes time and skill to explore important problems and decide which to pursue. I spend much of my year evaluating which problems to consider. Statistically speaking, I need to encounter 100 problems before identifying a 99th percentile problem to form a startup around. The reason I put so much energy into the idea, is that ideas can inspire great leaders to achieve great things. Without inspiration and hope, it is nearly impossible to harness the true potential of a leadership team. The true value of the company is only achieved when the leadership team implements the hell out of a solution.
Not all solutions are created equal. Some solutions are no-brainers once they’ve been discovered. Others are much more complicated. Most startup solutions that I see are half-baked. I have a bias for solutions that follow a standard mold. I hate when we have to invent a new type of wheel. By using a standard rollout plan, business model and marketing strategy, the leadership team can de-risk the startup (which I’ve already stated increases the value). Also, by understanding the plan early on, the startup studio can ensure that the team is suited for the tasks at hand.
Overall, valuating a startup is no simple task, there are a lot of components to consider to ensure the best and fairest valuation. However, there are some steps to take to help with this. The steps can include, having a strong team, going through each risk reduction stage (NO shortcuts!), being conservative with estimates, and avoiding the endowment effect. If you do these steps right, you’ll have an easier time valuating your startup and will end up with a higher number.
- Valuation Methods to consider are: Market comparisons and financial forecasts. Crunchbase, BizBuySell, and Bizquest. Financial forecasts are extremely difficult to construct however they are important for supporting your valuation.
- Valuation in a nut shell: The biggest determinant of your startup’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 recency and 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. (Carlos Eduardo Espinal)
- There are multiple methods in valuating a startup, some include: venture capital method, Berkus method, Scorecard valuation method, and the Risk Reduction model. (Marianne Hudson)
Author: Jesse Lawrence
Founder and CEO of Boulder Bits. Sci-fi lover, game theory strategist, and idea generator.