As a founder, you may think that startup valuation is only something that investors consider when deciding whether to take the leap with your company or not. But this isn’t the case — startup valuation is important for founders too. In fact, the valuation of your startup is a crucial tool that you can use during the various stages of your journey.
At the beginning of your journey, establishing an accurate valuation can have a significant impact on your company’s ability to raise funds while avoiding significant equity dilution.
Toward the middle of your journey, a reasonable valuation can help you succeed in additional funding rounds while keeping your startup on track. The right valuation promotes the right operational structure, which allows founders to easily understand what has been achieved, what still needs improvement, and what additional funding is necessary.
And as you approach a meaningful exit, a reasonable track record of valuations aligned with your historical performance puts you in the driver’s seat for negotiations. This allows you to determine your company’s valuation rather than have investors tell you what it should be — after all, how can you know what you deserve if you don’t know your company’s true worth?
Now, how do you arrive at a reasonable valuation? Let’s take a look.
A Reasonable Valuation: The Goldilocks Principle
In many cases, founders believe that a higher valuation is better. The higher the valuation, the more your company is worth, and the more value you have created… right? While this approach to valuing a company is understandable, it has some flaws that can place significant pressure on the business and hamper its long-term flexibility and growth potential.
In most cases, high valuations beyond market multiples are not priced on a business’ current performance… they are priced on the investor’s expected, future performance.
While this may seem like validation… in reality, the company is now inflexible in its operating approach. Companies with valuations in excess of market multiples must grow revenue very quickly to validate their valuation in time for the next financing event. When a company fails to do this, they run the risk of taking a down round on the next capital raise, and losing even more equity in the long run. As expected, associated tailwinds may hit the business and the founders after raising at an excessive valuation:
- Pressure to deploy large amounts of capital in operations without having revenue to support the inflated costs for the first few years… This can lead to a higher monthly net burn rate, which many investors will view as improper management and as such, assign a lower valuation in the long run if the growth does not materialize.
- Pressure to live up to expectations and grow quickly in hopes that the performance catches up to the valuation. This can trickle down to the team and cause an unpleasant working environment, which leads to higher risks taken and more mistakes made.
- Pressure to raise even more in the next round and then deal with the fallout if that doesn’t happen… Especially in times of economic turmoil and when funding slows down, this can lead to founders losing control of their business.
At the other end of the spectrum, a valuation that’s too low shortchanges you and everything you’ve worked for. You want to raise enough funds to continue growing, but a valuation that’s too low may not get you what you need. It will also end up diluting your equity for less money, a big pill to swallow.
Since high and low valuations both have their dangers, we believe founders should aim for the Goldilocks principle — a valuation that’s not too high and not too low, but just right.
How Can You Achieve a Reasonable Valuation?
While a valuation is crucial for startups at their various stages, achieving a reasonable, accurate valuation is easier said than done. This is especially true for startups. Established businesses have a clear-cut path toward valuation: they can choose from several formulas and input the company’s data into one of them. Startups don’t have this “luxury” since they’re often lacking basic financial data.
So founders and investors can use different criteria for valuation:
- Cost-to-duplicate: How much would it cost to duplicate a company just like yours? The answer is the valuation.
- Market multiple: How much did similar companies raise in recent funding rounds? Those ballpark figures are where your valuation could hover.
- Valuation by stage: Investors are willing to invest x amount, usually a range, based on the stage of your startup.
- The team: Many investors look at the founder and their team when considering an early-stage startup investment. Their background, experience, and yes, their charisma too, all make a difference. Bear this in mind when determining your valuation.
- Traction: One of our investment analysts, JT, cites the importance of traction as something that investors look for when deciding whether to invest in a startup. Traction is essentially any data or information that shows that there is a market for a startup’s product or service. It can include revenue, customers acquired, software or app downloads if relevant, etc. Gather as much data on your traction as you can.
Founders can use one or a combination of these assessment tools to achieve a reasonable valuation. You can crunch the numbers yourself, delegate this task to someone on your team, or outsource the task to experts who can help you achieve your goal.
Whatever you do, do it — and don’t aim for sky-high or lowball valuations. Stick with the Goldilocks principle so you can get a reasonable valuation that’s just right — and you could reap the benefits many times over.