How To Value Your Startup: Investor's perspectiveData: 07/06
De Marco De Biasi
It’s important to understand what the investor is thinking as you present your business plan.
- The first point they will think is the exit – how much can this company sell for, several years from now. I say sell because IPOs are very rare and it is nearly impossible to predict which companies will. Let’s be very optimistic and say that the investor thinks that, like Instagram, your company will sell for $1 Billion. (This is just an example. So do not get caught up in how unrealisict that is. This is still possible.)
- Next, they will think how much total money it will take you to grow the company to the point that someone will buy it for $1 Billion. In Instagram’s case they received a total of 56 Million in funding. This helps us figure out how much the investor will make in the end. $1 Billion – $56= $ 940 million That is how much value the company created. Let’s assume that if there were any debts, they were already deducted, and the operational costs are taken out as well. So everyone involved in Instagram collectively made $940 Million on the day Facebook bought them.
- Next, the investor will figure out what percentage of that she owns. Valuation versus percentage ownership. Some investors are more interested in the percentage of the company they own, versus the valuation. In that way, you might end up with a higher valuation than you would have had otherwise. You can certainly take this approach to picking a valuation, but just make sure you’ll be able to at least grow into that valuation - preferably grow significantly past it - by the time you raise your next round. If she funded Instagram at the seed stage, let’s say 20%. Basically, all of these are just anti-dilution measures. The investor that funded you early on does not want to get diluted too much by the VCs who will come in later and buy 33% of your company. That’s all that is. Let’s assume in the end, like in How Startup Funding Works, the angel gets diluted to 4%. 4% of $940 million is $37.6 Million. Let’s say this was our best case scenario.$37.6 Million is the most this investor thinks she can make on your startup. If you raised $3 Million in exchange for 4% – that would give the investor a 10X returns, ten times their money.
- When we think of valuation, the other side of the coin is dilution. For any fixed invested amount, the higher the valuation, the lower the dilution. Investors and founders can get fixated on this tradeoff of valuation vs. dilution. A better way to think about this tradeoff is ownership vs. value add. Obviously valuation and ownership have their own relationship - they’re basically the same thing or two sides of the same coing (for any fixed investment, the higher the valuation, the lower the ownership). But if you shift the framework slightly and view the exchange or tradeoff as “ownership” vs. “value add”, then that can dramatically shift the conversation between the founder and future investors. Instead of focusing on the end result, (i.e., valuation/dilution), it’s better to ask questions like, “for X% of the company, what is the investor going to do to justify that ownership?”
- Pre-Money Valuation Versus Post-Money Valuation. Heading into negotiations with investors, first-time founders need to understand the difference between pre-money valuations and post-money valuations, as well as the implications they each carry with them. The current pre-money valuation of your company is simply the valuation of your company at the present moment before accepting investment proceeds. It’s the starting point. When you discuss negotiating a valuation, you’re dealing with the pre-money valuation. As you’ll see, the post-money valuation is a calculation, not a negotiation.
The post-money valuation can be calculated as: pre-money valuation + investment proceeds = post-money valuation.
Why is the post-money valuation so important? There are two primary reasons:
- The post-money valuation sets the bar as the current value of the company immediately after receiving funding. This impacts stock option issuance prices as well as the ‘paper-value’ of existing shares held.
- Additionally, the post-money valuation dictates how future pre-money valuations will be calculated. If the company continues to grow and hit goals, the next funding round should see a nice cushion between the prior post-money and the new pre-money. If not, you may experience a flat or down round, which isn’t good for you or your investors.
There’s no clean formula. Even though it’s inexact, investors will want to know the thought process behind the valuation you pick.The key is to not spend too much time thinking about it. Some incredible companies, like Dropbox and Airbnb, got valuations that would seem extremely low in this market for their first rounds.
In the end, it’s your ability to execute that will turn your company into a big one - not your valuation. It’s more important to close the round, get the money in the bank and get back to building.