What is startup valuation and why is it important for investors?
The valuation of a company in which you invest affects the amount of equity you get for your cash. The lower the valuation, the more equity you will get for the same amount of money. It seems instinctive to push down the valuation while negotiating with the entrepreneur to get the best' deal' possible for your capital, right? Though a natural way of thinking, there are several factors to consider.
Startup Valuation Overview:
Valuation is the estimated value of a company. It is something of an art form, and its calculation is never entirely quantitative. Startup valuation requires reliance on factors that demonstrate a company's potential for success rather than its historical performance. Startup investment is a game of risk and reward. The fact that a startup might not fulfil its potential is the risk investors must take. And that is why a reasonable valuation is an essential part of the process of raising funds.
As Anna Vital from FundersandFounders.com puts it;
"At the early stages, valuation does not show the true value of a company. It shows how much of a company an investor gets for his investment."
In that sense, an early-stage startup is worth very little in concrete terms (perhaps a few assets and cash committed by the founders). It is only when a company becomes profitable that anyone can really assign a quantified valuation. Therefore, startup valuation is inevitably more qualitative as it focuses on the future and the potential.
And so, because so many of the factors that contribute to the early valuation of a startup are unproven and open to interpretation – artistic validation rather than scientific – it is possible for negotiation to take place.
How is valuation worked out then?
Ultimately, the valuation of an early-stage startup is a mutual agreement between the entrepreneurs and the investors. It is basically an indication of the founders' bargaining position – if they're confident, they can make the valuation high; if they're desperate, the valuation will typically be lower.
There are, however, a number of factors which you should be looking for when attempting to deduce whether a valuation is reasonable. Keep in mind though, that many of these are subjective. Some of the most common to consider are:
Traction/Proof of concept. Team experience. Assets. Market opportunity. And Comparative valuations – the general trend for companies' valuation sizes at similar stages will also play a considerable role in dictating the sizes.
Pre-money valuation is the valuation set by the company based on the factors listed above.
Post-money valuation is pre-money valuation plus the fund invested in that round. Your equity stake will be a proportion of this, depending on how much you invested.
When you negotiate terms with a startup, you care about two numbers: how much you're investing and the valuation, which determines how much equity you'll receive in exchange. If you invest 50,000NOK at a pre-money valuation of 1 million, then the post-money valuation is 1.05 million. In this example, you would receive (0.05÷1.05)×100, so 4.76% of the company.
If the company later decides to raise more money, the new investor(s) will take a chunk of the company away from the existing shareholders. This is called dilution. Dilution is normal. Typically when dilution occurs, all shareholders are diluted, including the founders, so that everyone ends up with a smaller portion of a more valuable company.
Should you negotiate the valuation?
Negotiating is not always possible; if an investor has already invested in the round at a given valuation, it would be problematic for the founders to accept other investors' funding at a lower valuation (every investor in the round wants equal terms). So unless you're the first investor going into a round, this discussion is redundant. That said, it will still be valuable when evaluating an investment opportunity to see whether it's worth your investment.
Most of the time, you are unlikely to influence the valuation (usually because someone has already invested at that valuation). Still, when deciding to invest, you need to consider how much that valuation is likely to increase before the company exits. You don't want to risk your capital when the reward is unlikely to match the risk.
For instance, if you invest 50k NOK into a company valued at a pre-money valuation of 20 million NOK, you'll get (50,000÷20,050,000)×100, which is 0.25%. If the company then sells for 50 million two years later (without having raised more funding so with no dilution), you'll receive 0.25% of 50 million, which is 125k NOK. So you can see that for the level of risk the reward is relatively slim and not what startup investors are looking for.
In contrast, let's now say that you invested 50k NOK at a pre-money valuation of 2 million giving you a 2.44% stake in the company. If it then exits for 50 million (without any further funding and dilution), you'd get a pay-out of 1.22 million. This is the importance of investing at the right valuation.
So in reality what you are evaluating when considering investing in a company, is that the valuation is high enough for the risk to be sufficiently incentivized by the chance of reward. Too much risk for too little reward is to be avoided.
With this in mind, the potential upsides of negotiating a valuation down seem more apparent. And if you can justify it, you're entirely within your rights as a prospective investor to tell a company that their valuation is too high.
But here's why you should be careful...
In simple terms, you'd like to get as large an equity share as possible for your capital. That way, if the company exits your pay-out will be greater. With startup investment, it is always an 'if'. But you can make it even more uncertain if you turn the screw too hard regarding valuation.
Consider that your receiving more of the pie for the same amount of money, while it is a better deal for you, might mean that you have a larger chunk of a pie worth nothing down the line. And here's why: Investors have the capital and capital equals power in this context (as in most). If investors press the founders to give away too much equity too early, it can harm the company's ability to grow and succeed. Giving away too much equity too soon can leave the company unable to close later funding rounds and unable to recruit top talent and incentivize employees. Both of which are crucial if the company is going to achieve the big exit that startup investors yearn for.
In summary, the chances are that you will never get to negotiate a startup's valuation. But it is essential to be aware that companies are sometimes overvalued; investing in an overvalued company is a pitfall best avoided. On the flip-side, a company that has been forced to undervalue itself by investors may fail for that very reason. As such, when picking an investment, valuation is something for you to consider seriously. Ultimately, we come back again to the same point: whether you invest at a valuation of 1.5million or 3million, it doesn't matter so much; what matters is that the company succeeds.
Founders like their investors would do well to remember this: there is a distinction between making a company look good to raise funds and actually making the company good. Both parties should try to focus on the latter.