A Startup Is Like a Home Still Being Built. Don't Value it at Next Year's Dream Market Price When Pitching an Angel Investor.
As an entrepreneur looking for professional investors, one of the quickest ways to lose credibility and get rejected is to start with a ridiculously high pre-money valuation. I see it happen often in my angel investment group, and you can see it happen almost every week on the Shark Tank TV show. It's like trying to sell a home still being built at next year's dream market price.
Equally bad is professing no valuation estimate at all, asking investors to "make me an offer." You look like a chump, and probably won't like their low-ball response. Investors know that valuations at startup early stages are negotiable, but they do expect that smart entrepreneurs understand the top three elements of a startup valuation would include the following.
1. First priority is real revenue, customers and contracts.
If you have a proven business model with some sales, it's credible to apply a multiplier of five to 10 times this number for the first element of valuation. Thus, $100,000 of gross revenue in the last 12 months might be extrapolated to $500,000 to $1 million in valuation. Future revenue projections are not relevant at the pre-revenue stage.
2. Team strength and experience is value.
If the founder and team members have built a previous startup in a related business domain, that fact may add up to an additional $1 million in valuation for your startup. Investors will look to see how many employees are full-time and paid, versus week-enders or volunteers. Connections to industry experts and channels are another positive to highlight.
3. Registered intellectual property adds value.
Patents filed, even provisional, as well as trademarks, copyrights and trade secrets count as barriers to entry and sustainable competitive advantages. A rule of thumb used by investors is that real intellectual property can justify an additional $1 million in valuation.
According to the Angel Capital Association (ACA) blog, the average startup valuation for new ventures receiving angel investments has been around $2.7 million. I think you can see how the three elements listed above can be used to justify a valuation in that range for your startup. Of course, there are several additional elements which may be relevant, and should be considered to increase the valuation:
- Your startup owns physical assets with significant market value. Most new ventures have not yet acquired test equipment, buildings or other expensive items that could be resold or would be hard to replace. Take a hard look around and add valuation for anything you find in this category.
- Value of solution work to date which cannot be replicated easily. If you have a finished solution that would cost anyone a million dollars to reproduce, it makes sense to include that in your valuation. Investors usually discount these claims, since they know you had a learning curve and potentially several throw-away iterations.
- Factor in rapid growth and large future revenue projections. Using discounted cash flow (DCF) on future projections only makes sense if you can show you are already making revenues on the curve of your projections. This factor is more relevant to venture capital investors who come in at a later stage and expect more traction to qualify.
- Get premium for billion-dollar markets with double-digit growth rates. If your target market segment is very large and growing, an additional goodwill factor of a million dollars may be justified. It also helps to show that you have a big lead on competitors, there are very few alternatives at this point, and the barriers to entry are very high.
- Relate your startup to similar startups funded with a higher valuation. The concept of "comparables" applies to your startup, just like it does when you sell your house. If you can compare your startup favorably to another one recently funded down the street, it's highly likely that you can get a similar valuation, no matter what the size.
As you can see, the valuation of an early-stage startup is not rocket science. The calculations of investment in mature businesses, including earnings multipliers, financial ratios and inventory analysis do not apply. Investors are not looking for precision but do expect you to understand the basics. You don't want to be accused of giving away the company or find your dream dying due to grandiose expectations that can't be met before your startup runs out of money.
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