How Startup Valuation Works and How a Company Valuation Affects Financing

Company Valuation

This is part 7 of a series discussing how to think about your startup at different stages of growth. Parts 1 – 6 cover some of the crucial elements of creating a successful SaaS startup and strategies to consider during the early stages of growth. If you haven’t read through the previous articles in this series yet, it’s worth going back and catching up with how to start a company (what to do first), followed by how to know when it’s time to hire your first employee (and who to hire), strategies for raising capital to build a startup team, how to raise a seed round (and how to find Angel Investors), how to pitch to investors and raise angel money, and finally, how to raise a Series A round from Venture Capital investors. This article explains how startup valuation works and how a company valuation affects financing.

A Quick Tutorial on Startup Valuations

startup valuationIn the previous articles in this series we explored a variety of scenarios you might find yourself in while creating your startup. In part 6, we talked about the process of raising a real series A round, serious money. For the purposes of this article, let’s assume you have one or several firms in the later stages of negotiations with you and you need to decide how much to take and how much of your company they are going to get for it.

There are plenty of articles out there that will talk about the math and the finer details surrounding calculating a company valuation for your startup when raising money. I want to discuss how startup valuation works, how should be thinking about valuation in general and what it means for you now and down the road.

What is a Company Valuation?

what is a company valuationSimply put, the value of your company is an agreement between you and your potential investors of that value, not that different from valuing a house. Yes, there are algorithms and models for valuing revenue, profit, customer lists and the like, but ultimately it will come down to a negotiation and an agreement, so keep your expectations realistic and remain flexible during this process.

How to Calculate Valuation of a Startup

How to Calculate Valuation of a StartupIf you actually have revenue and customers, the method to determine and increase a company’s valuation will likely start with some model or another, usually some multiple of your business metrics. Every situation is different, so I won’t go into specifics here, but there are plenty of great resources out there to help you more accurately calculate a realistic valuation of your startup.

Consider the result of such a model as just a starting point for establishing value rather than an actual number to use as leverage during negotiations. Don’t let your company valuation be the deciding factor between reaching an agreement with potential investors or not at all. Pick your battles wisely, be aware of whatever leverage you do have (if any), and play your cards right for long term success (more on this in a moment).

If you don’t yet have revenue or customers, a more likely scenario, the valuation is much harder to establish as there is nothing to base it on. Funny enough, you can actually get a higher company valuation before you ship anything because it is all speculation. Once you ship, everything changes and becomes measurable where pre-shipping valuations are much more subjective.

Ultimately, as with any negotiation, it will come down to how bad they want to invest and what other options you have. If you have investors lined up and wanting in on your deal, your value will of course be higher, as will be your leverage for negotiating. If this is the only investor interested, plan accordingly.

How Your Company Valuation Affects Startup Financing

How Your Company Valuation Affects Startup FinancingThe company valuation you establish for this round affects several things. The obvious one is the amount of your company they are going to get for their investment. The goal then would seem to be to get the highest valuation possible, so you give up as little equity as possible.

While it’s true that a higher company valuation in this first round will allow you to either raise more money than you had planned or hang on to more of the company ownership, it’s worth considering what a lower valuation offer might mean, especially in the long run.

Pre-Money Valuation (Example)

Let’s look at a pre-money valuation example. Assume you are trying to raise $1 million in this series A round. Your negotiations have resulted in a pre-money valuation of $5 million. For this they are getting 20% of the equity in the company. At a late point in the negotiations another investor comes in and offers you the same $1 million at a pre-money valuation of $8 million so they are only getting 12.5%. This seems like an easy decision. Assuming the investors are of equal value to you, what’s the issue? Take the higher valuation and give up less equity.

However, sometimes a better-known investment firm with a stellar track record and reputation will come in with a lower valuation. Now you have to decide what the value of a bigger name investing on your company is worth and what that might mean for you and your company in later rounds of financing. Let’s explore this possibility a little further by classifying the valuations and offers as coming from an A-tier and B-tier venture capital firm, respectively.

A-Tier and B-Tier Venture Capital Firms

A-Tier and B-Tier Venture Capital FirmsVenture Capital firms have definite reputations and performance records. There is an informal tiering of firms. The ‘A-tier’ firms like Bessemer Capital, Sequoia or Draper Fisher know they bring tremendous clout and aren’t afraid to trade on their reputation. This comes in the form of lower valuations so they get more equity for their investment. They also bring deeper pockets for later rounds, very seasoned expertise and relationships with companies that you will want to do business with.

Going with a ‘B-tier’ firm or even what’s considered a boutique firm might save you some equity now, but can potentially create problems down the road when you need more money. If you can get one of the best it is almost always worth the extra equity to have them involved. If none of the big boys have stepped up don’t stress over it, they are extremely selective.

Post-Money Valuation

Post-Money ValuationYour post-money valuation at the end of this round of financing (post-money valuation is the established valuation plus the money coming in) is establishing a bar that you are going to have to deal with later in subsequent rounds of financing or an acquisition.

This bar you are setting is the number at which you will be measured when it comes time to raise more money. In the first example above your bar is $6MM, in the second it’s $9MM. While the money you raised was $1MM in both cases, the $3MM difference in valuation affects later rounds. This means you have to raise your company valuation to $9MM in order for the next round of financing to not be considered a down round.

The Difference Between Up-Round and Down-Round Financing

Down rounds tend to be bad, you are raising money after not meeting expectations and it’s going to be harder to get more money at any kind of valuation you might like. If instead you took the lower valuation, then $6MM is your bar.

If the company is valued at $7MM for the next round, the difference between an up-round and a down-round can be significant and have an impact on your ability to raise more money. A down-round can easily cost you more equity than you saved when you took the higher valuation. It can be hard to wrap your head around this, especially when you are likely full of optimism regarding your startup’s possibilities. A seasoned investor knows you will be needing more money later.

Valuations and their effect on the venture deal are complex. This is a great time to get professional help.

Enjoyed this story? Read the final article in this series in which I discuss alternatives to venture capital, comparing private equity vs. debt capital, and how to consider your funding options based on your company’s stage of growth.

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