Your company’s valuation is determined by how much equity, or share ownership, an investor receives for their investment. A startup’s valuation represents its worth at a given point in time; its worth is based on the current size of the business, and estimated future earnings. It’s important for every founder to understand valuation, given its impact on not only their short-term prospects, but also on the long-term implications of the business.
Before raising or deploying capital, the first common question asked by both entrepreneurs and investors is: “what is the value of the company?” Correctly valuing a company is an essential part of the fundraising process, especially when raising money through equity.
The valuation that you, as a founder, and your investor agree upon will determine how much stock dilution there will be in the funding round. The valuation will also determine the price per share when it comes to selling your stock, either in future rounds or at an initial public offering (IPO).
For an early-stage startup, determining the valuation of your own company can be very tricky and imprecise, even more so if you are at the pre-revenue stage. It’s impossible to demonstrate commercial success at a large scale if you’re nowhere near product-market fit, much less a large share of your total addressable market (TAM).
Valuations take into account the product or service, projections for the business, and the TAM. At the early stage, valuation is more of an art than a science. Founders and investors are evaluating the company in the absence of concrete data points, and with no knowledge of the risks that the company will be exposed to, both now and in the future.
We can think of valuation as a measure of all the risks that have not been eliminated (team, tech, production, go-to-market strategy, etc). As a rule of thumb: the earlier the company’s stage, the higher the risk, the lower the valuation, the smaller the raise.
As a founder looking for capital, your mission is to show an investor:
Your company’s potential for value creation, how you’ll create it and how you’ll capture that value as the business scales.
The opportunity for an attractive return on investment.
Your ability to mitigate risk factors.
Let us explore some key valuation terms. In the context of a monetary investment, there are two ways to discuss valuation…
Pre-money and post-money
The company’s pre-money valuation and the amount invested determine the investor’s ownership percentage following the investment.
For example, if the pre-money valuation is $5M and the investment is $250k, then the percentage ownership is calculated as:
The pre- and post-money valuations cannot be treated in isolation when considering a proposed valuation. You should also consider other factors – such as liquidation preferences and dividends – to determine if this truly is a good deal.
The agreed valuation will determine whether it is a good deal. A trick for founders to be aware of is when an investor says, “I’ll invest $5M at a valuation of $20M. The VC is probably referring to the post-money valuation, which means they’ve given your company a pre-money valuation of $15M. If we do the calculation, $5M will buy 25% of a $20M post-money company. In contrast, a $5M investment at a pre-money valuation would only buy 20% of the $25M post-money company, with less dilution to the founders’ equity. The words pre- and post- have more difference than one could imagine.
How is valuation determined?
Most of the traditional corporate finance valuation methods are irrelevant to early-stage startups. For example:
Discounted Cash Flow (DCF) is dependant on a history of revenue and costs. While its assumptions on growth rates, market share, gross margins, etc. can be applied to create a valuation range, these assumptions are just assumptions for an early-stage company.
Price/Earnings (P/E) is another inappropriate valuation methodology since the majority of early-stage companies are losing money.
Price / Sales (P/S) may be used if a company has generated sales for a few years, but fails to offer a good dataset of companies one could compare the startup to.
However, two valuation methods are of greatest relevance for VCs looking at early-stage companies:
Recent comparable financings: The VC will make a comparison with similar companies, by sector and stage. While some of the information may not be public, entrepreneurs and VCs within Africa’s tech ecosystem will be up to date on recent valuations.
Potential value at exit: Africa’s startup ecosystem hasn’t seen many high-profile exits. However, the optimal goal is to exit with roughly 10x the capital invested over the fundraising lifecycle, whether that’s at a buyout or an IPO.
Without a fool-proof valuation method to rely on, the goal is to find a valuation with which you are comfortable: one that will allow you to raise what you need to achieve your goals (with acceptable dilution!) and one that investors will find attractive enough to write you a check.
For this reason, a helpful tip from other founders is to not put a valuation in your pitch deck, unless you’ve already signed a term sheet. It will be no more than guesswork. A guess too high will turn off price-sensitive investors, while guessing too low means you are over-diluting your company.
Remember there is “no free lunch”, and a high valuation is accompanied by high expectations for your future growth. A sensible approach is to let the market price your round, to the extent that you can, by allowing your lead investor to set terms and your valuation. What may sound like a concession is simply a means to defer to their expertise, and avoid biting off more than you can chew.
Read more articles
Data Room: Intro What is a data room, and how will it help you stand out to investors?
Deck: Market Size The size of your market opportunity can make or break your pitch. But there are…
