Coming up with the right valuation for your company in the startup phase of a company’s life cycle can be very tricky.
In the early stages of formation, the value of your company is most likely close to zero. Obviously, using zero as your valuation is not going to help you find investors, because while they might appreciate your honesty, they will immediately see your lack of business experience. But what is the best way to determine valuation? As you will find out, it is more of an art than a science.
First of all, a startup is worth as much as the market will pay. If investors are willing to invest in your startup at a $10 million prefinancing valuation, then your startup is worth $10 million.
In the absence of such “real” market valuation from an investor, using market comparables is a common method used in valuing startups. Market comparables can assist you in your negotiations with potential investors. A number of service providers (accounting firms, law firms, 409A valuation firms, data statistic firms) publish startup valuation data. The data varies from service provider to service provider and industry to industry (mobile, energy, gaming, healthcare, et cetera). You should find data that supports a higher valuation for your startup and use such data in your negotiations with potential investors.
Assuming that you have gathered startup valuation data for your industry, how do you increase your startup’s valuation relative to comparable startups? One of the better methods is through competition among potential investors. Raising capital is a numbers game and a juggling exercise at the same time. Do not limit your outreach to one potential investor. Keep as many potential investor balls in the air as possible when raising capital without alienating potential investors. With just one potential investor, you do not have much leverage, and your next best funding option may be your own pockets. You have a better chance of increasing your valuation by being able to tell a venture capital fund, “I like you and your firm, but your valuation is below other VCs’ valuations.” If a venture capital fund really wants to invest in your company, it will increase its valuation in response to competition from other funds.
Another way is to focus on your startup’s future in your pitch. If you can convince an investor that your startup could be the next Facebook, Twitter or Amazon, you will have a much better chance of increasing your current valuation, even if you are a raw startup.
In addition to market comparables, if a startup has revenue and profits, there are many mathematical methods, such as discounted cash flows, that could be used in valuing the startup. For a raw startup, projections for revenue and profits are speculative at best and are not helpful in determining valuations.
You will find that sophisticated angel and venture capital funds use the numbers available to them to determine valuations, which are often scribbled numbers on napkins and notepads. If your potential startup investor is valuing your startup with complicated Excel spreadsheets, he or she may not be the right investor for your company.
Melanie G. Rubocki is firm-wide vice chairwoman of the emerging companies subpractice group and head of the business group for the Boise office of Perkins Coie LLP. Matthew D. Purcell is an associate in the business group at the Boise office of Perkins Coie LLP.