As an entrepreneur, it’s important to understand what is the valuation of your company. Although, it’s more like a diabetic focusing on his sugar levels report, but it’s crucial to understand how it’s done. It’s important for an entrepreneur to understand the process of valuation so that he or she can have a chance to make a compelling and creative case to the investor by showcasing the companies true potential.
Before we understand what are the methods used by investors to determine your company valuation, let’s first understand what are the factors that influence the valuations from an investor's perspective.
Traction in the business:
This is the number one thing that will convince your investors to invest at the desired valuation. The main agenda of your company is to attract consumers, and you earn your extra brownie points when you showcase that your company has already attracted ‘X’ number of customers before they invest in you.
New player VS Old Player:
This logic is transparent here, it’s about the founder’s reputation. In comparison with a new player, a Rahul Yadav of Housing.com can extract higher valuation no matter what his next idea is. Entrepreneurs with past history of successful exits, in general, tend to attract higher valuation.
The intuition: Change this point. Not valid. Else Change the heading from “intuition” to marketing skills along with strong pedigree”This should be “Reputation” and not “intuition because the article refers to the intuition of the VC and not the startup.
This method is not scientific, but we can take a case study for this to understand this in detail. Instagram’s founder, Kevin Systrom was able to raise a $ 500k seed round, despite having none of the pre-requisites like successful exits or past history. The only thing strong that he had on paper was that he was working for Google during the time and had the prototype ready. In this case, VC’s said that they just followed their instinct. The learning here is that how you project yourself makes a huge difference when you are lacking in traction .
What’s the Revenues like?:
Valuation at early stages is more like showcasing your growth potential as opposed to the current value. Revenues are far moore important in B2B startups than in B2C. Revenues make it easier to value.In B2C startups, revenue may lower the valuation of your startup. This is because if you are showcasing revenues so early in the business means that you are charging the services you are offering, which will hinder the pace of growth. Slow growth mean’s lower valuation as startups are just not meant to make money, they are meant to make money and grow faster simultaneously.
The Distribution Channel:
The rationale here is simple, Let’s say you want to disrupt the business of Dog Food Industry. Although your business is in the ideation stage at present, but if you have a Facebook Page with 14 million likes on ‘Dogs Information’ then your Distribution channel is already ready. 14 Million user likes is a strong distribution channel, so despite you don’t have the customers right now, but you have a strong unfair advantage with you that can get you to million of users in months.
Flavour of the Season:
So just like you have the flavour of the season in the equity markets, similarly, investors in the startup world travel in packs and are okay in paying premium if the certain industry is doing good. For e.g. startups in Tech, Food-Tech, and e Commerce are the flavour of the current season.
Now that we have understood what the factors that influence the valuations are, let’s understand the method’s used for startup valuation.
Discounted cash flow (DCF) is an appropriate methodology for only those startups that have a recent track record of revenues and expenses. In other early stage startups, assumptions decide these parameters which can be itself questionable.
Another methodology which is also based on traditional corporate finance valuation is the Price/earnings methodology, but this will also not provide an appropriate valuation as most of the startups are always losing money. Although, there are certain cases in which startups are making some sales in that scenario Price/Sales methodology can be used.
However, at present most of the VC’s are investing in startups with two valuation methodologies to establish valuation and they are as follows:
Latest Comparable Financings:
In this process, VC’s or investors will identify similar companies in the sector you want to start your business in. They will also find out at which stage a certain company was in the same sector to analyse your company valuation. Transactions that are outdated or older than two years in any segment or sector are not considered as current or latest comparable valuations. The ambiguity here is that some information may not be public, but many entrepreneur’s and VC’s know the right information of recent valuations of comparable companies through word of mouth and their experience.
Potential Value at exit:
The goal of the early stage investors here is to look for 10 to 20 times the return on their investments. This is by far one of the most used processes to establish valuations. The investor guestimates the exit value of the company based on recent mergers and acquisition (M&A) transactions in the sector and sometimes also looks at the valuation of similar public companies. Once he is convinced that he can see a high potential exit to his investment, he puts the money in.
As you see these techniques are used to set the valuation range and most of the investors will only pay the price closer to the lower range. As it is widely said that deciding an early stage business is more like art than science, so entrepreneurs need to use their creativity to the optimum level in valuing their startups.