Valuation Heuristics
What to think about when valuing your startup
As a founder at an early stage startup, you, an investor or someone else is going to be interested in the value of your business. Now, a third party looking from the outside in is looking through certain experiences and biases that may not necessarily align with how you see the business. This is where the strength of the founder comes to play because she knows what an investor or third party doesn’t.
What do you tell the investor your business is valued at?
It is said the value of a thing is ‘Whatever anyone is willing to pay for it’ that gives the power to the buyer or the investor who wants to buy into your business. While investors do their valuation and have various metrics they look out for, startup founders should also be valuing their companies and know what amount of it to give away. The best way to approach abstract problems such as this is to have easy to reason about heuristics that you can have as a foundation.
Below are a few common heuristics to put into consideration
Heuristic #1: Asset approach— This is arguably the most concrete approach. With this method, a business is valued by the number of assets they have. Here, you value the building, computers, servers, staplers and every other thing you call an asset. This method works best for family owned businesses that have been run for years and are seeking external investment. This may not work for a typical startup since all they have is a software and some money in the bank.
Heuristic #2: Intellectual Property — In a world where startups raise money based on white papers with complex ideas loosely stringed together, a startup’s intellectual property can be a very worth heuristic.
The potential of a patent can give the value of your company a very well deserved boost
Heuristic #3: Contract, Letter of intent etc — Look, there’s a lot of progress you have made since you started this journey. You’ve met customers, potential customers, signed contracts, and made relationships that will be monetized soon. This will help you have a sales forcast and well, you will know how much you will be making if you keep on with the grind and intensity for 24 months. This then leads to the next point.
Heuristic #4: Growth, Cashflow (DCF) — In finance and private valuation, this method has been widely used and accepted though, it may need some tweaking for you to apply to a startup what really young. What you need to do here is project future revenues or (free cash flow) basically, in 5 years, what should you be earning and based on the risk and arrive at a discount rate based on various risk fators. For a young startup, this method will be tweaked and carefully used because you get what you put in. If your assumptions and projections are flawed then you get a flawed valuation.
Heuristic #5: Market Size — This metric is important because the bigger the market size, the higher the growth projections. Of course, you need to figure out your TAM, SAM and SOM. Your SOM is where your meat is and should be the main focus. Usually, you shouldn’t get hung over this metric cos you stll have your work cut out.
Heuristic #6: What are others valued at? (Comparables) — This is a popular valuation method that requires you to look at similar companies that have received funding. Similarities could differ depending on what market and industry the startup. A similar startup could be startups in the same industry, market, location, customers, etc
Most of the above is cumulative. You can’t really pick one and run with it. And for what it’s worth, knowing all this gives you a bargaining chip that allows you make your case on the negotiating table and not get finessed allowing you get in the room with reasonable numbers that can be justified.
