What Every Early-Stage Founder Should Know About Valuations
By Backstage Principal Lolita M Taub
I get a lot of questions regarding valuation from founders who are looking to fundraise for the first time. So, for this post, I list the most common Qs I get and my As to them.
What determines a company’s valuation?
In its most basic sense, valuation can be calculated by multiplying the shares outstanding by the price per share. The thing is that company valuation is more of an art than a science due to the mix of qualitative and quantitative factors that go into it.
Value of company = Shares outstanding * Price per Share
- Stage of the company:
- Early-stage valuation is impacted by factors such as entrepreneur experience, the perception of overall opportunity, and the amount being raised.
- Later-stage valuation heavily relies on financial performance and projections.
2. Funding competition: there is a positive correlation between the number of investors who want to fund a company and the valuation of such a company.
3. Leadership team experience: because there’s a perceived negative correlation between more experienced entrepreneurs and risk, valuations of companies with more experienced leadership teams will be higher. Note: personal biases will play a role here.
4. Size and trendiness of the market: Your market size (e.g., TAM, SAM, SOM) and the growing demand of a company’s market will also have a positive correlation with valuation.
5. An investor’s entry point: Some investors have a valuation investment range. For example, an investor might only invest in companies that are valued at $10M or less.
6. Financials and other numbers: There is a direct correlation between how well a company’s financials and numbers stack up (against its given industry and competitor benchmarks) with the company’s valuation.
7. Economic climate: There is a tentative positive correlation between the stock market’s performance and the valuation of a company. That’s to say that if the stock market is performing well, valuations will be higher and vice versa.
Basically, if many investors perceive a given company to be less of a risk and more of an investment opportunity (aka shows signs of a successful exit) — due to its strong leadership, market size/trendiness, and numbers — the valuation of a company is likely to be higher than lower. It makes sense, no?
Remember, investors want to invest on the horse that’s most likely to win the race.
What are some methods that investors use to value companies?
Investors may calculate valuation by assessing:
- Comparables: the valuation of other companies with a similar profile
- Multipliers: industry revenue/EBITDA/EBIT multipliers
- Formulas, such as: pre-money valuation = ($1M x #Engineers) — ($1M x #MBAs) AND Net Present Value (discounted cash flows)
- Venture Capital/Leveraged Buyout Method
- Monte Carlo Simulation
- Book Value
- Replacement Cost
Tools used in value calculation include CBInsights, Crunchbase, Google.
Disclaimer: There is no one valuation method without flaws.
Is it mandatory to calculate a company’s value to fundraise?
Valuation in fundraising has several benefits. At a basic level, founders will know exactly how much of the company they’ve sold and they’ll also have a cleaner cap table. Valuation will also make life easier for everyone involved — investors and founders.
That said, companies don’t need to value their companies in order to fundraise, at the start. There are multiple fundraising vehicles that allow for a postponed valuation to take place in a future and larger fundraising. Such mentioned vehicles include, but are not limited to, the:
- Convertible Note — Investors give companies money in exchange for an opportunity to buy the stock at a discount in a future financing round. Until then, the “investment” is considered debt that pays interest. For a deep dive on convertible notes and how they work, take a look at Convertible Note | Examples and How It Works by SeedInvest.
- KISS (Keep It Simple Security) by 500 Startups. There is a debt and an equity version. Raad Ahmed does a good job of simply explaining both on Quora:
KISS debt version accrues interest (5%), provides a maturity date of 18 months, and converts to preferred stock if the company raises $1 million in the next qualified round.
KISS equity securities have an 18-month maturity date and an automatic conversion into equity at the next round of financing if $1 million is raised. KISS equity securities do not have an interest rate though, which makes them attractive to founders.
3. SAFE (Simple Agreement for Future Equity) by Y Combinator. A SAFE is neither debt nor equity, has no maturity date or accruing interest. For more details, take a look at Complete Guide to SAFEs by The Dorm Room Fund.
Should companies aim for the highest valuation they should get?
No. Because a too-good-to-be-true kind of deal is likely to hurt everyone involved in the next round. If you have a high valuation in one round, then fail to hit the right milestones and end up having to raise at a lower valuation, that’s going to dilute your original shareholders. If that happens, it’s possible that they block a new financing. No founder wants that — it’s already hard to run a company and fundraise.
Also, if a company raises at higher valuations, the company’s investors will expect a bigger exit and will block a sell if they are not happy with a selling price.
About Lolita Taub
Lolita is Backstage Capital’s Principal for the “It’s About Damn Time” Fund, a fund focused on investing in Black women-founded startups. Her prior early-stage tech investing experience includes Portfolia and K Fund. Before joining the VC world, Lolita spent nearly a decade in B2B enterprise tech, consulting and selling solutions to Fortune 500 companies at IBM, Cisco Systems, and Silicon Valley and NYC startups. Lolita holds a BA from the University of Southern California and an MBA from the IE Business School. She’s living the dream working alongside and investing in the next generation of diversity-led tech unicorns. 🦄 Find @lolitataub on Twitter, on Linkedin, or on the web.