Valuing early-stage companies

Valuing early-stage companies

7th December 2015 by Shameel Khan

Valuing an early-stage business is notoriously difficult. Unfortunately, there is not a set formula or valuation method that is universally applicable for valuing companies at this stage for investors and entrepreneurs to lean on.

Traditional valuation methods (i.e. discounted cash flow) prescribe formulas based on a company’s past performance to give an indication of the company’s expected future performance. For a later-stage company this may work, but for an early-stage business that has little to no track record, whose future financial performance and cash flows are uncertain, has a high growth rate and whose terminal value is a long way in the future, these methods are difficult (basically impossible) to apply. This is why valuing an early stage company is often considered to be more of an art than a science.

The valuation of an early-stage company will be determined by a combination of factors, some of which are explored in this post.

HiRes-e1449252726769What is a valuation?

The main purpose of setting the valuation is to calculate what an investor needs to pay to own a percentage of the company today. There are two valuation numbers a company should be aware of; the pre-money and post-money valuation. These can be confusing but they make a big difference as to how much of your company you are looking to sell in your next investment round.

Pre-money valuation = the value of the company now, before you accept your upcoming investment

Post-money valuation = the value of the company after you accept your upcoming investment

Basic valuation calculation

Below are examples for calculating valuation:

If the business needed to raise £100k and believed that they should be valued at a £1m pre-money valuation (£1.1m post-money) then the business would need to offer 9.09% equity in their next round.  [1]

The maths for this is (100k/£1.1m) x 100 = 9.09%.

Contrastingly, if the business raised £100k at a £1m post-money valuation (£900k pre-money) they would have needed to sell 10% of their shares.

(£100k/£1m) x 100 = 10%

Understanding the difference between the pre-money and post-money valuation is fundamental to any investment deal. There are other investment terms and calculations that are important to understand but are not within the scope of this post. For a more detailed explanation on investment maths/terms see Brad Feld’s post on Venture Capital Deal Algebra.

Key factors to consider when valuing your company

The valuation of an early stage company will be determined by a combination of factors. Equity crowdfunding is a marketplace, like any other, and, therefore, the biggest determinate of the valuation of a company will be investor demand to get in on the deal. Below are some of the factors to consider:

  • Comparable companies/Industry averages – The industry in which a company operates will be extremely important in determining valuation. If a company operates in a “hot” industry i.e. Fintech, it is likely that it will be able to achieve a higher valuation compared to another company in a different industry at the same stage of development and current traction. This is because in a “hot” industry there will be a greater demand to make investments and more money ready to be invested resulting in higher industry average entry valuations. The second part to this is looking at comparable companies/industry exits. Looking at these will enable you to make a judgement on what a potential exit scenario could look like. Once a company has an idea of a potential exit scenario it is possible to work back towards a present valuation.
  • Market size – The larger the market in which a company operates, the bigger the potential upside of an investment. Therefore, the bigger the market, the bigger the potential valuation a company can command and vice versa.
  • Your team – An amazing team with high profile or experienced key members will be able to command a higher valuation as the higher the quality of the team, the more likely they will be able to build a successful company (or so their track record would suggest). For many investors the team is the most important factor in determining whether or not to invest.
  • Stage of development – If a business is still just an idea then it is very unlikely it will get the same valuation as a company that has a product in the market with customers or user base.
  • Traction – If a company has evidence that it is gaining amazing traction with really high growth rates then this will demonstrate to investors that the business is on to something and could result in a higher valuation.
  • Future Financing – Considering how many rounds of finance a business will need to reach an exit point is another important factor. Companies should avoid giving away too much equity too early, so that the founders and the team is incentivised to take the company all the way there. Good investors will understand this and take it into account.
  • Urgency – If a business needs finance urgently then it is likely that their valuation will be lower than a company that does not. This can appear a bit desperate, especially if you’re looking at a significant down round, so we’d suggest not resorting to this.
  • Unit economics – At the early-stage it is highly unlikely the company will be profitable (even many later-stage companies are unprofitable). Being able to demonstrate good unit economics for your product/service is important to show investors that your company will be profitable in the future.
  • The general economy – When the broader economy is performing badly (i.e. during a recession), it is likely that there will be less appetite to be invested in a high risk asset class such as early stage companies. Consequently, it is likely valuations during these periods will be lower than when the broader economy is performing well.

Other points to consider about valuations

Don’t risk down rounds

A company should think beyond their immediate round of finance. There is a significant risk in setting the valuation too high and then risking a down round on the company’s next raise. This does not help anyone. A company should have a road map of their financing rounds (as best as they can) and the immediate financing round should be thought of in the context of the company’s entire financing requirements. [2]

Terms

There is more to a financing round then just the valuation. The deal terms are equally important. You may be able to raise money at a higher valuation but if the deal terms are not good (i.e. liquidation preference shares at a high multiple ahead of you), you will be better off taking the investment at a lower valuation.

What should investors consider

All of the above applies to investors when considering the valuation of the company, but there are a few other points to bear in mind when thinking about a company’s valuation:

Upside risk – It’s not all about price.

Price is not the only factor to consider; Sam Altman, head of Y-Combinator, talks about ‘Upside Risk’.

An early-stage investor will make the majority of their money on their best or best few investments. These investments may deliver the big returns and cover the losses in the rest of the portfolio. Consequently, losing money on the company flat-lining is not the only risk an investor faces; the bigger risk could in fact be to not get in on the deal that turns out to be huge.

For an early-stage investor, getting overly hung up on valuation is not always the answer or at least your only consideration.[3]  The price should be reasonable but at the same time arguing over unsubstantial differences in valuations probably means the investment is not suited to you and your investment strategy.

Product, Market, Team

It is up to each investor to determine what they think a good investment opportunity is. Personally, I tend to agree with a lot of investors that the three most important factors to consider when making an early-stage investment are the product (and its future roadmap), the size of the market (and the opportunity) and the quality (and experience) of the team. These will likely be the most important factors in determining the success of a company and therefore will be most likely to deliver the returns you are looking for. Valuation is important but it should be secondary to ensuring you are investing in an company who you believe has the potential to deliver a successful company. Even better if you believe you can help them with their growth!

[1] Note that ownership percentage is always calculated after the investment.

[2] A down round occurs when you raise your next round of equity finance at a lower valuation to the previous round.

[3] This also includes terms if you are in the position where you are negotiating your own.

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Shameel Khan

Shameel works with entrepreneurs throughout the fundraising process as well as focusing on post-investment matters for our portfolio companies. He previously worked at Raileasy, an online rail ticket retailer and the accountancy firm BDO.

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