What every early-stage founder needs to know about valuations

Today we had our Morning Coffee with Lolita Taub.

Contxto – 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 questions I get, and my answers 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

Below I share some of the factors that Brad Feld shares in Venture Deals, followed by my notes on each:

1. 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 (for example, 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 US$10 million 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 stockmarket’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?

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 #of engineers) - ($1M x # of 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.

Related: You might be interested in checking out Contxto’s Database complete with Company, Investor, Founder, and Accelerator info.

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:

1. 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.
2. 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 equity securities have an 18-month maturity date and an automatic conversion into equity at the next round of financing if US$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 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.

If you have any questions, please tweet me @lolitataub.

This post was originally published in the author’s blog.