Investors series — What’s your valuation? And how to answer that question.
“What’s your valuation?”
Perhaps you:
Want to low-ball the founder so you can get a good deal?
Save time by figuring out if founders have unreasonable expectations on valuation, so there is no point in talking more?
That’s fine if you have well-defined logic, but I don’t think it makes sense:
If the founder is dumb enough to be low balled they’re not going to perform anyway
Expectations are important sure, but you can learn more by waiting a little longer
You learn very little from that question. What you want to know is:
How smart is this founder?
Do they have strong logic abilities?
Do they have a plan?
You can get the basic info and a hell of a lot more if you ask probing questions.
The better question has two parts:
How much do you need to raise to hit your milestones?
What dilution are you targeting in this round?
Why do startup valuations (at an early stage) don’t make sense
When startups are at a later stage, sure there are metrics. Bessemer tracks public SaaS multiples which can be a benchmark (though need some adjustments). Here is an example of what that would look like:
5x their shite all revenue is shite all.
When founders are selling hope and rainbows, they don’t have meaningful numbers. Their valuation is based on their potential (and sales ability).
So you need to figure out how to value ‘potential.’ Let’s face it. You can’t.
How valuations really work
There is a formula for valuation. It’s this:
Valuation = Investment / Investor ownership (Dilution)
So if you agree on a valuation of $10m post, your investment is $2m and the dilution is 20%.
Only a dumb founder would give up 50% of their startup in one round, right? Yeah, fucked cap table.
But they should be ‘happy’ to give up maybe 20% for the right suitor. Maybe 15% is ok, 25% they can live with… but no more.
Now they need investment. They calculate around $2m, but could be more or less. That sort of depends on you ;).
So we can map this out and see a range of post-money valuations (in $000s):
On this basis, the valuation is between $4m and around $13m. That’s a big range. You may be price sensitive.
To tighten this up, you could argue they will achieve more with a larger raise, so you think they should take $2m. The range is, therefore, $8m to $13m post.
So startup valuation comes from how much you will invest and what dilution the founders will accept. It’s an output range rather than an input.
Learning more
What you want to hear is:
“According to our calculator, we need $2m. We are targeting a dilution of around 15%.”
You do some basic math and figure out the valuation range in your head.
Then you ask them to explain the logic.
How did they come up with $2m?
How long is the runway?
What milestones will you achieve?
etc etc
If they have well-formed answers then you learn a lot about the founders. And if you are dealing with great founders then they get the opportunity to differentiate themselves.
Now, how I value my companies and how I like to recommend to value companies is following this logic :
Valuation = Target Revenue x Industry Multiples
Target Revenue: What will be the annual revenue the company is aiming to reach with the help of this fundraising round, 1 or 2 years from now?
Industry multiples: What are the valuation multiples of revenue for publicly listed companies in the same industry or with what revenue multiples competitors got bought in the industry.
This method has helped numerous businesses I had advised to get (1)a good answer to that question (2)lock a decent valuation aligned with their future (3)align investors /founders incentives to the goal of revenue growth (4)align expectations to be market conservative (5)use industry data to define how to market perceived value in the industry. To me and my peers, those 5 points are pretty damn good, probably the best method we have found so far, and that’s why we always choose it.
And you, what is your experience with valuation? Did you meet startups pitching you crazy valuations? Did you invest too “cheap”?
Best,
Djoann
