At some point in the life of a startup there will be a need to raise capital to grow the business.  In fact, the number of startups that are fully self-funded and able to grow and expand through the cash they generate is a pretty small number.  An important component of the process of raising capital is determining what your company is worth – in investor language, your valuation.  This is necessary for many reasons, not the least of which is to help an investor understand how much of the company they’ll own after they invest.

The subject of valuation and the mechanics of investment are expansive topics, so for this post, we’re just going to cover the basics of valuing your early stage company.  It’s not meant to replace the counsel of a good attorney, but it should help entrepreneurs gain a solid start in thinking about the subject of how much their company is worth.

To begin with, valuing early stage (and if it’s just you and perhaps a partner and your idea, you are early stage) companies is not an exact science.  There’s not a lot to go on since it’s just you (and your partners) and your idea/concept.  But there are things that you can do to reduce some of the ambiguity and guess work.  In this post, I’ve outlined some initial notions to keep in mind as well as some guidelines to use in valuing your company:

• Don’t fall into the trap of thinking your idea is the next Facebook and should be valued at $10M or $50M right out of the chute.  Remember, ultimately the market decides what you’re worth, not your own perception.  It’s OK to be “passionate about the potential, but be practical about the pennies.”
• Your value will be influenced (not necessarily based on) the following items.  The stronger these are, the better, as it’ll help in supporting your valuation.
  • Strength and experience of the leadership team: have they “been there, done that” before – building and growing a startup company?   Or, have they had considerable success in doing great things at an established company?
  • Measurable market validation: has the product or service received some degree of support from the end target customer/market?  Even though it’s early, your ability to test your hypothesis that people will want what you’re selling, will go a long way to helping investors understand your idea.
  • Prototypes:  do you have something that can demonstrate what “it” is?  Has it been in front of potential users and have you gotten feedback from them?
• Other factors that will influence an investor’s perception of your value include – the addressable market size, uniqueness of the offering, early customer traction, presence of competition, readiness of the market to buy the product, capital and time required to reach profitability and time to get into market.  Start adding these up to see what a prospective investor will see.
• Take an inventory of these things, attach a reasonable value to them and this will help create the support for your valuation.  Do keep in mind that the market is the ultimate decider of your company’s valuation; this will at least allow you to explain why you feel the company is worth what you’re claiming it to be.  NOTE:  see the items below regarding “typical” valuation numbers.

Some related process items to consider:

• If you have partners, have you discussed how much of the company each of you own?  If not, you should have this discussion.  Try to keep a balanced perspective in this conversation – just because you had the idea to start with, don’t look past the reality that it will take others to help make it successful.  Consider what each partner brings to the team and what value they’ll play in growing the business.
• While you’re talking about ownership stakes, think of how much you’re willing to give up to outside investors.  Many times this number is too low (potential greed issue) or too high (potential ownership issue).  It’s not unusual for Angel investors to ask for 30 – 50+% of the company, knowing that they’re taking on the greatest financial risk and will likely see their share reduced if future investors come on board.  Think of the ownership of the company in terms of a pie – what chunk of it will go to you and the founding team, to outside investors and lastly, future employees.  Don’t forget that you’re likely to be attracting new talent with the promise of offering them a (small) piece of the company.
• Because there is little to go on in terms of tangible assets, typical Angel investors will use comparable investments to help with valuation.  Since most early stage companies are at the same general starting point, a common valuation for a highly promising startup is $1M.  But a cautionary note – this will be influenced by how much they’re putting in and how much of an ownership stake they’re getting.  In other words, if they’re giving you $500K and you’ve agreed that this will give them a 50% ownership position, then the $1M valuation is appropriate.  On the other hand, if they’re giving you $50K and you’ve agreed that this is for 50% of the company, then your valuation is now $100K, not $1M.  Make sure the numbers line up, not just a random $1M valuation.

There’s a lot more that could be written about this subject, but I hope this helps you get started.  Again, keep in mind that the value of your company will be determined by what the market (ie, investors) believes your company is worth.  Build a good understanding of what you’re basing your value on, be reasonable in your expectations, plan for the future (in terms of other investors and employees) and work hard to create value.

Good luck!!

Marti Nyman, MOJO Agitator