When a startup grows to the point where it begins to seek investment, the valuation of the company is going to be one of the biggest factors to be agreed upon by the founders and investors. This is primarily because the valuation of the company determines how much of the company the investors will get in exchange for their funds, but it also has several long-term effects beyond the immediate investment round. Hence, getting the valuation right is crucial for startups, and here are some considerations founders must bear in mind to arrive at the right figure.
Valuation Methods
For more mature companies, the task of assigning a value to them is relatively easier due to the presence of standard methods, the most common of which is the earnings before interest, taxes, depreciation, and amortization (EBITDA) method. No such standard exists for new startups, first because they often do not have any revenue yet and also because tech startups often grow in unexpected ways, regardless of current revenue (or lack thereof.)
Nevertheless, there are a few approaches that are often adopted by venture capital investors when valuing a company, to arrive at an approximate amount from which to begin negotiations.
The first method is the Discounted cash flow analysis. DCF involves forecasting how much cash flow the company will produce in the future and then, using an expected rate of investment return, calculating how much that cash flow is worth. Another method that is often used is the “market multiple” method, which works by evaluating how much investors have paid for companies in the same vertical, as a multiple of the companies’ sales. The average is then extrapolated to the current investment as an estimate of how much the market values companies in that sector.
The underlying principle with these and other methods is that they are merely estimates which can be influenced upward or downward by a variety of factors such as the overall confidence which the investors have in the startup.
Pre-Money or Post-Money
It is always important to clarify if the quoted sum is the pre-money or post-money valuation. In the former, the amount refers to how much your company is worth excluding the funding that you are raising, while the latter refers to the company’s worth immediately after you receive the investment. For example, if your company is raising $500,000 at a pre-money valuation of $1,000,000; it means after the investment round is over, the company will be valued at $1,500,000. But if you are raising $500,000 at a post-money valuation of $1,000,000 then the company is worth $1,000,000 after the investment round is over. As we explained in our post on reviewing a term sheet, there can be a significant difference in the amount of equity you’ll be giving up in either case, so it’s worth clarifying that at the inception of the investment discussion.
Impact on Subsequent Rounds
Generally, a higher valuation is better for the startup. It helps the founders to keep more equity than with a lower valuation, which they can then offer to new investors in exchange for more investment down the line. A very high valuation can have damaging effects on founders’ ownership of the company in the event that subsequent investment rounds value the company at a lower price – so-called “down rounds.” Although down rounds often occur because a business doesn’t look as promising to investors as it did in the previous round, they can also occur due to factors beyond the founders’ control, such as a reduction of capital in the market as we saw during the peak of the COVID-19 pandemic.
Often existing investors have rights that will entitle them to additional shares in a down round, to prevent their ownership from being diluted in a down round. This protection can be in the form of weighted average anti-dilution and ratchet based anti-dilution which will have the effect of diluting founders, albeit to different extents, as we explained in our article on understanding term sheets. Where a down round appears imminent, founders must have their legal counsel review the investment documents from previous rounds and advise on what anti-dilution clauses exist and how that would impact the current round.
Other Termsheet Clauses
The valuation is typically the biggest factor in the minds of founders as they negotiate an investment round, but in our experience representing both startups and investors, there are sometimes more important terms of the deal which the founders would be better served by focusing their attention on. For instance, the valuation of a company might be less important in a few years if the founders have lost control of the company by giving up too much leverage via board and voting rights clauses.
It is crucial for founders to take a big-picture approach when negotiating a term sheet, and to have experienced representatives guide them through the process to ensure they are not being out-maneuvered to get a sky-high valuation at the expense of more important deal terms.
Conclusion
The valuation of a company will have an impact on the present and long-term future of the company, and that impact can be positive or negative. To avoid the pitfalls of a low valuation (and thus giving up too much equity), founder dilution, or loss of company control, founders will need to be very careful in negotiating with investors to arrive at a mutually-beneficial figure without losing sight of other crucial components of the deal.