Figuring the valuation on a company that isn’t making money is subjective but not arbitrary.
8 min read
Opinions expressed by Entrepreneur contributors are their own.
Every startup founder dreams of launching the next Airbnb, SpaceX or Uber. The glamour of these $1 billion+ valued startups motivates countless founders to chase after that coveted “unicorn” status with their own valuations.
However, the obvious question few can anwer is, “How exactly is a startup valued?”
Valuing a publicly traded company is very straightforward. Its market capitalization (or market cap) is simply the number of shares outstanding multiplied by current share price. The share price itself depends on known strengths of the company and market forces, and is therefore, seldom way off the mark.
However, the value of a (rarely profit-making) startup is not at all easy to calculate. In fact, it is at best, an estimate. In layperson language, you could take it to be the sum total of all the resources, intellectual capital, technology, brand value and financial assets that the startup brings to the table.
Very often, startups’ valuations far exceed the sum of their parts, and there’s no universally accepted formula that you can use. VCs, for example, start with the amount they want to exit with and go on to factor in the expected ROI, the amount they invest, the stockholding percentages they can negotiate with the founders to arrive at what’s called the “pre-money valuation.” That’s just one method, though. There are a ton of widely used methods to arrive at a startup’s pre-money valuation.
That brings us to the next logical question for founders — “What’s pre-money valuation and why should I care?”
Pre-money valuation is essentially how you value your business. It is the value you’ll quote to a potential venture capitalist or other funding source to get funding for your business. The higher (and more accurate) your valuation, the better is your capacity to attract funding. Unfortunately, research from CB Insights shows that the chances of the average startup hitting a billion dollars in valuation is less than one percent.
So what, you ask? Even if your startup doesn’t become the next unicorn in the Startups Hall of Fame, there’s no stopping you from getting a strong valuation from your investors. All you need to do is mind these seven things before your next pitch to a potential investor.
1. Paying customers who actually use the product.
Be it a search engine, a social network or even a dating app, every user loves a free-to-use service. However, most investors aren’t so thrilled about freebies. Not a single one of the top five US startups is a free-to-use service. Each one has paying customers.
Pinterest, which is a free-to-use social media network, comes in at number seven, but that too has its own clear revenue model. Even though the platform is free for members to use, it has customers who pay good money to advertise their products to Pinterest’s members, thus ensuring a steady revenue model.
No matter how potentially world-changing your idea might be, you need customers who pick up the tab for the work that you do. That’s the first thing that draws in discerning investors.
2. Traction: Where are you going and how fast are you getting there?
How long has it been since you founded your startup? How fast have you been growing relative to your competition? Where does the company seem to be headed in the next 12 to 24 months? These are all valid questions investors expect answers for when they evaluate a startup. Am ideal candidate for investment is a fast-growing startup in the initial stages of its lifecycle with a growth curve waiting to happen.
Some startups to hit a billion-dollar valuation remarkably fast. Scooter startup Bird hit the $1 billion mark 1.25 years after being founded; its valuation grew by mind boggling numbers in a matter of months. Valued at $400 million in March 2018, it nearly tripled in valuation in under three months!
3. Profitability: Show me the money!
Anyone can show a lot of revenue by burning through a ton of funding. Discounts, sales and freebies are easy ways to reel in the buyers and grow your revenues. However, simply focusing on revenues with nary a thought about margins, profitability or cash flows is a shortcut to startup disaster, as many failed ecommerce businesses have repeatedly demonstrated.
Africa’s first unicorn startup Jumia showed us that it’s possible to focus on ROI and profitability even in an intensely revenue-oriented industry like ecommerce. Instead of focusing on just conversion optimization, Jumia targeted revenue optimization through a strategy of aggressive retargeting ads. The results were stupendous. From a 57 percent ROAS (Return On Ad Spend) in Egypt to 120 percent in Nigeria, Jumia’s is the largest ecommerce player in all of Africa.
4. Brand value
As a new entity, consumers first need to be aware of a startup to use its products or services. Brand awareness and recall are critical to the success of any startup. However, not all brand value comes from spending big marketing dollars. A lot of it can come from word of mouth, PR and other sources.
SpaceX, currently valued between $20 and $25 billion, has outpaced revenue growth year on year. It’s true that SpaceX has pushed new boundaries in terms of low cost satellite launches, giving established players a run for their money. But the outsized valuation the company enjoys is in no small part to the halo effect the SpaceX brand enjoys from its founder Elon Musk’s personality cult.
5. Frequency of capital infusion
Consumers are not the only people with a fear of missing out (FOMO). When investors see a startup that’s received funding multiple times in the past, their interest is sparked. Clearly the startup’s earlier investors had faith that it would do well; letting a chance to invest in it go by might be a missed opportunity.
And that’s how money follows money in the startup world.
While the amount of funds raised by a startup can be a factor of its founders’ ability to pitch and close a deal, a startup’s past funding is often the prime motivator for new funding to come in. Ask any founder — it’s toughest to get early investors to believe in your vision and offer seed capital. Once the company has started off and proved itself, subsequent rounds come in on the basis of previous funding rounds and buzz about the company in the investor community.
6. Competition and maturity of market
First mover advantage may sound fabulous to a copycat business but it can be terrifying to the startup taking those first steps. When companies enter a new market or develop a market through a novel business concept, founders have two tasks ahead of them. First convince investors and then convince the consumer that their business idea is fabulous.
On the flipside, entering a mature market that’s crowded with established players means a startup is another me-too and its potential for growth will be limited. Funding will reflect this harsh reality.
However, if you’re a disruptor like Warby Parker, you have nothing to worry about. Warby Parker pulled off three compelling feats with consummate ease. Not only did it create the very first ecommerce business with a vertically integrated supply chain, it also dared to carve a niche for itself in the eyewear market that was monopolized by Italian giant Luxottica. Better still, Warby Parker even managed to raise $215 million at a valuation of $1.2 billion in just five years.
7. Understanding of business model
Finally, the amount of funds you raise and the strength of your valuation, boils down to the business you are in and how strong a grip you have on making it work. Hindsight is always 20/20, it’s taking a sound decision in the moment that makes all the difference.
Take Facebook for example. In its original avatar, Mark Zuckerberg and his co-founders spent considerable amounts of time and effort on getting advertisers for their site. Thankfully, Facebook did not become yet another publisher site for one-size-fits-all advertising. Instead, Facebook eventually realized that the company’s real value lay in their rich user data and gigantic user base that they monetized later to spectacular results.
No matter how big or small your business. As long as you know the mantra that makes your project sing, you can count on investors jumping in and joining the chorus!